Many investors may be hesitant to liquidate (sell) or reallocate (sell and buy) pieces of their portfolios since capital gains taxation will eat into their earnings. Investors are facing a 30 percent total tax bill for liquidation of an asset including the long-term capital gain tax rate of 20 percent, plus the Affordable Care Act tax rate of 3.8 percent, and the state and local tax rate of around 7 percent. Furthermore, investors face limited investment options that could be classified as discounted with little upside potential.
Thankfully, QOZs now present accredited investors who have capital gains in their portfolios with the ability to defer taxation until December 31, 2026, by reinvesting their capital gains into a QOZ investment. In so doing, the investor may diversify his or her portfolio with investments in an asset class which has not yet seen significant appreciation. Another powerful feature of the QOZ program is the tax-free nature of future capital gains on appreciation of QOZ investments. If the investment is held in an QOZ for a full 10 years, then the gain on the QOZ investment can be liquidated on a tax-free basis (i.e., a full stepped-up basis). The tax benefits available with a QOZ investment cannot be overstated for the long-term, growth-oriented investor. However, please note that gain or appreciation are not guaranteed, and your investment may lose value. Most stock market investors have no idea that the QOZ option exists. A Wall Street financial advisor is not likely to suggest to their clients the option of selling stocks and bonds for a QOZ investment. That would impact the advisor’s income by reducing their assets under management (AUM).
The Tax Incentives for a Qualified Opportunity Zone Investment
Per the original legislation, tax incentives for investors are mainly in the following three categories – defer, reduce, and exclude:
When an asset (stocks, bonds, real estate, etc.) is sold and the capital gain from that asset is invested into a QOZ fund, the tax on the gain is deferred until the date that the QOZ investment is sold or until December 31, 2026. Only the gain from the sale (including depreciation recapture) needs to be reinvested. The portion of the sale proceeds that represent a return of capital (adjusted basis) can be cashed out with no tax consequences and reinvested in alternative real estate investments with a new full tax basis. The deferral applies to federal taxes as well as most state income taxes.
Due to a statutory requirement to substantially improve the property by doubling the investor’s initial adjusted basis within a 30-month period, the qualified opportunity zone fund (QOZF) will have developed and stabilized the property well before 2026. Once stabilized, the fund manager will place long-term debt financing on the property. The proceeds from the new long-term financing will pay off the pre-existing construction loan, with the remaining loan proceeds being distributed tax-free to the investors. This tax-free distribution is expected to represent between 40 percent to 60 percent of the original investment amount and may be used to pay the deferred capital gain tax liability in 2027 with essentially new dollars. If, on the other hand, a tax-free distribution is not made by the sponsor, then investors will need to find an alternative source of funds to pay their tax bill at the end of 2026 as their initial rollover funds would be tied up in the QOZ investment.
At the time of this writing, the step-up basis provisions within the Act have timed out. However, we present them here in the interest of a more complete disclosure of original legislation and congressional intent. These provisions allowed for the basis of the invested gain is increased by 15 percent if the QOZ investment is held for at least 7 years prior to December 31, 2026. Thus, in order to enjoy the full 15 percent reduction in the tax on the rolled over capital gain, the QOZ investment must have been made before December 31, 2019. Investments made between January 1, 2020 and December 31, 2021 enjoy an increase in basis of 10 percent since the investment will have been held in the QOZ for 5 years by December 31, 2026. Per the current statute, investments made after December 31, 2021 are required to pay tax on the full gain but still have the deferral until December 31, 2026. For those investing after December 31, 2021, the deferral of the tax on the full reinvested gain is still a significant advantage. There is ample time for the development and stabilization of the QOZ property which enables the tax-free distribution from refinancing and provides the investor with new dollars to pay the tax in 2027.
Any appreciation of the gains invested in a QOZ is excluded entirely from federal and most state taxable income if the investment is held for at least 10 years. Practically, this means that to earn the exclusion the investment must be held for at least 10 years beginning from the time the QOZF equity raise is completed. Assuming a successful OZ real estate development or significant OZ business growth, the benefits of building wealth with this tax-free advantage cannot be overstated. While there are no guarantees of future yields, most QOZ sponsors are projecting potential total estimated returns between 2.5 to 3.5 times the original investment. QOZ investors desiring the full tax advantage should be prepared for a long-term hold without liquidity. Preferred annual returns for QOZ funds are typically between 6 percent to 8 percent and are accrued to the investors from day one. Cash flow distributions, on the other hand, mag begin as early as two to three years once the property construction is completed and the property substantially leased. Furthermore, investors may want to consider the advantages that the investment could present to themselves and their heirs. Unlike a §1031 exchange deferral, proceeds from the eventual sale of the QOZ investment would have a new tax basis and could provide significant tax sheltering advantages if the gains are reinvested in depreciable real estate.
Potential Bonus Depreciation
In addition to the main benefits of deferral, reduction, and exclusion, there are additional tax advantages to the QOZ investor including a income tax shelter due to bonus depreciation. Once the QOZ property is stabilized, the sponsor allocates the cost of constructing capital assets with shorter useful lifespans (3, 5, 10, or 15years) to investors as significant bonus depreciation (IRC §179 expense) which now has an annual deduction limit of $1 million. Of note, there is a full phase-out provision for taxpayers with an annual income over $2.5 million. This bonus depreciation can be used to fully shelter distributions from the QOZ fund, and excess depreciation can be used to shelter passive income from other investments (including DSTs, private REITs, and real estate funds). Initially enacted as a short-term incentive to spur investment by small businesses, bonus depreciation is being phased out from the years 2023 – 2026, decreasing by 20% each year. The bonus depreciation phase-out will apply to both new and used property, with the same qualifications in place during the phase out period. Once the property is sold with the 100 percent back-end tax exclusion, the prior depreciation does not have to be recaptured. At the time of sale, the remaining passive losses carryforward, are converted to active losses, and can be deducted against ordinary income. Never before has our government provided such a powerful tool for building wealth in America.
A Limited Window of Opportunity
Unless Congress extends the QOZ program past December 31, 2026, investors have only few more years to enjoy any significant tax deferral on QOZ properties. For the most part, U.S. equity market investors have enjoyed a bull market for stocks over the last decade following the 2008 Financial Crisis and Great Recession. However, these gains are threatened by recent severe market volatility, inflation, global trade wars, the political and economic risks of future elections, and the COVID pandemic. These factors point to a short window of opportunity to lock in gains through asset liquidation or reallocation.