Opportunity Zone Magazine Opportunity Zone Magazine Volume 1, Issue 1 | Page 71

POTENTIAL STATE PITFALLS: WHY CHOOSING YOUR INVESTMENT LOCATION IS IMPERATIVE
Phase II: Five-Year Tax Basis Step-Up
The QOF investors start off with a $0 tax basis in
the Fund, since the gain is being deferred until 2026.
However, after holding the QOF for five years, the
program allows the taxpayer to “step-up” or increase the
tax basis in their investment by 10 percent. Therefore,
a taxpayer with a $1 million deferred gain invested in a
QOF will increase their tax basis from $0 to $100,000
after five years.
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Phase III: Seven-Year Step-Up
After a seven-year hold, the taxpayer is entitled to a
secondary step-up of five percent, so in the seventh
year the taxpayer in the above example would receive a
$50,000 step-up taking the total tax basis to $150,000.
At this point, a sale before Dec. 31, 2026 would yield an
$850,000 gain, rather than the full $1 million gain that
was deferred.
When choosing an
investment state, tax planning
is imperative. Since only 31
states have fully embraced the
program, taxpayers may still
incur a tax liability in their
home state,
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Phase IV: Dec. 31, 2026 Deferred Gain Recognition
Assuming the QOF has not yet been sold by the end
of 2026, the investor will be required to pick up the
remaining deferred gain of $850,000 ($1 million -
$150,000 basis step-ups from years five and seven).
At this point, the investor’s tax basis in the QOF has
increased to the full $1 million deferred gain. A sale
of the Fund at this point would yield a federal tax gain
equal to the difference between the sales prices and the $1
million tax basis. Therefore, 15 percent of the tax gain
($150,000) will permanently escape federal taxation. If
the taxpayer holds the QOF through 2029 or longer (10
year hold), they can also exclude from income tax the
appreciated value of the Fund (the tax basis steps up to
fair market value at year ten or more when sold).
STATE TAX RULES: A MINEFIELD FOR INVESTORS
State conformity to this program is varied and requires a very
careful state-by-state analysis.
Even though every state has qualified OZ census tracts, the
OZ program is a federal statute and state conformity is in the
hands of the state legislators. To date, only 31 states and the
District of Columbia8 have elected to conform to the federal
program.
While the federal program offers tax planning opportunities,
the state ramifications can be a minefield for the uninformed.
When choosing an investment state, tax planning is
imperative. Since only 31 states have fully embraced the
program, taxpayers may still incur a tax liability in their home
state, and potentially other states if the QOF makes multi-
state investments. As a result, taxpayers considering making
an QOF investment should have a CPA or attorney who is
very familiar with the tax aspects of the program thoroughly
review the investment prospectus.
OPPORTUNITY ZONE STATE-LEVEL TREATMENT
Assume a New York resident (a conforming QOZ state) reinvests
a $1 million gain from the sale of a New York asset in 2018 into a
2019 QOF that then invests into a California (a non-conforming
state that may allow limited OZ projects) real estate project.
Further, assume that the QOF subsequently appreciates to $1.7
million in year 10, the year of sale of the QOF investment.
OPPORTUNITYZONEMAGAZINE.COM
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