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With this year’s strong stock and property markets, figuring out how to minimize capital gains tax may be top of mind for investors. Qualified opportunity funds can provide tax advantages, but acting fast makes a difference: You can reap the benefits of three tax perks instead of just two if you invest by year-end.
What is a qualified opportunity fund?
In 2017, the Tax Cuts and Jobs Act established a new tax perk allowing investors to defer and minimize capital gains taxes when reinvesting capital gains into qualified opportunity zones, which are economically depressed regions within the U.S. Qualified opportunity funds invest in businesses or properties within qualified opportunity zones, offering that preferential tax treatment to the fund investors.
By encouraging investment into opportunity zones, the government hopes to propel economic growth by creating more jobs, driving business activity, expanding housing options and kickstarting new startups in distressed communities. Whether that plan will work is up for debate: A June 2020 study by the Urban Institute found that though there have been investments that made community impact, oftentimes the capital has not gone toward the areas with the greatest need, but rather has benefitted real estate developers more.
On the other hand, the White House Council of Economic Advisors assessed the initial impact of qualified opportunity zone tax breaks in August 2020. It found that by year-end 2019, qualified opportunity funds raised $75 billion in private investment, which CEA projections show could shift 1 million people from poverty to self-sufficiency, reducing poverty in opportunity zones by 11% percent.
Why invest in qualified opportunity funds?
Say you’ve sold an asset (real estate, investments, a business, etc.) and have a large capital gains tax liability on your hands. Or you’d like to offload an investment, but the capital gains tax consequences have kept you from doing so. By rolling those capital gains into a qualified opportunity fund, you can defer and reduce your capital gains tax liability, diversify your portfolio and make a positive impact.
There are three main tax benefits of investing in qualified opportunity funds, and in particular, in investing in these funds in 2021:
You can defer paying taxes on your original capital gain until the tax year 2026, which means you won't actually pay taxes until you file your 2026 tax return in 2027.
If you invest by the end of 2021, you'll be able to hold your investment for five years, which allows you to qualify for a 10% reduction in the original deferred capital gain amount due in 2027.
If you hold your investment for at least 10 years, you'll owe no capital gains on any additional appreciation beyond what you paid in 2027. When investing in qualified opportunity funds, the longer you hold onto your investment, the greater your overall tax benefit.
“It’s very substantial. The net benefit to investors or the impact is between 40% to 50% higher after-tax returns than a non-opportunity zone investment,” says Jill Homan, president of Javelin 19 Investments, a Washington, D.C.-based real estate and investment advisory firm focused on qualified opportunity zones.
Qualified opportunity funds also provide investors with a way to diversify their portfolios outside of the traditional stock and bond markets; they can branch out into real estate or startup businesses. Investors can choose from single-asset investment opportunities or multiasset funds that invest in a collection of properties or businesses, often spread across different asset classes or geographies.
And you’ll feel good knowing that your investment may help improve poverty-stricken communities and provide opportunities to boost economic mobility.
Caveats to keep in mind
As with any tax break, many rules apply. You must reinvest your eligible gains into a qualified opportunity fund within 180 days from when the gain would be recognized to qualify for these tax advantages. And, not all gains are eligible: Only capital gains or qualified 1231 gains (gains on certain types of business properties) recognized for federal income tax purposes prior to Jan. 1, 2027, will count. Also, these gains cannot be generated from transactions with a related person.
Depending upon the qualified opportunity fund, you may need to be an accredited investor in order to participate. That means having earned income of at least $200,000 in each of the past two years ($300,000 with a spouse) and net worth, alone or with a spouse, of at least $1 million in investable assets. Even if the qualified opportunity fund you select doesn’t require accredited investors, holding the investment for the long term increases your tax benefits, so make sure to invest funds you won’t need access to for a while.
Investing in qualified opportunity funds will also require some due diligence on your part. Since these funds aren’t rated by typical fund rating agencies such as Morningstar, Lipper or S&P, you’ll need to examine the assets within the fund to gain comfort with the management team, investment strategy and potential returns.
However, Homan points out that compared with traditional private equity, investors often have more visibility into the underlying investments within the fund. Once investors roll gains over, qualified opportunity funds must deploy invested capital quickly to satisfy certain operating and testing requirements, which allows investors to obtain up-to-date information about the investments and deals they are funding.
How to start investing in qualified opportunity funds
In order to make sure you’re following the rules, considering all potential implications and filing the appropriate paperwork, consulting with tax or financial advisors well-versed in qualified opportunity funds can help smooth the investment process.
“Whether an investor is eligible to use opportunity zones depends on the character of the gain and timing of that gain,” Homan says.
She recommends that investors who are interested in qualified opportunity funds and have gains start out by talking with their accountant. “That’s really your first step — to become equipped and know this is the timing I’m working with, this is the amount of capital I have, and then your next step is looking at your options in the marketplace.”
Despite needing to jump through some hoops, opportunity zone investments are compelling.
“For investors, there are a number of funds to evaluate, and you can also look at investing in individual deals. This is a really active marketplace and one of the most significant tax incentives in a generation. It’s going to do a whole lot of good,” Homan says.
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