The Ship Has Not Sailed on Qualified Opportunity Zone InvestmentsTax Planning
Do you have substantial capital gains looking for rescue from the taxman?
If you want to defer taxes on your capital gains, you should take a look at investing in qualified opportunity funds— these are businesses that invest in qualified opportunity zones.
Although some of the tax benefits of qualified opportunity funds are no longer available for new investors, the remaining benefits can provide significant tax deferral and tax reduction for all types of capital gains.
What Are Qualified Opportunity Zones?
The qualified opportunity zone program was created by the Tax Cuts and Jobs Act back in 2018 to spur investment in low-income communities.
The government designed 8,764 census tracts in all 50 states, the District of Columbia and five U.S. territories as qualified opportunity zones.2 (A “census tract” is a statistical subdivision of a county; it generally has a population of between 1,200 and 8,000 people.) Qualified opportunity zones are mostly in economically distressed areas with at least a 20 percent poverty rate.
But up to 5 percent of qualified opportunity zones need not be low-income.3 Nearly 200 qualified opportunity zones are adjacent to poor areas but are not themselves low-income.
These include some well-known emerging real estate markets such as census tracts in Brooklyn, the South End in Boston, the Warehouse District of New Orleans, Central Los Angeles, and Inner South Seattle.
What Are Qualified Opportunity Funds?
Taxpayers can’t invest directly in qualified opportunity zones.
Instead, they must invest through qualified opportunity funds—corporations, partnerships, or LLCs organized to pool money from investors to invest in qualified opportunity zone property.
Qualified opportunity funds must hold at least 90 percent of their assets in such property.4
A survey of nearly 1,500 qualified opportunity funds found that residential real estate development was the leading investment, followed by commercial development, and followed distantly by hospitality, renewable energy, and operating businesses.
A qualified opportunity fund can’t invest in another qualified opportunity fund.
The real estate qualified opportunity fund must substantially improve the property. This requires that within 31 months after acquisition, the fund must make capital improvements that exceed the purchase price of the property, excluding the land.
Example. If a qualified opportunity fund purchases a building for $1.2 million and the land is worth $200,000, it must invest at least $1 million into the property over 31 months.
A corporation, partnership, or LLC self-certifies its election as a qualified opportunity fund by attaching IRS Form 8996, Qualified Opportunity Fund, to its federal income tax return. In addition to filing the initial Form 8996, a qualified opportunity fund must file Form 8996 annually to certify that the fund continues to meet the 90 percent investment standard—or pay a penalty.
The Government Accounting Office estimated that there were about 6,000 qualified opportunity funds as of 2019; there are undoubtedly more today.7 Most accept investments only from accredited investors—those who have at least $1 million in assets (not counting the primary residence) or who earn $200,000 per year if single or $300,000 if married. Most funds also require substantial minimum investments—often $50,000 or more.
How You Invest Your Capital Gains
You can invest capital gains generated from any asset sale—such as real estate, stocks, business assets, and cryptocurrency.
You need invest only the capital gains realized from the asset sale, not the entire proceeds.
But you can invest more. You have the option of investing the entire proceeds. When you invest the entire proceeds, you have two separate investments:
- one to defer capital gains, and
- a second regular investment unrelated to capital gains.
The opportunity law created no limits on the amount of capital gains you may invest. It makes no difference if the gains are long term or short term. If you wish, you can invest only a portion of your capital gains in a qualified opportunity fund. You may also divide your gain from the same sale and invest it with several different qualified opportunity funds.
Remember, for the investment, you look at your capital gains. You have 180 days from the date of the asset sale to invest all or part of the proceeds in one or more qualified opportunity funds.
The Tax Benefits
Initially, there were three tax incentives for investing in qualified opportunity funds:
- Step-up in basis
- Tax deferral through 2026
- Exclusion of capital gains
Step-up in basis is no longer available to new investors. But the other incentives remain.
Step-Up in Basis for Pre-2022 Investments
Taxpayers who invested in a qualified opportunity fund in 2018 or 2019 receive a 10 percent step-up in tax basis after five years, and an additional 5 percent step-up after seven years, effectively eliminating up to 15 percent of their original gain.
Taxpayers who invested in a qualified opportunity fund in 2020 or 2021 and who hold onto their investment for at least five years receive a 10 percent step-up, effectively eliminating 10 percent of their original gain.
Both of these tax incentives are no longer available for new investors in qualified opportunity funds.
There’s hope. Bipartisan legislation has been introduced in Congress to extend the deferral period of the qualified opportunity zone incentive through the end of 2028. The bill also would allow a 5 percent step-up in basis if the qualified opportunity fund investment is held for six years versus the seven-year holding period required under current law. Thus, investors in 2022 and 2023 would receive the 15 percent step-up.
