Among the many benefits of investing in a qualified opportunity fund (“QOF”) is the deferral of tax on current capital gains. Specifically, if an amount equivalent to a current capital gain is invested in a QOF within 180 days of the realization event, the tax generally will not come due until the earlier of the year in which the QOF investment is disposed of or 2026. As an added benefit, there may be a reduction in the amount of the capital gain subject to tax (up to 15 percent) when the tax bill comes due.
Many investors assume that the capital gains rate to be applied when the tax bill comes due is the same rate that would have applied absent deferral. Those investors may be surprised to learn that they are potentially engaged in a game of tax rate arbitrage.
While short-term capital gains are taxed at the taxpayers’ respective ordinary income tax rates (now capped at 37 percent), long-term capital gains tax rates are currently imposed on a non-corporate taxpayer at 0 percent, 15 percent and 20 percent, based on the taxpayer’s taxable income. In addition, taxpayers earning over $250,000 (if married filing jointly) or $200,000 (if single or head of household), are subject to an additional 3.8 percent tax on their net investment income. Thus, the maximum current long-term capital gains rate is 23.8 percent.
An often neglected risk of investing in QOFs is the potential future increase in either the ordinary income rate (with respect to investment of short-term capital gains) or the long-term capital gains rate. Neither the Internal Revenue Code nor the proposed regulations under the QOF program expressly freeze the rate applicable to deferred gains when the tax later comes due. In the event of a downturn in the economy, further increases in the budget deficit, or other factors supporting the need for additional revenue, there is a possibility that Congress would increase the individual tax rate and/or the capital gains tax rate in the future.
If Congress raises either the individual rate or the capital gains rate in the future, QOF investors may still benefit economically from the QOF program. But, whether the time value of money associated with the deferral along with the potential future discount of the deferred gain (by as much as 15 percent) is sufficient to offset the potential added tax cost is anyone’s guess at this time.
QOF investors should understand that the current deferral on capital gains tax is not free from the risk that the individual income tax rate, capital gains rate and/or the net investment income tax rate in effect during the tax payment year may be higher than corresponding rates in the deferral year. As always, investors should consult with their tax advisors before making a decision to invest deferred capital gains in a QOF.