Wrapping your head around taxes can give anyone a headache, especially when you’ve been hit with capital gains tax from the sale of real estate, stocks, bonds, or other assets. And up until recently, there were few, if any, ways to avoid the expense. But thanks to the 2017 Tax Cuts and Jobs Act, you can now delay and reduce your capital gains plus make tax-free money. How? By directly investing in a Qualified Opportunity Zone (QOZ) through an Opportunity Fund.
Part one of our series highlights the basics of QOZs and their locations, including zones right here in West Lafayette, Indiana. In this installment, we’ll discuss how you can suspend or cut down your capital gains tax and add tax-free potential to your financial portfolio.
1. Delay Capital Gains
When you roll your capital gains tax into an Opportunity Fund, your IRS tax payment can be deferred. Any capital gain qualifies, whether it’s from the appreciated sale of stocks, bonds, real estate, a business, or other assets. Once invested, your tax gets put on hold until you either sell your stake in the Opportunity Fund or when the program ends on December 21, 2026, whichever comes first. After that, your deferred tax will come due.
2. Reduce Capital Gains
Investing in a QOZ allows you to lower your capital gains tax by increasing your tax basis. A tax basis takes into account certain adjustments to your assets like depreciation, improvements, or fees to determine how much tax you owe. For example, when your tax basis increases, you’ll owe less in capital gains.
Opportunity Funds can raise your tax basis, trimming your overall tax bill. If you keep your fund for five years, you’ll get a 10% step-up in tax basis. Hold onto them for another two years (seven years total), and your tax basis goes up another 5% for a total of 15%. Since this program expires at the end of 2026, investments must be made by the end of 2019 to take advantage of the full 15% tax reduction benefit.
Tax Reduction Scenario
Let’s imagine in early 2019, you sold an investment with a $100,000 gain. Soon after, you invest your money into an Opportunity Fund, deferring your capital gains expense until December 31, 2026.
- After five years, you receive a 10% increase in tax basis calculated from your original $100,000 investment, so $10,000.
- Two years later, you get an additional 5% step-up in tax basis ($5,000), for a total of $15,000.
- On December 31, 2026, it’s time to pay your deferred gain. But now you can deduct $15,000 from your original investment, and only be taxed on $85,000 instead of the initial $100,000.
3. Tax-Exempt Appreciation
Opportunity Funds offer one more tax-exempt perk with even more significant money-saving potential. If you keep your investment in the fund for ten or more years, the tax basis can be raised to the fair market value of the property. That means you won’t be taxed on any gains from the appreciation in the QOZ fund. Why is this a big deal? Because if the value of your investment increases a lot, you’ll earn all that money tax-free. Let’s look at an example.
Tax-Free Investment Scenario
Using the numbers from above, imagine you invest $100,000 into a QOZ fund. After seven years, you pay your reduced capital gains tax. But instead of pulling the money out, you leave it in the Opportunity Fund.
- After ten or more years of total investment time, you decide to take out your money.
- The investment has appreciated, and now the fair market value is $250,000.
- With the tax basis increased to match the fair market value, you make $150,000—without paying any additional taxes.
Investing in a QOZ gives everyday people some great tax benefits and the ability to invigorate a struggling community. And it’s also a great way to boost your financial portfolio without accumulating more taxes. In the final part of our series, we’ll go even deeper into Opportunity Funds and how you can make a wise investment. Reach out to Kyle Mandeville at 765-742-9068 to start a conversation today.
The content of this blog is intended to be general and informational in nature. It is advertising material and is not intended to be, nor is it, legal advice to or for any particular person, case, or circumstance. Each situation is different, and you should consult an attorney if you have any questions about your situation.