We’re coming up on tax time (unless you’re an early filer!) As a result, one of the questions I get at least 1-2 times a week is, “R. J., I sold a business / piece of real estate / equities / fill in the blank! They should name a road after me for all I’m paying in taxes! Anything I can do about it, even now?”
Funny you should ask!
May I introduce (or re-introduce) you to a concept that, until six months ago, I was a “hater.” Today? Paint me as cautiously enthusiastic, with only a few caveats. (Hey … I am a conservative advisor!)
So, what’s the “hot idea?” An economic development strategy that the US tax code refers to as a “Qualified Opportunity Zone” (QOZ.) That is, over 8,700 zones in America & Puerto Rico that Congress is pouring out tax love for qualified investors.
Given all the tax benefits the government is showering on this strategy, I have heard it being referred to as a “tax-free loan from IRS” to buy investment-grade, income-producing real estate… Well! A tax-free loan … from IRS??? Imagine That™!
Note: If you missed our February webinar on this topic, I interviewed a wonderful professional friend, Sly Pusiri, who told me, “R. J., you really need to talk to Jeff Feinstein.” Man, he was right as usual! Jeff is brilliant in his craft, as well as motivated by more than just making a buck. His company is just now closing funding its 8th offering in this space. What I love is they have created an offering that is great for investors and also great for the forgotten middle-class Americans looking for quality, affordable housing.
This article just gives you the basics at 30,000 feet. Go to our YouTube Channel for the Qualified Opportunity Zone video playlist with all the details straight from the experts themselves!
Qualified Opportunity Zone Primer
So, what are Qualified Opportunity Zones?
First, this is NOT Section 8 housing! No slight intended as Section 8 housing is a necessary safety net, but we’re focused here on providing for the housing needs of middle-income families.
Basically, Congress took a look at the 2010 census data (yes, I know that was a while ago, but no one accused bureaucracy of speediness) and saw the challenges middle-income Americans were facing even then. Congress then offered incentives to allow developers to build homes, condos, townhomes, live-work-play spaces, etc., in areas that, without government intervention, would not have been attractive areas for residential housing.
In addition, Congress created tax breaks for investors. The biggie being capital gains tax deferrals, which we’ll talk about in a minute.
Normally, once you sell an asset, you owe the IRS capital gains taxes (also with taxes due to the respective state. In California, it can be as much as another 13.3%!) With Qualified Opportunity Zones, however, Congress is unlocking capital gains and allowing the gains to move into real estate (on which housing is desperately needed.) People get housing. Investors get to reduce and defer capital gains taxes on their immediate sale and eliminate future capital gains taxes on their new real estate in the Qualified Opportunity Zone. Amazing!!!
Watch the qualified opportunity zone primer here.
That sounds a little too good to be true, right?
I hear you … but that’s what makes this such a good option for more investors than ever.
How does it work?
Income & Tax Benefits
As these projects get built out in the first 12-24 months in their respective funds, investors can expect a 5%-7% income stream with little to no tax to pay. There is neither federal nor state tax on the income (at least in the first 5-7 years) because of shelter from depreciation and a pro-rata share of interest deduction.
Additionally, the QOZ program has three major tax benefits for investors.
1. Deferral of capital gains. When we sell an asset that normally triggers a capital gains tax, we can invest those capital gains into a Qualified Opportunity Zone (QOZ.) If it is done within 180 days of the sale closing, the capital gains tax on those gains will not be due until April 15th of 2027. (A pending bipartisan revision bill in Congress will push this out until 4/15/2029! It also would reinstate a 10% “basis bump” … that is, reducing the deferred capital gains that would be taxable by 10%!)
2. No capital gains tax on QOZ fund profits. For qualifying QOZ funds that hold their real estate investments for ten years, there will be NO capital gains tax on the profits. In other words, the QOZ investment property has a tax-free appreciation. Nice!
3. Use of depreciation with no recapture. QOZ investments are real estate, which means we can take an annual depreciation expense just like any other investment project. But here’s the great part. Once again, at the 10-year mark, you will not owe depreciation recapture taxes!
But wait! It gets better!
When you invest in Qualified Opportunity Zones, you don’t have to put in your basis. Whaaaaat?
Let’s say you’re selling some real estate you bought for $1 million and sold for $3 million. You can invest that $2 million of gain into the QOZ and reinvest your $1 million basis (which isn’t subject to capital gains tax) in your pocket … or use it for income while the QOZ fund is ramping up its income stream to pay out to you as an investor.
Wait ... What is Basis Again?
The best way to explain basis is with an example.
Let’s say you bought a piece of real estate 10 years ago for $500,000, and today, you’re selling it for $1.5 million.
With a QOZ, you can pull out the original $500,000 and only put the $1,000,000 of profit into the QOZ. You can take that $500,000 and use it however you wish. It’s yours. You won’t owe capital gains with the $1 million of profit moved into a QOZ.
That’s basis—the purchase price of the property, plus any improvements and less depreciation.
(Hint: this also works with equities…although there are no improvements or depreciation on stocks.)
Wait ... Could I Use A QOZ To Defer Taxes On The Sale Of My: Business? Stocks/Mutual Funds/ETFs? Crypto? Oil & Gas?
Let’s look at some common examples of situations where people benefit from investing in Qualified Opportunity Zones.
Case Study #1. Selling an Appreciated Asset.
If you’re expecting a big capital gains tax bill this year from the sale of an appreciated asset(s) but are still within the 180-day window, you can reinvest the profits and defer the tax. Well, at least until April 15, 2027, or hopefully, April 15, 2029! At the same time, you’ll be diversifying your investment portfolio into single- and multi-family income-producing real estate.
Case Study #2. Real Estate Sale.
We had someone call us who sold an investment property and wanted to do a 1031 initially, but then everything fell through. He had five more days on the clock and was in a panic about what to do.
In this example, our friend sold his investment real estate for $2 million (numbers changed for privacy) with $1 million in basis. He was able to pocket that basis tax-free and move the remaining million into a QOZ fund to defer the taxes and take advantage of the tax-free growth when the fund liquidates in 10 years.
This is such a major difference from a 1031 exchange. I have to say it again. With a 1031 exchange, you have to reinvest the basis as well as the gain. With the QOZ, you can keep all – some – or reinvest all of the basis if you want to. You choose!
Case Study #3. Short Term Gains.
This works well on short-term capital gains, too. We’re seeing short-term capital gains taxes at 37% rates, plus state income tax on top of that. In Cali, again, that puts you over 50%! Ouch!!
So, instead, park those profits into the QOZ … with or without the basis reinvested.
FAQ
Certainly, a small novel could be written explaining QOZs. And we had many questions during our webinar.
Some of the most common ones were:
- What is the cash-out or refinancing option for Qualified Opportunity Zones?
- What’s the minimum investment in a QOZ Fund?
- Is the timing similar to a 1031?
- What if someone needs their money out before the end of 10 years? (Such as paying the original, deferred capital gains tax due in 2027/2029)
It’s best to get an in-depth explanation from our expert, Jeff Feinstein, here.
What To Do Next?
One little speedbump here is that you have to act fast because there is an expiration date on it unless Congress extends the tax deferral advantage. We expect they will because the program has been wildly successful. However, we’re still watching for the vote.
If you have questions about Qualified Opportunity Zones or are facing a “broken 1031,” email info@wealthlegacygroup.com to schedule a complimentary call and see if this might be a good solution to reducing, deferring, and even eliminating some of those capital gains taxes…Imagine That™!
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R. J. Kelly, Wealth Legacy Group®, Inc. – March 2024
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