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Using opportunity zone investments to super charge estate planning

Authored by John Loew

The significant income tax benefits afforded to opportunity zone (OZ) investors create numerous gift and estate tax planning considerations. The OZ incentive allows investors to gift their interest in a qualified opportunity fund (QOF) to a grantor trust enhancing the available tax benefits, particularly in light of doubling the lifetime gift exemption that was made available to taxpayers as a result of the Tax Cuts & Jobs Act (TCJA). If lifetime gifting is warranted, this strategy maximizes the tax-deferral benefit of a QOF investment for both investors and their heirs, potentially resulting in the best combined estate and income tax outcomes.

Opportunity zone benefits

The OZ incentive, created by the TCJA, is designed to stimulate new investment in designated communities. Virtually anyone with capital gains can receive federal tax benefits by investing those gains in a QOF, which in turn invests in real estate projects or operating businesses located within the more than 8,000 qualified OZs across all 50 states and U.S. territories.

A QOF investment offers three potential tax benefits:

  • First, the tax on the original capital gain is deferred and reported on the 2026 tax return, or in the year the investment in the QOF is sold, if earlier. 
  • Second, 10% of the deferred gain is forgiven for QOF investments held for five years, and 15% is forgiven if the investment is held for seven years by Dec. 31, 2026. 
  • Third, the tax basis of an OZ investment held at least 10 years is deemed its fair market value on sale. The result is that all taxable gain on the OZ investment is permanently eliminated, which is the most valuable attribute of the OZ incentive.

Estate planning benefits

Individuals generally have two different types of assets:

  1. Income in respect of a decedent (IRD) assets are generally income tax favored during a person’s lifetime, like an IRA, 401(k) account, annuity, note receivable from the sale of an asset or, now, the deferred gain portion of a QOF investment related to an OZ.
  2. Non-IRD assets are stocks, bonds, or real estate that would generate income taxed as capital gain when sold. This type of asset gets a step-up in basis if held until the owner’s death.

Non-IRD assets can be gifted during a donor’s lifetime, but the donor’s income tax basis carries over to the recipient. Consequently, any unrealized gain inherent in that asset passes to the recipient. The recipient, therefore, recognizes capital gains when the asset is sold. If the asset is not gifted during the donor’s lifetime, but received by a beneficiary as the result of a transfer by will or trust, the asset gets a step-up in basis at the decedent’s death to the date of death value. However, if applicable, the estate will pay a tax on the stepped-up value of the asset. In sum, non-IRD assets are awarded favorable income tax treatment at the expense of estate taxes.

IRD assets, in contrast, are given a favorable income tax treatment during the holder’s lifetime (e.g., a deferral of current recognition for any income build-up) until payments are received from the asset. Under the proposed OZ regulations, the original deferred capital gain is treated as an IRD asset.

IRD assets often cannot be gifted in a tax efficient manner because the IRS does not allow the income from the asset to be assigned to another taxpayer. In other words, the transferring of ownership during the holder’s life, even if allowed under the current law, would accelerate the recognition of income. A QOF investment generally cannot be gifted to another taxpayer without triggering immediate recognition of the original deferred gain, termed an “inclusion event.” However, a QOF investment may be gifted to a grantor trust without triggering an inclusion event.

Proper planning

If an investor properly plans for the ultimate disposition of IRD assets to the next generation, the OZ income tax deferral on the original gain remains in place past the investor’s death until reported on the 2026 tax return. The regulations also clarified that the QOF can be transferred at death and the OZ tax benefits are maintained. Since there is no step-up for the original gain that was deferred until 2026, the potential for the tax-free appreciation benefit on the QOF investment remains intact. 

For example, an investor that will clearly have a taxable estate could gift their QOF investment to a grantor trust, thus removing the OZ investment from their taxable estate using tax basis instead of fair market value. Upon the grantor’s death and distribution of the QOF investment from the trust, their heir(s) will assume the original tax basis of the QOF investment (no step-up on death), but the tax basis of the QOF will step-up upon disposition by the heirs, if held 10 or more years (measured from the date of the QOF investment by the grantor). Significantly, the heir receives a step-up in basis at the time the asset is sold and not at the decedent’s death. As such, the heir pays no tax on capital gains, even if the QOF interest is held and appreciates in value subsequent to the decedent’s death.

