Opportunity zone tax incentives are a powerful but highly underutilized financial planning tool. Because this statute is new, many tax payers and even some financial advisors are not aware of the numerous ways they can be used to create tax-efficient financial results.
To help mitigate economic disparity, Congress created QOFs as part of the Tax Cuts and Jobs Act (TCJA) of 2017. The TCJA changed the strategies available for financial planners. It narrowed the use of 1031 Exchanges, but by creating QOFs it greatly broadened the types of capital gains eligible for tax incentives. Now a capital gain from selling a stock, a business, or just about anything else you can think of, creates the opportunity to enjoy significant tax incentives.
To qualify for the tax incentive, investors need to reinvest a capital gain into a qualified opportunity fund (QOF) within 180 days of realizing the gain. QOFs in turn, reinvest the capital into any of the more than 8,700 designated low-income “opportunity zones” nationally. Opportunity zones themselves are defined by census tracts typically with populations of two to eight thousand people and highly variable economic potential.
QOF tax incentives are generous and well worth pursuing. Pundits often cite an after-tax advantage of 3% based on a market return of 7 to 8% and a 10-year holding period. The math works out to an extra 40% return (3%/7.5%=40%) to investors not just one time but year after year. Tax-free compound growth is a wonderful thing!
Here are the tax incentives:
QOFs are still relatively new and often overlooked but increasingly, financial professionals are using them to create uniquely tax-efficient strategies. Some of the strategies below require that thezinvestor control their holding period. There are QOFs that offer the liquidity of tradable shares but they need to be sought out. The first generation of QOFs had fixed holding periods, normally 10 years and this is still the case for the overwhelming majority of QOFs.
Tax payers with capital gains in collectible assets, such as art, precious metals (even ETFs invested in collectibles such as gold ETFs, wine etc., should be particularly motivated to utilize QOF tax-incentives. The same legislation that created QOFs eliminated the eligibility of collectibles to claim 1031 (like-kind exchange) tax treatment. Before the Tax Cuts and Jobs Act a collector could sell an appreciated asset and defer the tax by executing a 1031 exchange into a new like-kind asset. Now when a collector has a capital gain, they cannot defer the tax through a “like-kind exchange,” and they also face a higher marginal capital gain tax rate of 28% versus 20% for most asset classes. They can, however, defer the tax through a QOF investment.
For a taxpayer to claim QOF benefits they have to reinvest an amount equal to or less than capital gains they have taken in the last 180 days. Fortunately, unlike 1031 exchanges, QOF investments do not need to invest the same funds received from the capital gain – there is no cash tracing requirement, and this can be very helpful for an investor with liquidity. If an investor would like to benefit from QOF tax incentives but currently only has cash that is not eligible, they could trigger a gain elsewhere in their portfolio. For example, an investor could sell a stock with a low-cost basis and buy it back immediately. Their money will now be eligible for a QOF tax incentive for the next 180 days – up to the amount of the triggered capital gain. Additionally, they will have eliminated the unrealized capital gain liability from their stock position. This transaction would not be subject to wash sale rules because those apply to harvesting tax losses, not gains.
The biggest tax benefit offered by a QOF investment is the potential for tax-free compound growth. Once an investor achieves a 10-year hold in the QOF they can elect to step-up their cost basis 100%, eliminating any capital gain liability. This benefit is often thought of as a 10-year benefit, but that is just the beginning because the benefit does not expire until 2047 – another 24 years. Compound growth curves accelerate in the outer years, and this is certainly true for QOFs. Using typical market returns, roughly 84% of tax benefits are derived after year 10. Unfortunately, many QOFs have planned liquidations shortly after the 10th year, ending the tax-free compound growth prematurely. If you are lucky enough not to have to withdraw from your investment, then the option to keep this powerful wealth-creating tax incentive rolling can be very beneficial.
As always, these strategies only work if the underlying fund performs, so it is crucial to understand a fund’s strategy, management, and fees.
Given the significant tax savings they can deliver and the many ways they can be utilized, qualified opportunity funds (QOFs) are likely to continue to gain prominence as a financial planning tool every investor and advisor should examine when designing a tax-efficient financial strategy.
Please Keep in Mind:
Not all qualified opportunity funds (QOFs) offer the liquidity needed for many of these strategies.
This article discusses potential federal tax benefits, but note that most states offer benefits to QOF investors as well.
Legislation is expected to be introduced which would extend qualified opportunity fund tax incentives. This legislation would likely extend the QOF deferral benefit period from 2026 to 2028 or 2029 and bring back the currently expired 5% and 10% tax elimination incentives on the original investment. The bill is considered to have a good chance of being passed but the final form of the legislation and the timing of enactment are impossible to determine at this time. Current QOF investors are expected to participate in the benefits of this potential extension.
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