- Investors can defer, and potentially eliminate, paying capital gains tax by reinvesting realized gains within the last 180 days into Qualified Opportunity Zone funds
- The 2017 Tax Cuts and Jobs Act made available substantial tax breaks regardless of the size of the gain, and deferral can be on the sale of any asset, not just real estate
- It takes careful planning to capture all the tax benefits, but for certain clients there’s still time to defer capital gains tax liability if you sold in 2022
- We also take a look at the differences between a QOZ investment versus the benefits of a 1031 exchange with real estate
Doing good while making money is not a bad combination. Qualified Opportunity Zone (QOZ) investments allow you to do just that. The 2017 Tax Cuts and Jobs Act (TCJA) created what’s known as the Qualified Opportunity Zone program which offers tax breaks for investors for putting money to work in economically challenged communities.
The upside for investors is that you can defer taxation on gains on the sale of any asset, business, piece of equipment, and more – not just real estate. There’s even a tax-free option that we’ll outline. (A 1031 exchange, by contrast, is only available for real estate investments.) The caveat is, though, that tax benefits are only available if you hold the investment within a Qualified Opportunity Fund (QOF) for the stated period.
What is a Qualified Opportunity Fund?
QOFs are intended to pool capital together to invest in distressed geographic areas. They are a type of investment vehicle that features tax incentives at the federal level so that capital gains tax is delayed, which can boost your long-term net return. QOFs generally file as a partnership for federal income tax purposes and are established to invest solely in QOZ property. To be considered a QOF, the fund must hold at least 90% of its assets in QOZ property along with meeting other requirements. The IRS also lays out a host of qualifiers, so it is a somewhat narrow scope of properties and businesses that are included.
What Makes QOFs Appealing to Investors?
What’s advantageous for our clients is that many asset types can qualify for the capital gains tax deferral. If you have a low cost basis in assets such as real estate, art & jewelry, cars, a business, or even just a mutual fund, then you can benefit from reinvesting in a QOF. Moreover, you have the option to reinvest just your gains to capture deferral benefits. Finally, there’s still time to process a qualifying transaction if the gain was made in 2022 and the asset was sold as a partnership, S Corp, and the like, and was reported on a K-1.
Another benefit to QOFs from the investor’s perspective is that there are no limits on the amount of tax deferral, so QOF investing can be particularly lucrative for high-net-worth individuals and families. It is also possible to be forgiven from capital gains tax liability on any growth in the QOF if you hold the investment for 10 or more years. Of course, this requires careful planning and a thorough assessment of your financial situation – we work with clients to make sure they are not opening their long-term plan to other risks just to capture a bit more tax savings.
According to the IRS, you generally have 180 days to invest an eligible gain into a QOF. Be aware that the first day of the 180-day period is the date the gain would have been recognized had you not elected to defer recognizing it. To be eligible for the tax deferral, the gain must be from the sale or exchange of property with an unrelated party (no more than 20% common ownership). The IRS also allows many types of taxpayers to leverage the benefits of QOZ investments – individuals, C Corps (including regulated investment companies (RICs) and real estate investment trusts (REITs), partnerships, and other pass-through entities.
Crunching the Numbers
Here’s how it can work: Suppose you sold an investment in 2023 with a $100,000 realized gain and would otherwise face a 20% capital gains tax rate. You can bypass paying $20,000 in 2023 by reinvesting the $100,000 gain into a QOF. If the QOF grows by, say, 8% annually over the next 10 years, then you would have $215,892 by the end of the period.
By contrast, $80,000 of starting capital ($100,000 net of the 20% tax) would have grown to just $172,714. Keep in mind that the more than $115,000 of QOZ appreciation is not subject to capital gains tax, further bolstering your net return. Now, you would owe capital gains tax on the original $100,000 gain but not until 2027.
In the end, by reinvesting your gain into a QOZ fund, you would have come out ahead by more than $50,000 after all’s said and done (and the tax man is made happy!). Of course, you can work with us to determine the potential tax savings for your situation.
A QOZ Investment vs. A 1031 Exchange: Which Is Better? (It Depends)
We have written on the benefits of a 1031 exchange, and we continue to believe it to be a strong method to reduce taxes for folks in certain situations. In fact, a 1031 exchange may be a better alternative to a QOZ investment when it comes to long-term tax deferral if you plan to hold the investment indefinitely.
But if you plan to be more active with your real estate investing, then a QOZ fund has the upper hand since you can separate your capital gain from your basis, then optimize from there. With a 1031 exchange, you can more easily diversify your real estate holdings, regardless of geography, without triggering capital gains taxes. Lastly, when it comes to estate planning, a 1031 exchange works better since there is no sunset on the tax benefits – deferred gains are gone upon the holder’s passing due to the step-up in basis provision.
The Bottom Line
QOFs were a big trend following the passage of the 2017 TCJA. While Opportunity Zone investments are largely gone from the headlines, the tax benefits for almost all investors live on. If you have a large gain in any asset, you can reinvest just the gain into a QOF and postpone paying taxes for many years, leading to larger after-tax proceeds (potentially tax-free). For real estate, specifically, we can work together to determine if reinvesting your gain into a QOZ investment is right or if performing a 1031 exchange is the savvier play.