If a taxpayer realized a $200,000 gain from a taxable sale or exchange, the QO Zone policy allows the taxpayer to avoid a current year tax on the gain by investing it in a QO Zone Fund. As no income is recognized from the rolled-over gain, the taxpayer would receive a zero basis for the $200,000 investment in the QO Fund. The Fund can be organized as a partnership or a corporation. For purposes of this illustration, the Fund is organized as a taxable corporation.
Thus, if the taxpayer sold the QO Fund interest for $200,000 at the end of the first year, the taxpayer would recognize the $200,000 gain and the tax benefit from the QO Fund investment would be a one-year deferral of the tax cost on the gain. For each additional year the taxpayer holds the investment, the benefit increases by the deferral of the tax cost on the gain.
If the taxpayer holds the QO Fund investment for five years, 10% of the gain ($20,000) is forgiven and added to the basis of the QO Fund investment. Thus, the taxpayer’s original basis of $0 is increased by $20,000, providing a permanent exclusion for 10% of the original gain invested. If the taxpayer holds the QO Fund investment for seven years, an additional 5% of the gain, or $10,000, is forgiven and added to the basis in the QO Fund investment, creating a total stepped-up basis of $30,000, or 15% of the original gain invested in the Fund. If the taxpayer sold the QO Fund investment during year 8 for $250,000, the taxpayer would recognize a $220,000 gain, comprised of $50,000 of appreciation in the Fund’s value and $170,000 of the original gain deferred from the rollover.
The QO Fund policy includes a limit on the number of years a gain can be deferred. Deferred gains not recognized through a taxable sale or exchange before 12/31/26 must be recognized on that date. If the taxpayer above had benefitted from the five-year and seven-year basis adjustments and had not sold the investment before 12/31/26, the taxpayer must recognize the remaining $170,000 of gain as a rollover into the Fund on that date. The gain recognition creates additional basis in the QO Fund interest. Therefore, following the recognition of the $170,000 gain, the taxpayer would have a total basis in the QO Fund of $200,000.
Investors holding QO Fund interests for 10 years may elect to exclude gains realized on the sale of the QO Fund shares. If the taxpayer above, having benefitted from a five-year and seven-year basis adjustment, sold the investment in the 11th year for $275,000, the investor would realize a $75,000 gain that could be excluded from the taxpayer’s gross income. Under this scenario, the investor’s full tax benefits from the QO Fund investment would include: permanent exclusion for 15% of the gain invested in the QO Fund, a deferral of the tax cost for the remaining 85% of the gain from the date of the investment through 12/31/26, and a permanent exclusion of the gain realized on the sale of the QO Fund shares.