Do you have significant capital gains from selling real estate, stocks, business assets, or other investments? Would you like to reinvest those gains and defer your tax bill? Look no further than qualified opportunity funds, one of the IRS Tax loopholes overlooked by many. These investments can provide significant tax breaks—if you follow the rules. Keep reading to learn more about qualified opportunity zones (QOZs) and how they can benefit you.
What Are Qualified Opportunity Zones?
Qualified opportunity zones are areas in the United States that the government has designated as being in need of economic development.
The Tax Cuts and Jobs Act of 2017 created the qualified opportunity zone program to spur economic development in low-income communities. The Treasury Department certified zones in all 50 states, the District of Columbia, and U.S. territories. You can find a map of qualified opportunity zones on the U.S. Department of Housing and Urban Development (HUD) website.
While you cannot invest directly in a qualified opportunity zone, you can receive tax benefits from reinvesting capital gains into a qualified opportunity fund (QOF).
What Is a Qualified Opportunity Fund?
A qualified opportunity fund is a type of investment vehicle that invests in property within a QOZ. The fund might invest directly by holding business property in a QOZ or indirectly by holding stock or an ownership interest in certain businesses in a QOZ.
QOFs must hold at least 90% of their assets in qualified opportunity zone property.
Tax Benefits of Investing in a Qualified Opportunity Zone
There are two potential tax incentives for investing in a QOF:
- Deferral. First, investing in an opportunity zone allows you to defer capital gains tax, including net Sec. 1231 gains. You have 180 days from the date of sale or exchange of appreciated property to reinvest your proceeds into a QOF to defer the capital gain. You can defer the capital gain until you sell the QOF or December 31, 2026, whichever occurs first. While you can reinvest both your return of principal and capital gains, only the capital gain portion is eligible for the tax benefits.
- Exemption. Finally, you may be able to exclude any appreciation on your original capital gain investment in the QOF if you keep your money in the QOF for at least ten years.
Previously, investors could also receive a discount upon recognizing the capital gains they initially invested in the program. Depending on the timing of the investment and how long they held onto it, they could permanently exempt up to 10% of their gain from capital gains tax. This benefit is no longer available to new investors, but the other incentives remain.
Let’s look at an example to see how this would work. Say you sold an investment property in 2022 and realized a $1 million long-term capital gain. You invested that $1 million capital gain into a qualifying investment within 180 days, deferring the federal capital gains taxes and net investment income tax that would have been payable on your 2022 federal income tax return.
By 2032, the fair market value of your interest in the QOF has increased from $1 million to $2 million. You decide to exit the QOF and liquidate your entire position. You already reported your capital gain on your initial $1 million investment on the mandatory recognition date of December 31, 2026. You paid the related tax on your 2026 federal income tax return using assets outside the QOF. So the remaining $1 million isn’t subject to capital gains tax since you were invested in the QOF for at least ten years.
The above covers a QOF investment’s potential federal income tax benefits, but many states also provide tax benefits for the qualified opportunity zone program.
How Do I Invest in a Qualified Opportunity Zone?
You must first find a qualified opportunity fund to invest in a qualified opportunity zone. There are many different funds to choose from, but most accept investments only from accredited investors.
An accredited investor is a person or entity that meets specific criteria established by the Securities and Exchange Commission (SEC). The SEC defines an accredited investor as an individual who:
- Earns more than $200,000 per year or has a net worth of more than $1 million (excluding their primary residence
- Is a qualified purchaser as defined by Reg D of the Securities Act of 1933
- Is an institutional investor
Most funds also require a minimum investment of at least $50,000.
Of course, there are always risks associated with investing your money, so be sure to do your research before investing and consult a financial advisor if you have any questions. However, qualified opportunity funds can be an interesting way to reduce your tax bill while investing in a high-potential area. Contact us today if you have questions about the tax benefits of investing in a qualified opportunity fund. We’re happy to help you make more informed decisions about potential tax-saving strategies.