The Capital Gains Tax ‘Opportunity’ of a Lifetime

A little-known provision within the Tax Cuts and Jobs Act of 2017 provides investors with a chance to earn returns on attractive investments, receive remarkable decreases to their capital gains taxes and make an impact on local communities.

They are called Opportunity Zones. To better understand this exciting program, wealth managers and accredited investors should learn about the tax benefits available.

Opportunity Zones were established by Congress to promote long-term economic stimulus through investments in low-income community census tracts in all 50 U.S. states, six U.S. territories and the District of Columbia.

Investors are able to roll over their capital gains of any investment into a Qualified Opportunity Fund (QOF).  QOFs steer money into qualified projects to ensure investors capture the associated tax breaks while meeting other fund-specific requirements and stipulations.

The tax benefits should not be understated. Payments on capital gains tax on the initial investment in QOFs can be deferred until December 31, 2026, or the sale of the new investment, whichever is earlier, with rates reduced by 10% if they remain in the fund for five years and 15% after seven years. Additionally, taxes on capital gains from appreciation on the investment are eliminated if a participant stays in the fund for at least 10 years.

How it works

How exactly might rolling over capital gains into a Qualified Opportunity Fund (QOF) help you? Let’s say you recently sold an equity stake in a company and realized $100,000 in long-term capital gains (LTGC). In this example, we will assume a long-term capital gains tax rate at 23.8% (20% federal and 3.8% net-investment income tax). The investable gain you are left with is $76,200. You then invest that money into a traditional portfolio of diversified assets.

Now take $100,000 in capital gains and roll it into a QOF. By doing so, you have deferred your capital gains tax on the full $100,000. For this example, let us assume an annualized return of 12% over a ten year period for both the diversified traditional portfolio and the investment in the Opportunity Fund. The below illustration shows a timeline that breaks down the associated tax benefits and growth of the respective investments.  

What makes this such an incredible tax break opportunity is that investors who remain in a QOF for 10 years will pay no capital gains tax on post-acquisition gains. The permanent exclusion only applies to gains accrued in the fund. This means that for an investment of $100,000 through a QOF, at the end of 10 years, the investor will have paid $20,230 in capital gains taxes and will realize the full appreciation of their QOF investment. In this hypothetical example after tax, the investor would see an 11.2% net IRR compared to a 7.1% net IRR in a traditional investment assuming both funds achieve a 12% annualized return over ten years. 

The tax advantages in this new program are unmatched. With the potential to defer, reduce and completely eliminate capital gains, you can see why this program has stirred up such a buzz. However, not all funds are the same and there are risks associated with any investment. To learn more about Opportunity Zones click here

*Note for the comparison case: The investment window is generally 180 days after sale, with the exception for 1231 gains, for which the window is triggered as of the end of the applicable tax year rather than the date of sale. 10% step-up in basis after 5 years. 15% step-up in basis after 7 years. The deferred capital gain tax to be paid in year 2026 is not considered due to the potential refinancing during the period.  Cash value of depreciation is not considered for simplicity. This is a hypothetical illustration of mathematical principles as it relates to the new tax code and does not predict or project the performance of an investment or investment strategy. It is not intended to be, nor should it be construed or used as investment, tax, or financial advice. An investor should consider his or her current and anticipated investment horizon and income tax bracket when making an investment decision, as the illustration may not reflect these factors. Tax rate on dividends is not considered for simplicity and may affect net returns. Investors from different states are subjected to state tax rate in correspondence and may receive different net returns.