Tax reduction via opportunity zone funds
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It’s tough to think of a highly appreciated asset as the problem child in a portfolio. The goal is to choose investments that will flourish, after all. And those strong performers are typically the ones you love best and hold onto the longest.
But things can get complicated when it’s time to let go — when that stock stops growing and you’re ready to sell, or when you’re preparing to part with a valuable business or property.
That’s because the federal government likes winners, too — and thanks to capital gains taxes, you could end up sharing a hefty portion of your profit with the IRS.
But there are strategies that can help. I’ve written before about using a 1031 Exchange or a Deferred Sales Trust to defer capital gains taxes when selling real estate. Now a newer strategy is giving the 1031 and DST some competition: A Qualified Opportunity Zone Fund can be used with any investment that will trigger capital gains.
Like any investment strategy, it comes with risks, and it’s not for everyone. But for those who feel trapped by capital gains, the tax savings and potential for profit make it worth looking into.
A new type of fund
Opportunity Zone Funds became part of the tax code with the Tax Cuts and Jobs Act of 2017. The funds are created by partnerships or corporations that invest in eligible properties within designated Opportunity Zones.
The IRS defines an Opportunity Zone, or O-Zone, as an “economically-distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment.”
In other words, the communities on the receiving end of these funds hope to benefit from revitalization, while investors can reap tax benefits by putting their money toward those improvements.
In order to qualify, an Opportunity Zone Fund must invest at least 90% of its capital in O-Zone property.
How does it work?
When an investor sells an asset, he or she can roll any amount of the gain into an Opportunity Zone Fund within 180 days of the sale. The investor can then defer capital gains taxes on that amount until Dec. 31, 2026, or until the Opportunity Zone Fund investment is sold or exchanged (whichever comes first).
An investor who keeps the money in the Opportunity Zone Fund for at least five years can defer payment of capital gains and exclude 10% of the taxable gains from the original amount invested.
If the investor keeps the money in the fund for at least seven years, he or she can exclude another 5% (for a total of 15%) of the taxable gains from the original amount invested.
Investors who hold the money in the fund for at least 10 years can exclude 15% of the original amount invested. In addition, any accrued capital gains generated from the investment are 100% tax exempt.
So, let’s say an investor sells an asset and has a $100,000 tax liability. By holding the money in an Opportunity Zone Fund for 10 years, the investor would avoid paying capital gains taxes for a decade, reduce his liability to $85,000, and any gain on the money invested in the fund would be tax-free.
What are the risks?
Because this is a new investment strategy, there are some uncertainties, including:
The IRS and Treasury Department are still working on the specifics of how Opportunity Zone Funds will work over time — both for investors and those in charge of funds. So, you may enter into this investment with questions that can’t be answered just yet. (That doesn’t mean you shouldn’t ask, though.)
Because the areas earmarked for improvement are distressed, recovery may not go as quickly as planned — and a fund won’t gain in value if the targeted community and its businesses aren’t gaining in value. So, like any investment, there’s no guarantee you’ll make money.
The tax plan is currently set to sunset on Dec. 31, 2026. If it isn’t extended, investors would be required to begin paying taxes on accrued capital gains after this date, regardless of how long they hold on to the fund as an investment.
Did I mention that this isn’t for everybody? In fact, you must be an “accredited” investor in order to participate, meaning investors who have a net worth exceeding $1 million and/or an annual income exceeding $200,000 individually or $300,000 for joint households.
However, it can be an alternative for those who want to diversify, who might like the idea of an investment with social impact or are seeking a long-term investment with tax benefits.
If you think it could fit with your overall financial plan, discuss the pros and cons with your tax or financial professional. Ask for a comparison of the benefits of investing in Opportunity Zones vs. a 1031 Exchange or Deferred Sales Trust. And talk about the funds available and how to choose the right one.
Currently, the number of funds is limited, but once the Treasury Department finalizes its regulations, you can expect to see more — and more investor interest.
C. Grant Conness is Investment Adviser Representative at Global Wealth Management. Kim Franke-Folstad contributed to this article.
This article was written by and presents the views of the author, not Kiplinger editorial staff. Check adviser records with the SEC or FINRA.
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