Note: The deferred tax on the sale of the original asset will still be reported in 2026 (with the 10% or 15% discount, if applicable). If the grantor is living at that time, the tax can be paid with personal funds, thereby further reducing assets within their taxable estate. If the grantor dies prior to 2026, the resulting tax liability would either fall on the recipient of the QOF, if it is transferred out of the trust, or become the responsibility of the trust if it continues as the holder of the QOF.

Caution: There is an instance where the transfer of QOF assets at death can become an inclusion event for purposes of federal taxes. This instance can occur if the QOF investor identified a specific amount to be provided to an heir upon the investor’s death, say $1 million. If the executor for the estate knows a QOF investment is valued at $1 million and fulfills that specific bequest by transferring that investment to the heir, the act will trigger recognition of income on that investment. Anytime an IRD asset is passed on to satisfy a bequest of a specific dollar amount, acceleration of the income is triggered. To avoid this, you can pass on the OZ related investment by name instead of making a dollar amount bequest.

Lifetime transfer planning

The preferred way to handle a transfer of a QOF asset during an investor’s lifetime is a transfer into an intentionally defective grantor trust (IDGT). In this type of trust, the grantor is responsible for paying taxes on the income the trust generates, but trust assets are not counted as part of the owner's estate. With an IDGT, the value of the grantor's estate is reduced by the amount of the asset transfer into the trust. The individual can gift or make a combined gift and sale of assets to the IDGT in exchange for a promissory note of some length, such as 10 or 15 years. The note will pay enough interest to classify the note as above market, but the underlying assets are expected to appreciate at a faster rate. The beneficiaries of the IDGT will receive assets that have grown without reductions for income taxes, which the grantor has paid. If structured properly, the IDGT can be an effective estate-planning tool allowing a person to lower his or her taxable estate while gifting assets to beneficiaries at a locked-in value. The trust's grantor can also lower his or her taxable estate by paying income taxes on the trust assets, essentially gifting extra wealth to the beneficiaries.

Because of the ability provided by a QOF to shelter post-acquisition appreciation from capital gains after 10 years, these investments, when coupled with an IDGT, can provide a way to layer long-term transfer tax and income tax efficiency inside a multi-generational trust. The ability to exclude post-acquisition capital gains from gross income is a powerful planning tool when coupled with a trust that is excluded from the parent’s estate because the downside to transferring assets out of parent’s estate—the loss of the stepped-up basis at death—is off-set for QOF interests held by the trust for the requisite 10 years.

For example, compare a 2019 gift of $5M of partnership units with zero tax basis into an IDGT versus $5M of capital gains deployed into a QOF, which is subsequently gifted to the IDGT.  Assume further a sale of both investments in 2030 for $10M.  In the case of the partnership units, the entire $10M will be subject to capital gains tax in 2030.  In the case of the QOF, the initial $5M of deferred gain will be subject to capital gains tax on 85% of the gain in 2026.  In year 2030, upon sale, however, the remaining $5M of appreciation avoids tax entirely because of the step-up on assets held ten years in a QOF.  With the QOF investment, one avoids the tax on $5.75M of capital gains. Using a tax rate of 20%, this represents a savings of $1.15M.

Neither the termination of grantor trust status when the grantor dies nor the distribution by the trust to a beneficiary after the grantor’s death results in the inclusion of the originally deferred gain. In each instance, the OZ tax deferral and the potential for tax-free appreciation continue as a benefit for the recipient. However, termination of the grantor trust status during the lifetime of the grantor would be an inclusion event triggering recognition of the original deferred gain.

Conclusion

An investment in a QOF may be suitable for older investors when part of a sophisticated estate planning strategy. Investors should think of the QOF investment as “patient capital” or as a “generational asset,” as the tax-free appreciation of the QOF investment is available only after a 10-year hold. Historically, non-IRD assets received a great income tax result (via step-up when the owner dies) but a poor estate tax result (because fair market value is applied for estate tax purposes, rather than tax basis). If structured properly, the QOF gives the best of both worlds.

As the result of the complexity of pairing QOF investments with trust instruments, investors should rely on the guidance of both their accountants and attorneys to properly structure a QOF with a trust to provide the maximum return with the least amount of tax liability for both the investor and their heirs.

For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.

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