There appears to be some confusion among financial advisors about the deferral opportunities related to gains allocated on an investor’s K-1 related to potential investments in opportunity zones. For investors considering deferral of allocated K-1 gains to reduce their current tax liability for 2018, the deadline for making the deferral election is rapidly approaching.
I have been discussing some of the key issues impacting an investor’s election to defer with advisors to provide them with a decision-making process that maximizes the investor’s options with respect to investing allocated K-1 gains in opportunity zones.
Most investors are aware of the benefits of deferring K-1 gain allocations and making opportunity zone investments, including a potential 15% reduction of the taxes due in 2026 if the deferral occurs before Dec. 31 of this year and the exclusion of any gains realized on their opportunity zone investments if held 10 years. However, failure to make a deferral election within the specified time period eliminates any chance for the investor to take advantage of the deferral benefits provided by the new tax law. While advisors are aware of these tax benefits, many are unaware of the strategies that can extend the investor’s timeline to make a final decision on deferring gains and for finding appropriate investment opportunities in opportunity zones.
The law provides investors with 180 days to make the deferral election. K-1 gain allocations are deemed to have been realized by an investor on Dec. 31, so the 180 day period ends on June 28. For investors to be fully protected, they should make the deferral election of K-1 gains no later than June 27 so that the proper paperwork can be filed within the 180-day timeframe.
Setting Up a Qualified Opportunity Fund
To fund the deferral of K-1 allocated gains, an investor does not need to use funds from the investment generating the gain. A deferral election can be made for tax purposes with the funds capitalizing the Qualified Opportunity Fund (“QOF”) coming from any source including funds that are borrowed on margin or under a loan agreement. This allows investors to maintain their investment in the fund generating the K-1 gains while simultaneously deferring the tax on those gains until 2026. Advisors should be aware that an investor can borrow funds to create and capitalize a QOF. For certain investors, this capability can create additional tax benefits depending on the source of the borrowed funds.
In addition, investors can defer all or part of a realized gain or an allocated gain appearing on a K-1. Should an investor generate a $5 million gain on the sale of Google stock, for example, the corresponding tax on any portion of that $5 million gain can be deferred. For investors receiving allocated gains on K-1s, the same holds true where all, or a portion of, the tax attributable to allocated gains can be deferred.