While QO Funds have the potential to create significant tax savings for investors, they are not the best option for every investor. The following examples illustrate some of the factors to consider before recommending these investments to clients.
The first factor to consider is the before-tax rates of return for the taxpayer’s investment options. Assume the taxpayer in the above example invested in a QO Fund organized as a partnership, rather than a taxable corporation. In addition, assume the investor has a 37% marginal income tax rate, a 20% capital gains tax rate, and a four-year investment horizon. For investment terms that do not reach the five-year statutory requirement, thereby not creating a step-up in basis, the primary advantage to the QO Fund investment would be the ability to defer the tax cost for the $200,000 gain invested in the QO Fund.
If the gain is a capital gain, an investment in a non-QO Fund would trigger a 20% capital gains tax that would reduce the funds available to invest to $160,000. If the gain triggered the Net Investment Income (NII) tax of 3.8%, the after-tax investment amount would drop to $152,400. Alternatively, the full $200,000 gain could be invested in a QO Fund with no current year tax cost.
Exhibit 1 compares the after-tax accumulation amounts for the two investment options for a four-year investment horizon. The calculations assume the funds are organized as pass-through entities that will require the investor to pay income tax on the distributive share from the fund each year and the annual earnings reported by the investor will increase the basis in the fund. In addition, the QO Fund and non-QO Fund investment options will have the same before-tax rate of return of 8%, will distribute the tax cost to the investor each year, and make no additional distributions to the investor. Further, the calculations assume the earnings reported each year are correlated with the funds’ value and the investment will be sold at the end of the investment term for its fair market value.
Under these assumptions, the investment in the QO Fund creates a $10,346 benefit attributable to the deferral of the $47,600 tax cost for four years and the ability to invest the full $200,000 gain in the Fund. However, these calculations assume that the two investments have the same before-tax rates of return. Congress regularly supports policies such as QO Zones because the before-tax rates of return in economically-challenged areas tend to lag behind more economically-vibrant areas. If the before-tax rate of return of the QO Zone Fund was 4% rather than 8%, the gain deferral advantage is eliminated (as illustrated in Exhibit 2).
For an investor with these circumstances, the indifference point between the QO Fund and non-QO Fund options is a before-tax rate of return of 6.19% for the QO Fund. That is, the QO Fund would have to earn a before-tax rate of return of more than 6.19% to produce an after-tax accumulation higher than the non-QO Fund option.
If the investor sells the QO Fund investment before the fifth year, the ability to exclude some of the original gain will be forfeited. Thus, the second factor to consider is the holding period. Using the same annualized return assumptions in the Exhibit 2 example (4% for QO Fund and 8% for Non-QO Fund), Exhibits 3 and 4 present the after-tax accumulations for a sale in the sixth year, including a stepped-up basis for 10% of the original gain invested in the QO Fund, and the after-tax accumulations for a sale in the eighth year, including a stepped-up basis for 15% of the original gain invested.
The advantage of the non-QO Fund investment is maintained even as the holding period increases. As evidenced in these examples, the QO Fund investment benefits from the five-year and seven-year stepped-up basis adjustments but the adjustments do not overcome the wide discrepancy in the before-tax rates of return. For the six-year holding period example, the indifference point is 5.743%. That is, the QO Fund would produce a higher after-tax accumulation when the before-tax rate of return for the QO Fund is greater than 5.743%. For the eight-year holding period example, the indifference point is a before-tax rate of return of 5.784% for the QO Fund.
Gains rolled over into a QO Fund cannot be deferred beyond 12/31/26. Exhibit 5 presents the after-tax accumulations when assuming a nine-year holding period. In the QO Fund calculation, the investor would recognize the remaining $170,000 of gain and withdraw $40,460 from the fund to pay the tax.
Again, the wide difference in the before-tax rates of return favor the non-QO Fund investment even though the QO Fund option benefitted from an exclusion for 15% of the gain invested and a nine-year deferral for the tax on 85% of the gain. For this holding period, the indifference point is a before-tax rate of return of 5.90%.
When the QO Fund investment holding period reaches 10 years, the investor may elect to exclude gains recognized from the sale of the QO Fund. The above calculations assume both investment options are organized as partnerships. As income from a QO Fund is passed through to the investor and increases the investor’s basis each year, a gain from a Fund investment will only be realized if the Fund’s share price appreciates beyond the accumulated after-tax earnings of the partnership. Thus, as there is no guarantee the QO Fund shares will appreciate beyond its past earnings, there is no guarantee a gain will be realized on the sale of the shares.
Consistent with the assumptions from the previous calculations, Exhibit 6 presents the after-tax accumulations assuming there is no gain realized from the sale at the end of the 11-year holding period. That is, under this assumption, the investor’s QO Fund interest would have a fair market value and basis amount equal to the after-tax accumulation amount.
Alternatively, if the value of the interest appreciates beyond the accumulated earnings allocated to the partner, the gain realized would be the difference between the sales price and the after-tax accumulation (basis). If the Fund interest is sold for $275,000, a gain realized in the QO Fund option of $54,544 ($275,000 – $220,456) may be excluded from the investor’s gross income. However, the non-QO Fund would experience a $13,250 ($275,000 – $261,750) gain that would trigger an additional $3,154 in capital gains and NII taxes ($13,250 × .238).
A third factor to consider is the investor’s marginal tax rate. The above examples assume the investor has a constant marginal income tax rate of 37%. It is not clear from the statute how the QO Zone policy will interact with other provisions in the law such as the Qualified Business Income (QBI) deduction. If the investment options described above created an annual 20% QBI deduction, the effective marginal tax rate would be 29.6% (37% × .80) and produce the after-tax accumulations for the holding period options shown in Exhibit 7.
As the taxpayer’s marginal tax rate drops, the value of the gain deferral decreases as well. Assume the investor had a $100,000 gain instead of a $200,000 gain. If the investor had a marginal tax rate of 32% instead of 37%, a capital gains rate of 15% instead of 20%, and avoided the NII tax, the tax cost for the gain deferred would be $15,000 instead of $47,600.
With a 20% QBI deduction for the annual distributive share of income, the effective marginal tax rate would be 25.6%. Exhibit 8 presents the after-tax accumulations for each holding period option.
Finally, the legal entity choice for the QO Fund will also influence the after-tax accumulations. The above examples assume the investment options are organized as a partnership and thus the annual earnings of the funds are taxed at the investor’s marginal tax rate.
If the Funds are organized as taxable corporations, the annual earnings will be taxed at the new corporate tax rate of 21% and will not be eligible for the QBI deduction. In addition, the taxpayer would incur a capital gains tax for selling the investment at the end of the investment period as the investor’s basis in the Fund’s shares would not be increased by an annual distributive share of earnings. Under this scenario, the ability to exclude gains from the sale of the QO Fund investment after the 10-year holding period becomes more valuable as it allows the investor to avoid the double taxation that is inherent in an investment in a taxable corporation.
For the C corporation example in Exhibit 9, the relatively low indifference points (relative to the individual investor at a higher marginal tax rate) suggests a lower risk/return threshold in QO Funds.
It is interesting to note that for each of the previous examples, the basis adjustment is not proportional to the influence of the time value of money compounding effect; therefore, the return indifference point between the QO Fund and the Non-QO Fund for a four-year holding period is higher than for later-year holding periods. In addition, the statute creates a 12/31/26 time limit on gain deferral. Therefore, greater benefits will accrue to the taxpayer the earlier the taxpayer makes an investment in a QO Fund.