If you recently sold your business, you may have heard about defering or even eliminating some of your taxes by investing in a Qualified Opportunity Fund (QOF). If you're thinking "What the heck is a QOF?", this article is for you. In 5 minutes, you will (a) understand QOF's and the tax benefits available, (b) see if you qualify, and (c) have a QOF strategy that's right for you.
What is a QOF?
A QOF is a type of investment. Yep, it's that simple. It works kind of like a mutual fund - you invest money into a QOF "fund", and the manager of that fund selects the specific investments.
QOF's are unique in that:
- only certain people qualify to invest in them (people who have a capital gain), and
- only certain things can be invested in (companies &/or properties located in specific places)
QOF's were created to help encourage development within disadvantaged communities. People like you who just sold their business are typically sitting on cash, cash that would be perfect for investing into properties and companies located within these "opportunity zones". Realizing that people in your position are also facing a big tax bill in the coming year, the government incentivizes you to invest your newfound cash by giving you a way to avoid the tax! It's a win-win! You benefit with tax savings, and communities benefit by having access to more jobs and and educational opportunities. The "fund" just makes it easy - their job is to manage the nitty gritty details so that you don't have to!
What are the tax benefits of a Qualified Opportunity Fund?
There are two tax benefits available to QOF investors:
- The first benefit is called a "deferral". This just means that you don't have to pay your tax bill right away. There are two main reason people like this deferral benefit. First, it allows you to invest your money to make more money instead of using that money to pay taxes. Second, it allows you to "kick the tax burden out" to a future year - ideally a year where your tax rate is lower than it will be this year!
- The second benefit is an optional one (and depends on how long you are interested in holding onto your new investment). If you are willing to keep your money invested in the QOF fund for 10 years, you don't pay any taxes on the gain from your investments. That's why I like to call this one the "woohoo no taxes" benefit! Just to illustrate, let's say you invest $5 million into the fund and cash out at $20 million, your tax bill is ZERO.
Sound good? If so, see if you qualify in 2 easy steps:
Step 1: Make sure the sale of your business falls within these time limits:
If any of these apply, the timing of your sale is perfect!
- You sold your business in 2022 and received the cash proceeds from the sale within the past 180 days
- You sold your business in 2022, and you are partnership or a corporation (it's okay if you received the cash proceeds >180 days ago as long as you are not a sole proprietor)
- You sold your business in 2023
- You will sell your business in 2023
Step 2: Make sure your proceeds are eligible for the benefit:
When you sell your business, a certain portion of your proceeds will likely be taxed as ordinary income while another portion will be taxed as a capital gain. Any portion of the sale taxable as a "capital gain" qualifies for the QOF tax benefit, while amounts taxed as "ordinary income" do not qualify.
Still in? Let's figure out how much you can save!
Step 1: Determine your capital gain.
Schedule an appointment with your tax advisor after the sale of your business (and before tax season)! You only have 180 days after you receive the cash proceeds from the sale of your business to pursue this tax strategy, so time is of the essense!
Ask your CPA to help you fill out IRS Form 8949 "Sale & Disposition of Assets" in advance. Although this form will ultimately be filed with your taxes, you want it as early as possible for planning purposes! This is the form where your CPA will list everything from the sale of your business that the IRS will consider as "capital assets" subject to capital gains tax. Page 1 lists your short-term capital gains and Page 2 lists your long-term capital gains. Both qualify for your QOF investment strategy!
All you need to do is pull the total (listed in Column H) from the bottom of both pages - this is your total capital gain. This is the amount you should invest into a QOF to receive the biggest possible tax benefit - an offset of 100% of your capital gains tax!
Step 2: Determine your potential savings.
Your potential savings is equal to the amount of money you would have had to pay in short-and-long-term capital gains taxes. This number will vary from person to person, but will be easy for your CPA to estimate based on your annual income.
Like what you see? Map your strategy!
Step 1: Make sure you have a "deferral" plan in place.
Remember, the first benefit of a QOF investment is just a deferral - meaning you will still have to pay the capital gains tax associated with the sale of your business at some point! Right now, the IRS requires you to pay your capital gains tax on the earlier of (a) the time you exit your QOF investment or (b) April 15, 2027.
Since most QOF investors also want to take advantage of the "woohoo no taxes" benefit of a QOF investment - the ability to avoid paying any tax on the gain from your new investment - you need to make sure you have enough "liquid" funds available (outside of the QOF) to pay your deferred capital gains tax bill when it comes due in 2027.
Step 2: Know what you are looking for in a QOF fund manager.
It's important to know what you are looking for in a QOF investment before you start looking at options. Here are three important metrics:
- Find a QOF fund that specializes in individual investors like you.
- Find a QOF fund with the same investment goals as you. Believe it or not, many QOF funds have a single purpose - to defer taxes. They aren't set up to make money! It's important to find a fund that is aligned with your goals. Similar to mutual funds, certain QOF funds focus on emerging growth (higher risk, higher returns), while other focus on stability (typically real estate) or preservation of income (lower risk, lower return).
- Find a QOF fund with the same time horizon as you. If your goal is just to defer your taxes to a year where your capital gains rate will be lower, choose one or more QOF's with exit year targets that align with when you want to pay the tax. (Your options are 2024, 2025, 2026, or 2027.) If your goal is to defer taxes, make a nice return on your investment, and pay zero taxes on the gain, choose a QOF with a growth-driven manager and a 10-year target.
FDLD specializes in bringing growth-stage, high impact investment opportunities to individual investors, including but not limited to QOF options. We have a down-to-earth, no pressure approach and love introducing investors to their options in private equity.
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