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Tax Benefits of Investing in Opportunity Zones
While there are multiple benefits to investing in qualified opportunity zones, it’s important to recall that the very existence of opportunity zones originates in a piece of legislation called the Tax Cuts and Jobs Act of 2017. The stated goal of the legislation was to generate more opportunities for Americans through economic stimulus as a result of the creation of opportunity zones. By designating certain census tracts as QOZs, the expectation was that investors would be encouraged to invest in areas that would be most likely to benefit from economic stimulus, thereby increasing tax revenues and new jobs to the designated areas.
Tax Benefits
For the investors, the primary carrot being dangled was a series of potentially lucrative tax benefits targeting monies that would otherwise have been subject to capital gains taxes. As any accredited investor can attest, an opportunity to defer or eliminate capital gains taxes is one to be taken seriously, and QOZ investing offered the opportunity for both deferral and eventual elimination of these onerous taxes. Most investors agree the tax-free growth on the investment is by far the largest of the benefits.
The legislation is currently slated to expire on December 31, 2026, unless Congress acts to extend the expiration on the TCJA. As the Act enjoyed bipartisan support upon passage, it’s entirely possible that this will happen, but so far there has been no legislation advanced, though it has been proposed and discussed as recently as last year. Regardless of whether the Act expires as currently scheduled, it’s clear that its tax benefits are worthy of consideration for any investors who are ready to realize a capital gain, or who have done so recently.
Let’s review the Act’s two most significant tax breaks.
Important Qualifiers for QOZ Investments
Recall that a QOZ investment has two important qualifiers: it requires the realization of a capital gain (which would otherwise be subject to both Federal and, where applicable, state capital gains taxes), and it requires reinvestment of the realized gains within 180 days of the event that triggered them (i.e., the sale of some appreciated asset).
Done properly, the first tax advantage is potent. Payment of the capital gains tax on the original investment (not the QOZ investment) is deferred until the expiration of the Act on December 31, 2026, with the actual payment not due to the Treasury Department until the tax filing deadline on April 15, 2027.
Absent a time machine, investors can’t zip back and take full advantage of the original eight-year deferral offered to early investors. Regardless, even the limited window of opportunity that remains to tax-averse investors offers a multi-year deferral that permits taxpayers to put the eventual tax payment to work in a new investment. Most taxpayers would surely agree that a limited tax deferral is preferable to having to pay Uncle Sam immediately.
The remaining tax break will survive the legislation even if it does expire as foreseen on December 31, 2026: capital gains taxes on the OZ investment itself will be eliminated entirely if the investor holds the OZ investment for a minimum of ten years. The scope of the tax savings is entirely dependent on the performance of the investment itself, which is not guaranteed, but a theoretical $500,000 investment that doubles over a ten-year period could present the investor with a potential $100,000 tax savings upon sale of the QOZ investment.
Clearly, any potential six-figure tax savings would be something to consider as investors ponder the many courses of action open to them with a recently-realized capital gain.
The bottom line: by holding an Opportunity Zone investment for at least ten years, investors can potentially earn significant profits without having to pay any taxes on them. This can help investors to grow their wealth more quickly. Moreover, most QOZ funds plan to offer liquidity to investors early into the 10-year program which can help investors pay their future tax bill on the original capital gain.
Another important benefit to consider: QOZs can potentially negate depreciation recapture, a process all too familiar to experienced real estate investors. An investor in a business property can use depreciation to write off some of the property’s value as it decreases over time… but depreciation recapture essentially allows the IRS to collect taxes on the financial gain the investor realizes by selling such a property. The difference between the sale value of the asset and its depreciated value is accounted for. But taking the realized gain and investing in a QOZ fund has the potential to eliminate depreciation recapture, as the value of the capital gain is under the umbrella of protection offered by the TCJA. Keep in mind that deprecation recapture is currently taxed at 25%.
QOZ Investing
QOZ investing can be a complex process, and investors should work with a qualified and experienced advisor before making their investments. By deferring and potentially reducing capital gains taxes and simultaneously earning tax-free growth, it’s possible to earn attractive returns while also contributing to the revitalization of economically distressed communities. When properly executed, QOZ investing is a win-win for both investors and the communities that benefit from their investments. Keep in mind that QOZ investments are for accredited investors only.
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