Investing in Opportunity Zones Can Help You Manage Capital Gains
If you sold an investment this year, you might be starting at a significant capital gains tax obligation and wondering if there’s anything you can do before year-end. One tool that may be beneficial to consider is investing in a Qualified Opportunity Zone (“QOZ”) fund. Re-investing those gains in a QOZ fund is a great vehicle for deferring the tax, reducing the taxable gain, and potentially diversifying your portfolio.
Opportunity Zone funds are a relatively new investment tool, arising out of tax reform, but really only getting going in 2019. It offers three primary tax benefits:
- Tax deferral for up to seven years
If you have a capital gain and make a qualifying investment into a QOZ fund within 180 days of that capital gain being triggered, then you are allowed to defer that gain for up to seven years until 2026.
- For example, if you have $300,000 in capital gains from rebalancing your investment portfolio, the tax liability on those capital gains will be deferred until 2026.
To take advantage of the full 15% reduction in capital gains, invest by December 31, 2019.
- Permanent reduction in gain
If you hold the Opportunity Zone investment for the full seven-year period, then you get to permanently reduce that gain by 15%. However, to take advantage of the full reduction, you must invest by December 31, 2019. Any investment after December 31, 2019, will not qualify for a 15% step-up in basis but may qualify for a 10% step-up in basis.
- Continuing with our previous example, if you have $300,000 in capital gains invested into an Opportunity Zone fund by December 31, 2019, your tax liability in 2026 will be on $255,000, rather than the initial $300,000 ($300,000 capital gain x 15% step-up in basis).
- Tax-free appreciation
If you continue to hold the OZ investment for ten years, then any appreciation on that new investment is tax free after the ten year period.
- Continuing again with our previous example, if the $300,000 investment into an Opportunity Zone grows to be worth $700,000 after 10 years, the $400,000 of appreciation from the investment is then received tax-free.
The Section 1231 caveat
If your capital gain is the result of selling or trading business assets, then your capital gain might fall into the category of a Section 1231 gain, which has some special rules.
Under normal circumstances, if you have a capital gain generated on August 1, then August 1 signals the beginning of the 180-day window. However, if you have a Section 1231 gain on August 1, you would have to wait until December 31 to make the OZ investment. That’s because a taxpayer won’t know until the end of the year if the taxpayer has a net Section 1231 gain from all of his or her activities. If you end up having a net gain on December 31, the 180-day period begins on the last day of the tax year.
According to the second round of Opportunity Zone regulations, if you were to make a contribution to an opportunity zone fund in September thinking you were taking advantage of that 180-day window, you’d technically have a disqualifying contribution because your window hasn’t even opened up yet.
It’s possible that this issue will get addressed by future regulations so you should discuss with your tax advisor if this situation applies to you.
How we can help
CLA can help you take advantage of tax opportunities through thoughtful tax planning. Opportunity Zone funds may not be suitable for you in terms of the time horizon and your risk tolerance. This is where your investment advisor becomes an important part of the conversation to help ensure that this approach works with your overall investment philosophy. CLA brings these two disciplines together for you to help determine whether Opportunity Zones are right for you. No matter where you are in your financial journey, CLA exists to create opportunities and we are here to help.
- Michael Prinzo
- Managing Principal of Tax