Taft summer associate Lauren Lambert contributed to this article.
A taxpayer who invests an amount of capital gains in a QOF generally defers recognizing the gain until the earlier of (i) the date on which he or she disposes of the QOF interest and (ii) December 31, 2026. The tax code provides investors who hold their interest for at least 7 years (or 5 years) prior to the recognition date with a basis bump that permits them to permanently exclude 15% (or 10%) of deferred gain. But even if you did not invest in a QOF prior to December 31, 2021—and thus aren’t eligible for permanent gain exclusion via the basis bumps—there may be another, less obvious way to avoid ever recognizing some of the deferred gain.
On the date of recognition, a taxpayer is required to recognize all remaining deferred gain, up to the interest’s fair market value on that date. The amount of remaining deferred gain that exceeds the interest’s fair market value on the date of recognition may be permanently excluded. For instance, if a taxpayer purchased a QOF interest by investing $500 of capital gains in a QOF, but on the date of recognition the QOF’s interest value is, for whatever reason, only $400, the taxpayer would recognize only $400 of the remaining $500 of deferred gain. The taxpayer would never have to pay federal income tax on the other $100 of gain.
There may be several reasons why a QOF investor could take the position that their QOF interest has a lower valuation. For example, the value of an interest may be discounted if it is a minority interest that offers limited ability to exert managerial control, or if there are limitations on the interest’s voting power or transferability. Additionally, changes in the underlying development may lead an appraiser to find that the development, and hence the partnership interest, is now worth less.
Bottom Line: As December 31, 2026 approaches, QOF investors should keep this less obvious gain exclusion opportunity in mind and consider whether any unique features of their own investment allow them to take advantage of it.
“If you’re going to be able to look back on something and laugh about it, you might as well laugh about it now.” – Marie Osmond