Much has been written about the potential social and financial benefits of investing in opportunity zones via qualified opportunity funds (QOF). The potential bottom-line benefits are particularly compelling as a strategy for clients looking to defer taxes, especially if they have a long-term investment horizon. Potential investors often wonder, however, how these investments fit within the context of estate planning and how can they be utilized to maximize benefits.
Before answering these questions, let’s start with a quick summary of current gift and estate tax law. The current gift tax exemption increases to $11.58 million in 2020. However, absent further action from Congress, in 2026 the gift tax exemption is scheduled to return to approximately $6 million. The gift tax exemption can be used to transfer wealth by lifetime gift or upon a person’s death. The lifetime use of the exemption reduces the exemption remaining upon death. Further, an individual has only one exemption available, which can be used and divided among as many beneficiaries as the individual chooses. If there are gifts or transfers upon death in excess of the exemption, those assets are currently taxed at 40% — not an insignificant tax liability, especially when considering the planned reduction in the exemption level in 2026.
When opportunity zones were first created, there were significant questions about the estate planning ramifications, including what might happen upon a QOF investor’s death. Many of these questions have been answered, some favorably and some not so favorably.
First, the good news is that an investor’s death does not trigger tax upon the deferred gain. Instead, the recipient steps into the shoes of the decedent with respect to the QOF investment. The recipient takes the original owner’s holding period for purposes of the five- and seven-year step-ups in basis (10% and 5%, respectively), and for measuring the 10-year period after which the QOF investment can be disposed of with no taxable gain. In other words, these periods don’t reset because of death. After 10 years from the original investment, the recipient of a QOF investment from a decedent qualifies for a full step-up in basis just as the original investor would have.
Next, the not-so-good news is that when a QOF investor dies, the QOF investment is potentially subject to a 40% estate tax on its date-of-death value. However, unlike most other assets, the QOF investment does not get a full step-up in basis to the date-of-death value, and the recipient of the investment must pay tax on the originally deferred gain (subject to the basis adjustments, if applicable) on December 31, 2026, or upon earlier sale of the QOF investment. The recipient should receive an itemized deduction for any estate tax paid with respect to the QOF investment, but that may be small consolation if the recipient doesn’t have other funds with which to pay the tax due in April 2027.
So, given these parameters, what QOF strategies make sense from an estate planning perspective? One possibility involves the use of an irrevocable “grantor trust.” With a grantor trust, the individual who established the trust (the grantor) is treated as the owner of the trust’s assets for income tax purposes, responsible for paying all income tax attributable to those assets. However, the trust is designed to be excluded from the grantor’s estate for federal estate tax purposes. The grantor would contribute to the trust either a QOF investment or appreciated assets that can be sold by the trust and reinvested in a QOF. Under the right circumstances, there are several potential benefits.
First, because the grantor is responsible for the payment of income taxes — including the deferred gain recognized on December 31, 2026 — more value can accumulate within the trust. And, income tax paid by the grantor reduces the grantor’s gross estate, leaving less subject to estate tax at the grantor’s death.
Second, all future appreciation occurs inside the trust and outside of the grantor’s gross estate. This can save 40% in estate tax on all future appreciation.
Third, if the QOF investment is retained for at least 10 years, when the investment is ultimately liquidated, no income tax would be owed by the grantor or by the trust.
For example, assume a grantor trust invests $5 million of gain in a QOF. On December 31, 2026, the grantor pays the resulting tax in April 2027. Further, in 10 years, the QOF interest has increased in value to $10 million. None of the increased value would be subject to estate or generation-skipping taxes, and the entire trust continues for the beneficiaries tax-free. Plus, after 10 years, whenever the QOF investment is liquidated, no income tax would be triggered to the grantor or the trust.
One of the keys to this strategy is the payment of income tax by the grantor. Should the grantor die, the death terminates the grantor trust status, and the grantor trust becomes responsible for the payment of its own income taxes, including the deferred taxes associated with the QOF investment that become payable at the end of 2026. Consideration should be given to both the likely longevity of the grantor and the trust’s ability to pay the tax if needed. If the trust would be unable to pay tax on the deferred gain in the event of the grantor’s death, the grantor could consider purchasing life insurance inside the trust or adding assets to the trust under the grantor’s estate plan to provide the necessary funds. Further, as with QOF interests held outside of an irrevocable grantor trust, the grantor trust still gets basis adjustments after five and seven years, and the full step-up on disposition of the QOF interest after 10 years, with the investment clock tied to these benefits starting at the time of the original investment, not at the time of death.
Overall, fitting QOF investments into a broader estate planning strategy could provide added benefits if structured properly.
The information provided is the author’s opinion for informational and educational purposes only and is not investment, legal or tax advice, nor a security, strategy or investment product recommendation.