Capital Gains are always a double-edged sword. On one hand, selling an appreciated taxable asset has created a tax bill. On the other hand, that means your investment was successful, as in you sold it for more than you bought it. Especially in years with large tax bills, using different strategies to address your tax situation can be extremely beneficial. Qualified Opportunity Zones (QOZs), along with other strategies, can help support your overall financial goals while still taking advantage of ways to defer or reduce your taxes. Since few people want to pay more taxes than they have to, understanding what a QOZ is, how it works, and how to benefit from it can help level up your tax planning and possibly lead to lower taxes.
What are They?
One of the provisions in the Tax Cuts and Jobs Act of 2017 was to create Qualified Opportunity Zones. In an attempt to encourage economic development, Congress instituted tax-favorable rules around investing in areas that local governments deemed “economically distressed”. The goal was to encourage investors and developers to focus on areas that could use additional economic help. In exchange, investors could defer and even reduce their capital gains from a previous investment. The idea was to give investors favorable tax treatment while allowing cities to choose where to focus their development.
Investors looking into these QOZs fall into two categories, generally. The first are those who want to invest in land, properties, and/or businesses directly and plan to improve them. The latter category is for investors looking for a good investment without needing to dedicate time to managing the assets. For this group, there are Qualified Opportunity Funds (QOF) available to solve this problem. These funds are investment companies designed specifically to invest in QOZs. For investors focused on the investment and taxes more than renovating real estate, these funds may be a good option.
Take highly appreciated rental properties, for example. Selling and recognizing tens or hundreds of thousands of capital gains may not be attractive to investors. As an alternative, they can still sell their property and reinvest the proceeds into a QOZ or QOF. This could also apply to selling a business, stock, or other qualifying assets. For real estate investors or business owners looking to buy a new business, direct investment within the QOZ may be preferable. However, do the necessary homework to verify all the rules and regulations around what investments and properties will qualify for the QOZ deferral.
How it Works
Since 2017, different zones around the country have been created and designated as a QOZ. There are currently 8,764 zones in the United States, many throughout each state. The process to pick a QOZ can be relatively straightforward, since all you need to do is invest in a property, business, or QOF that operates within the geographical area.
The eligible gains that could apply to a QOZ can be relatively broader. Capital gains (think selling stock) and 1231 gains (think selling business assets) can both generally qualify for the deferral status. The IRS has stated that from the sale of the asset, there is generally a 180-day period to invest into the QOZ. The new purchase is treated as a separate transaction from the previously recognized capital gain, so the basis and holding period would not carry over. As a result, there are reporting requirements to elect the deferral status, so work with your accountant for clarity and file everything correctly on your tax return.
It is important to note that since this strategy was technically one of the temporary provisions of the Tax Cuts and Jobs Act, the government set the QOZs deferral status to expire in 2026. As of the publication of this article, Congress has been working on extending this provision as part of the broader extension of the Tax Cuts and Jobs Act. If successful, it is likely that a similar version (or perhaps an improved version) will continue past 2026 if the new bill is passed this year.
Benefits and Drawbacks
When done correctly, the obvious primary benefit is that gains can be deferred each year or until the end of 2026. As a result, QOZs provide investors with more flexibility around tax planning. If an asset must be sold in a year, for whatever reason, this deferral status can help move these taxes to a more favorable year. Imagine a business owner selling their business; their taxable income could swing from $500,000 to $0 within two tax returns. Using a strategy to pay taxes in a year where the tax rate is 0% (not 20% or 40%) is definitely enticing.
Past the annual benefit of deferring capital gains tax, it is also possible to reduce the taxes as well. If an investment in a QOZ is held for at least 5 years, there is a 10% exclusion of the capital gains that were originally deferred. That rises to 15% if held for at least 7 years. If held for 10 years, investors could also receive a full step-up on the basis of the property within the QOZ (notably, not the original capital gains).
While QOZ may present a great way to defer taxes into the future, make sure the benefits outweigh the costs for your situation. With the level of detail involved in this strategy, the time and money required for investors and their accountants, advisors, real estate agents, attorneys, contractors, insurance agents, and other professionals may be substantial. Deferring gains and/or holding assets in a QOZ long enough to get the reductions may only be worth it if there is a potential to save tens or hundreds of thousands of true dollars, after all of the expenses are accounted for.
Qualified Opportunity Zones
Selling a highly appreciated business, real estate, stock, etc., could create a tax issue that people dread. While everyone should always pay the taxes they owe without exception, there are ways to time and even reduce the payment of those taxes. QOZs provide investors with one strategy to help solve that problem. Talk with your financial team to see if QOZs align with your long-term goals.
TC Falkner 