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Opportunity Zone Tax Benefits: An Alternative For Realized Capital Gains

More than $250 billion has flowed into funds investing in Opportunity Zones since Congress created the program in 2017, and for good reason: The tax benefits of Opportunity Zone investing can be substantial — including deferral of taxes on past gains and tax-free future growth. Unsurprisingly, there are also significant tradeoffs. In this post, we’ll explain the mechanics of Opportunity Zones, describe scenarios where they might be a good fit, highlight the potential drawbacks and lastly walk through a comparison of using or not using an Opportunity Zone.

Here are some key takeaways to consider before diving into the definitions:

  • Investing previously realized capital gains (from a stock sale or other exit event) in a Qualified Opportunity Zone carries significant tax benefits, including deferring of all taxes on those gains until 2026 and a 0% tax rate on any future gains from the Opportunity Zone Investment.
  • Opportunity Zone investing can be a good fit if you expect or have already realized a big capital gain, because the tax benefits give you the freedom to realize those gains without immediate tax concerns.
  • The downsides of Opportunity Zones include high fees, a long period of illiquidity, exposure to concentrated assets, and negative cash flow during years after the tax deferral period but before the investment becomes liquid.

What Is An Opportunity Zone?‍

Congress created Opportunity Zones in 2017 to spur economic development in under-invested communities. There are some 8,700 designated Opportunity Zones in all 50 states and several U.S. territories. Through tax deferral and other benefits, the law creates incentives to invest and improve real estate in these low-income areas.

How do Opportunity Zone investments work?

Investments in Opportunity Zones are eligible for preferential tax treatment if they are made through a Qualified Opportunity Fund (QOF). QOF is an official designation for investment vehicles that commit to investing 90% or more of its assets in a Qualified Opportunity Zone and file for QOF status with the government.

Tax Benefits of Investing in an Opportunity Zone

Opportunity Zones can be a way to defer capital gains taxes on recently realized capital gains (and even eliminate a portion of those taxes).

Investors who have eligible realized capital gains (from the sale of stocks, real estate, business interests, or other investments) can roll those gains into a QOZ fund. If they do so within 180 days of realizing the gain, three forms of tax incentive are available:

Tax Deferral. First, capital gains rolled into a QOF may be deferred until the investment is sold or exchanged, or the end of 2026 (unless Congress extends this deadline), whichever is sooner. If the investor puts $1 million of capital gains into a QOF in a timely fashion, for example, that gain will not be taxed right away. If the investor’s capital gain tax rate were, say, 35%, that would mean an additional $350,000 that is reinvested and compounding for them. (It is worth noting that unless Congress extends the end of the deferral past 2026, you may be on the hook for taxes come 2027, while your investment is still locked in a QOZ fund).

Basis Adjustment. In addition, the investor can save even more through an adjustment in cost basis. If the investor holds the qualified investment for at least 10 years, the investor is eligible for an adjustment in the basis of the investment in the QOF. At this milestone, the investment in the QOF would have its cost basis adjusted to match the fair market value on the date that the QOF investment is sold or exchanged.

Why is this a big deal? Because investors pay taxes on their accumulated gains — the difference between their cost basis and the sale price. If the cost basis is adjusted to equal the sale price, then, in plain terms, this means that there is no taxable appreciation in the QOZ investment, and the investor pays no taxes on the amount that the investment grew while it was in the QOF. So the original capital gains invested in the QOF would be taxed — 85 or 90% of them, depending on how long you hold the investment — but any additional gains you earn from appreciation of the QOF investment would be tax free.

How To Invest In Qualified Opportunity Funds

‍Establishing a QOF is not a simple task. For that reason, most investors choose to take advantage of the Opportunity Zone tax incentives by placing their qualified capital gains into an existing QOF investments run by an institution. Like any professionally managed fund, these QOFs manage the underlying investments with the goal of generating returns for their investors.

The Benefits of Opportunity Zones

Opportunity Zones and Qualified Opportunity Funds can be a fit if you expect to or have already realized a big capital gain. Because you are allowed to defer all of the capital gains taxes on that already-realized gain within a 180-day period, and because you can eliminate some taxes entirely (via the basis adjustment rule), you have the freedom to realize those gains without immediate tax concerns.

The Typical Tradeoffs of Opportunity Zones

Limited Liquidity. The tax benefits of Opportunity Zones can be significant, but only for investors who are willing to wait at minimum 5 years and in many cases at least 10 years. Money has to stay in a QOF for at least five years from the fund close, not the date you invest in the fund, to realize the tax reduction benefits and ten years from the fund close to realize the basis adjustment benefit. In almost every case QOFs do not allow withdrawals during that initial 5-year period and may have limited withdrawals until the fund has hit its 10-year mark, so access to funds is limited.

Costs. Qualified Opportunity Fund costs and fees can be substantially higher than the costs and fees associated with more traditional investments which can eat up a substantial amount of the benefits. Set-up costs for QOFs, for example, can run above 6% of capital invested, and annual management fees typically range from 1.50% to 2.00% plus 15%-20% of returns above a specified return (hurdle rate).

Concentration Risk. QOFs are investments that are entirely focused on real estate and often in one particular investment or region. What this means, practically, is that you are concentrating your investment in one sector and often one project/region, which increases your investment volatility and risk.

