Using An Opportunity Zone Investment to Defer Short Term Capital Gains

Carl E. Sera, CMT
Carl E. Sera, CMT
Managing Principal, Sera Capital
Carl Sera is a Chartered Market Technician and the Managing Principal at Sera Capital Management, LLC. He has over 14 years of experience in the financial services industry with a focus on investment management.

apartment buildingWe’ve  written here before about using a 1031 Exchange or a Delaware Statutory Trust to defer capital gains taxes when selling real estate. But now a newer strategy is giving the 1031 and DST some competition; it’s called a Qualified Opportunity Zone Fund. And you can use it with any investment that will trigger capital gains while DSTs can only be used for real estate.  So the QOZ has more flexibility.

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 examining.

What is a Qualified Opportunity Zone 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.
  • To qualify, an Opportunity Zone Fund must invest at least 90% of its capital in O-Zone property.

What is Considered an Qualified Opportunity Zone

An Opportunity Zone is an economically distressed community that conveys preferential tax treatment to long-term investors under federal tax rules. In other words, it’s a tax-based economic development tool intended to spur investment and create jobs in troubled areas of the country.

To be designated an Opportunity Zone, a census tract must first be nominated by the state or other jurisdiction for this purpose and then be certified by the U.S. Treasury and the IRS.

For an area to qualify as an Opportunity Zone it must be characterized by either of the following:

  • a poverty rate of at least 20 percent, or
  • a median household income that is less than 80 percent of the median household income of its neighbors.

In total, there are more than 8,700 certified Opportunity Zones. They are located in every state, plus the District of Columbia and five U.S. territories. And they’re not all rural or inner-city — some of the locations just might surprise you.

You can research the tracts designated as Opportunity Zones using the online tool Opportunity Zone Explorer. The IRS has also published a list of tracts, by state, in Notice 2018-48.

How Does Investing in a QOZ Work For The Investor?

  • 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.

A Case Study of the Tax Benefits Associated with investing in a QZF

Coby, who lives in Michigan, sold his company for $20 million on October 1, 2018. His basis in the company was $0, and as a result, he will owe $4 million in capital gains tax. If he invests a quarter of the proceeds ($5 million) in a QOF within 180 days of the sale, he will be able to defer a quarter of the capital gains tax ($1 million). At this point, his basis in the QOF investment would be $0.

10% of Initial Capital Gains Eliminated After Five Years

However, after five years, his basis would be increased to $500,000, which would effectively wipe out 10% of his deferred capital gains tax, or $100,000.

15% of Initial Capital Gains Eliminated After Seven Years

After seven years, his basis is increased to 15% of the deferred gain invested, or $750,000, eliminating another $50,000 in capital gains tax.

What if Coby’s investment in the QOF has performed extraordinarily well and doubled in value to $10 million? Were he to sell it after seven years, he would realize $9.25 million in gains ($10 million, less the basis of $750,000), on which he would owe $1.85 million in taxes. In the end, he would net $8.15 million.  However, selling after 7 years is not what Coby should do.  Why? Because the after-tax rate of return on a QOZ is not maximized if sold in less than 10 years.  In fact, at Sera Capital we do not recommend that people invest in these unless they plan on holding for at least 10 years.

Remaining Initial Capital Gains Must Be Paid After December 31, 2026

What happens next if Coby intends to hold for the 10-year period?  Were he to hold onto the QOF investment through December 31, 2026, he would have to realize all deferred capital gains, per the Internal Revenue Code. In this case, he would realize a $4.25 million gain (the initial $5 million investment, less the adjusted $750,000 basis) and owe $850,000 in capital gains tax. He would continue to hold the investment, but now with an adjusted basis of $5 million.

No Capital Gains Owed If Sold After 10 Years

If he held onto the QOF investment for more than 10 years, his basis would be adjusted again to match the fair market value of the QOF when he sells it. Coby would pay no capital gains tax on gains earned from the investment. The only taxes he would have paid on the investment would have been the deferred tax paid on December 31, 2026.  This means that if after 10 years the QOZ fund is worth $10 million he keeps the entire $10 million tax free.  We know of no other investment vehicle that provides this type of compelling tax advantages.  The investor gets to defer taxes, then reduce their tax bill then eliminate the gains after 10 years.  Furthermore, the top QOZ fund sponsors since they raise billions of dollars in these funds, have a mechanism that will provide the investor with the capital to pay the taxes due after December 31, 2026.