Of course, no one knows if this law will be enacted.
Tax Deferral Through 2026
Any capital gains invested in a qualified opportunity fund within 180 days will be tax deferred until December 31, 2026, or an earlier date on which the investment is sold.
Effectively, delaying the tax payment gives you an interest-free loan from the federal government. It enables you to invest your entire capital gain for several years before paying tax on it.
Exclusion of Capital Gains after 10 Years
If the qualified opportunity fund investment is held for at least 10 years, its basis is adjusted to equal its fair market value on the date it is sold. In other words, there is zero capital gains tax due on any profits from the sale of a qualified opportunity fund investment after a 10-year holding period. (There is also no depreciation recapture after the basis adjustment.)
This is by far the most significant tax benefit from investing in qualified opportunity funds, accounting for over 90 percent of the tax benefit.
You don’t have to sell your qualified opportunity fund investment after 10 years. You can hold it until 2047 and avoid paying capital gains tax on any appreciation that occurs through the end of that year.
How the States Treat the Qualified Opportunity Fund
Of the 41 states that tax capital gains, 33 and Washington, D.C. provide the same tax benefits for qualified opportunity zone investments as the federal program. Alabama, Arkansas, and Hawaii offer some of the benefits.
Five states have opted out entirely: California, Massachusetts, Mississippi, New York, and North Carolina.
Jason, a former Tesla employee, sells $1.1 million of company stock on July 1, 2022. His basis in the stock is $100,000, so he has a $1 million capital gain.
If he pays tax on his gain, he’ll owe $238,000 (20 percent long-term capital gains tax plus 3.8 percent net investment income tax).
Instead, he invests his $1 million gain in a qualified opportunity fund within 180 days of the stock sale.
- He need pay no tax on his $1 million gain during 2022, 2023, 2024, or 2025.
- He will have to pay the $238,000 capital gains tax on his $1 million at the end of 2026. This will be due with his 2026 return filed in 2027.
If Jason’s qualified opportunity fund investment appreciates 6 percent per year, he’ll have $1.79 million after 10 years. If he sells his investment, he can elect to step up his basis to an amount equal to the sale price, resulting in no tax due on the sale.
Subtracting the $238,000 capital gains tax Jason paid in 2026, he is left with $1,552,000 after 10 years.
What if Jason sells his stock for $1.1 million, pays the $238,000 capital gains tax, and then invests his remaining $762,000 gain in the stock market? If his stock appreciates 6 percent per year, he’ll have $1,364,626 after 10 years. If he sells his stock at this time, he’ll owe a $143,425 capital gains tax, leaving him with $1,221,201.
Are Qualified Opportunity Funds a Good Investment?
The tax benefits provided by qualified opportunity funds can be substantial. If you have capital gains from sales of assets other than real estate, qualified opportunity fund investments are the only means available to both defer tax on those gains (until 2026) and avoid tax altogether on the profits earned from the investment.
But the tax benefits are worth little if a qualified opportunity fund’s investments are not successful. Also, keep in mind that you must invest for at least 10 years to benefit from the capital gains exclusion.
Will you be forced to invest in high-crime inner cities or severely economically depressed rural areas? Not necessarily.
Most qualified opportunity funds concentrate their investments in less economically distressed qualified opportunity zones that present less risk.
One survey found that
- the top 5 percent of qualified opportunity zones received 78 percent of the total investments,
- the top 1 percent of qualified opportunity zones received 42 percent of the total investments, and
- 63 percent of qualified opportunity zones received zero investment.
Even so, you should exercise extreme care before investing in any qualified opportunity fund. Qualified opportunity funds are unregistered private placement investments outside of SEC oversight. And these funds aren’t rated by fund rating agencies such as Morningstar, Lipper, or S&P.
Many qualified opportunity funds charge investors substantial fees, which can eat up much of your investment gains. Before handing over your money, make sure you’re comfortable with a qualified opportunity fund’s management team, investment strategy, and potential returns and fees.
Over 8,000 census tracts have been designated as opportunity zones. Taxpayers may invest in these through qualified opportunity funds that pool money from investors, primarily for real estate investments.
You can invest any amount of capital gains from any asset sale into a qualified opportunity fund and pay zero taxes on those gains until 2026.
The biggest benefit to the opportunity fund investment is the zero capital gains tax due on any profits from the sale of a qualified opportunity fund investment after a 10-year holding period.
Taxpayers who invested in a qualified opportunity fund in 2018 or 2019 receive a 10 percent step-up in tax basis after five years and an additional 5 percent step-up after seven years. Taxpayers who invested in 2020 or 2021 receive a 10 percent step-up after five years.
Remember the benefit: the step-up reduces your initial capital gains.
You must invest your gains within 180 days of an asset sale to receive the capital gains tax deferral and exclusion.