Negative Cash Flow. If you invest now in a fund that closes at the end of 2022 you would likely not have liquid access to your QOF investment funds until at least 2028, but you would owe taxes on your deferred gains at the beginning of 2027. This could create a cash flow issue for you without proper planning.

Example on Opportunity Zone Tax Benefits

The context. Imagine a California startup founder who has recently sold her company. She’s taken advantage of the Qualified Small Business (QSBS) exemption to protect her first $10 million of gains from state and federal taxes, and maybe she even used QSBS stacking to extend the exemption to another $10 million or $20 million.

But this was a big exit, and she has significantly more gains that would otherwise be taxed at 35%, including state and federal capital gains taxes and the federal net investment income tax. Maybe a Charitable Remainder Trust is a fit for some of those gains, but she is also particularly interested in real estate and wants to diversify into a QOF.

Assumptions

  • She is looking to protect $1 million of gains, so she is looking at a potential tax bill of $350,000, and she’s looking for an alternative plan.
  • Net of fees, the QOF would return 9% annually. (This is based on target returns from Opportunity Zone Funds we partner with.)
  • This is a ten-year investment plan.

Expected returns. With an investment in a Qualified Opportunity Fund, our founder can significantly reduce that $350,000 bill and increase her returns by ~28% over the next decade or more.

If she simply paid her taxes and then reinvested the remaining $650,000 in a taxable account and paid the additional taxes when she sells, she might have around $1.4 million in her pocket at the end of ten years.

If she put the $1 million into a QOF and held for the full 10 years, by contrast, she could defer the $350,000 million in taxes until 2027, reinvest it and pay no taxes on the appreciation that happens inside the QOF. After the founder pays her deferred taxes and the QOF’s fees, she might have as much as $1.8 million in her pocket, or an additional 28% return.

opportunity zones
Opporunity zones. You can take a look at how those numbers play out over time in the comparison table at the bottom of this post.

Is an Opportunity Fund investment the right solution?

Qualified Opportunity Fund investments can help defer or eliminate some taxes on highly appreciated assets, provided that you don’t need access to the capital for 5 or, even better, 10 years. The fees, however, can be substantial, and can eat away at a large portion of the gains. No doubt an Opportunity Fund investment is better than sitting tight in a taxable investment account, but liquidity constraints and those ongoing fees could diminish returns compared to alternative tax planning strategies.‍

Results with a Qualified Opportunity Fund

 Year Start of Year Value Taxes After Tax Value Investment Growth End of Year Value
 2022 $1,000,000 $0 $1,000,000 $0 $1,000,000
 2023 $1,000,000 $0 $1,000,000 $90,000 $1,090,000
 2024 $1,090,000 $0 $1,090,000 $98,100 $1,188,100
 2025 $1,188,624 $0 $1,188,100 $106,929 $1,295,029
 2026 $1,295,029 $0 $1,295,029  $116,553 $1,411,582
 2027 $1,411,582 $350,000  $1,061,582  $127,042 $1,118,624
 2028 $1,188,624 $0  $1,188,624 $106,976 $1,295,600 
 2029 $1,295,600 $0 $1,295,600 $116,604 $1,412,204
 2030 $1,412,204 $0 $1,412,204 $127,098 $1,539,302 
 2031 $1,539,302 $0  $1,539,302 $138,537 $1,677,840
 2032 $1,677,840 $0 $1,677,840 $151,006 $1,828,845
Results with An Opportunity Zone

Note that because QOF funds cannot be deployed until the fund closes, per regulations, we assume no growth in QOF assets in the first year.

Results without an Opportunity Zone

 Year Start of Year Value Taxes After Tax Value Investment Growth End of Year Value
 2022 $1,000,000 $350,000 $650,000 $65,000 $715,000
 2023 $715,000 $0 $715,000 $71,500 $786,500 
 2024 $786,500 $0 $786,500 $78,650 $865,150 
 2025 $865,150 $0 $865,150 $86,515 $951,665 
 2026 $951,665 $0 $951,665  $95,167 $1,046,832
 2027 $1,046,832 $0  $1,046,832  $104,683 $1,151,515
 2028 $1,151,515 $0  $1,151,515 $115,151  $1,266,666 
 2029 $1,266,666 $0 $1,266,666  $126,667 $1,393,333 
 2030 $1,393,333 $0 $1,393,333  $139,333 $1,532,666 
 2031 $1,532,666 $0  $1,532,666  $153,267 $1,685,933 
 2032 $1,685,933 $421,584 $1,264,349  $168,593 $1,432,942 
Results without an Opportunity Zone

Next Steps

Want to know more about Opportunity Zones? Check out our next article on tax deferral strategies. Use our tax saving CRUT calculator to evaluate the potential return on investment given your situation. And if you have any questions, contact us through our chat button below, or set a time to meet with us.

About Valur

We have built a platform to give everyone access to the tax planning tools of the ultra-rich like Mark Zuckerberg (Facebook founder), Phil Knight (Nike founder) and others. Valur makes it simple and seamless for our customers to utilize the tax advantaged structures that are otherwise expensive and inaccessible to build their wealth more efficiently. From picking the best strategy to taking care of all the setup and ongoing overhead, we make take care of it and make it easy.