Lastly, in this example we showed that Coby had a $0 cost basis.  But what if his cost basis had been $12 million instead.  Then Coby could have invested the $8 million difference into a QOZ and paid zero taxes on the entire sales proceeds at time zero.  He would put the $12 million in his pocket and invest the remaining taxable component.

Who Can Invest in a Qualified Opportunity Zone Fund?

Investments in a Qualified Opportunity Fund, with accompanying tax benefits, are available to the following:

  •  individuals
  • multi-member LLCs that are treated as partnerships or corporations for federal income tax purposes
  • S corporations
  • partnerships
  • C corporations, including regulated investment companies (RICs) and real estate investment trusts (REITs)
  • trusts
  • estates

As a result, the gains to be reinvested can come from any number of sources — including real estate developers, affluent individuals and families and their family offices, venture capitalists and investment or private equity banks, even mutual funds.

Please note, that Qualified opportunity zone tax benefits only apply to capital gains, not to ordinary income. If a transaction produces both ordinary income and capital gains, the entire gain can still be invested in a QOZ if the taxpayer elects to do so, but only the capital gain amount will be eligible for the QOZ benefits.

How long does a taxpayer have to invest capital gains in a QOF?

The general rule is that a taxpayer has 180 days from the date of the sale that results in capital gains to invest into a QOF. The taxpayer will then make an election on their tax return to defer the gain. For example, if the taxpayer sold stock in 2021, they would have 180 days from the date of the stock sale to invest into a QOF and the election would be made on the 2021 tax return to defer the gain.

There are exceptions to this general 180-day rule that provide investors flexibility on when they can invest into a QOF to defer gains related to pass-through entities or installment sales.

How much capital gains can be deferred?

The taxpayer can elect to defer as much or as little gain as they choose. There is no limit on the amount of gain that can be deferred. For example, if a taxpayer sells stock for $1.5 million with a basis of $500,000, the taxpayer will have a gain of $1 million. The taxpayer can defer all the gains by investing all of it in a QOF and then making an election on a timely filed return. However, the taxpayer may defer as little of the gain as he or she chooses. The taxpayer could defer $100,000 of the gain by investing only that amount in a QOF.

How long can the gains be deferred?

The taxpayer can defer the gains until Dec. 31, 2026, provided the investment in the QOF is not sold before that date. If the qualifying investment is sold before Dec.31, 2026, the taxpayer will recognize a gain in the calendar year of sale.

How does an Qualified Opportunity Zone Investment Compare to a 1031 Exchange?

There are significant differences between the tax benefits that accrue from an investment in an Opportunity Zone versus like-kind property that qualifies for a 1031 exchange.

Among the major differences are that, for a 1031 exchange, only your real estate assets qualify, and the exchange must include the value of the asset and the gain. For an Opportunity Zone investment, all assets that give rise to a capital gain qualify and only the gain portion of the transaction must be reinvested.

The time horizon is another difference. For a 1031 exchange, the step-up in basis only occurs upon death. For an Opportunity Zone investment, the increase in basis occurs once the investment is held for more than 10 years

Opportunity Zone  1031 Exchange 
Qualifying gains Virtually any short- or long-term capital gain that is treated as a capital gain Real estate only
Amount that must be reinvested Gain portion only Total sales price — including both the asset’s initial basis and gain
When reinvested gain is taxed The earlier of when asset is sold or December 31, 2026 When (if) asset is sold
When appreciation of reinvestment is taxed Stepped up basis after 10 years Stepped up basis upon death
Depreciation recapture subject to tax as ordinary income No, if held greater than 10 years Yes

 

Are there any risks with a QOF investment?

While investing in a qualified opportunity zone fund investment allows for easy deferral of capital gains taxes, it comes with its share of risks. Below are some of the risks associated with a QOF investment.

  • 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? As a matter of fact, you must be an “accredited” investor 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 appealing 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.

Lastly, we like to explain that DSTs from top well-established sponsors are a 1 on a 1 to 10 scale since they are designed for older mostly retirees.  Their expected rates of return are also a 1 on a 1 to 10 scale.  These DSTs own income producing properties that are already built, operating and collecting rents.  A QOZ is in stark contrast to a DST.  They are riskier in our opinion because the sponsors must add value which often involves creating something from nothing and then and only after it is built or modified do the rent collections begin.  What makes a QOZ fund compelling is the tax advantages.

If you think it could be a fit with your overall financial plan, be sure to discuss the pros and cons with your CPA or financial professional. You can also reach out to Sera Capital for a comparison of the benefits of investing in Opportunity Zones vs. a 1031 Exchange vs a Delaware Statutory Trust (DST).

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