Read This Before Investing in an Opportunity Zone (QOZ) - Ideal REI

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Read This Before Investing in an Opportunity Zone (QOZ)

Selling shares of stock from your investment portfolio can yield large capital gains, but those gains can come with a cost. A capital gain earned by selling shares of stock will be taxed accordingly by the IRS in the year they are realized as part of an earned income; but what if there was a way to temporarily or permanently defer the tax that you incur from receiving a capital gain?

Thanks to the Tax Cuts and Jobs Act signed in 2017; you can choose to invest some or all of the capital gain into a real estate investment to avoid paying taxes on the gain. This tax break can be temporary or permanent, depending on the amount of time the investment is held. This program is called a Qualified Opportunity Zone (QOZ).

The Qualified Opportunity Zone program of the Tax Cuts and Jobs Act is to stimulate economic growth and increase jobs within an impoverished area of a community that otherwise would not have these opportunities for growth.

The United States Secretary of the Treasury is responsible for recognizing these communities as part of a qualified opportunity zone. To be recognized, the community must be nominated by the state as being economically impoverished.

There are approximately 8,700 qualified opportunity zones throughout the country. As an incentive for those who want to invest in real estate and avoid big tax hits, the IRS is offering a tax-free investment when using capital gains to fund the investment within a QOZ.

The Qualified Opportunity Zone program is intended for long-term investments, but even short-term investments can yield temporary tax breaks. We will go through each of these scenarios, but first, let’s talk about how to get started.

Get Started Investing in an Opportunity Zone

First things first, you will need a Qualified Opportunity Fund (QOF) in order to invest in a QOZ. To enter into a qualified opportunity fund, you must file IRS Form 8996 on time with your income tax return. Once you have a certified qualified opportunity fund, you can invest in a qualified opportunity zone.

In the first 180 days after receiving a capital gain, you must invest the capital gain into a QOZ property. Before making the investment, you need to decide how much of the capital gain you are going to invest and for how long. Depending on the amount you invest, and the duration of the investment will determine if you receive a temporary tax break or a permanent tax break and what percentage of tax break you are eligible for, so it is important to know your options before you invest.

qualified opportunity zone fund area
Most opportunity zones are in the less desirable areas of cities and towns. These areas desperately need investment, but remember, investors avoid these areas for a reason.

Know Your Investment Options

Before we dive into this section, you must know the difference between deferred capital gains and appreciated capital gains.

A deferred capital gain is the starting amount you will use to set up a QOF and make an investment in a QOZ to avoid paying capital-gains taxes. (Remember: QOF = qualified opportunity fund, QOZ = qualified opportunity zone.)

An appreciated capital gain is a gain you receive when selling the investment. It is separate from the deferred capital gain used to make the investment.

The Qualified Opportunity Zone program ends on December 31, 2026, so you will need to make your investment before December 31, 2019, to receive the maximum 15% tax benefit on deferred capital gains.

Ten years is the magic number if you want to permanently avoid paying taxes on appreciated capital gains in a QOZ. Unless you hold your investment for 10+ years, you will be required to pay taxes on the appreciated capital gain of your QOZ investment.

Not everyone can hold onto an investment for 10 years, so let’s look at all of the options as a whole to see the tax amounts associated with appreciated capital gains when selling a QOZ investment.

Option #1 – Temporary Deferral Only (Less than 5 Years)

When rolling over your capital gain into a QOF, you will be deferring the taxes owed on those capital gains. If you sell the investment in the first five years, you will be subject to paying taxes on the capital gain earned from the sale. Only the taxes on the capital gains that were put into the QOF will be deferred.

Here’s an example:

John Q Taxpayer invests a $10,000 capital gain into a QOZ. (Based on current the IRS tax rate of 20%, John Q Taxpayer would have had to pay $2,000 in taxes if he had not have invested in a QOZ property. Therefore, he gets to keep his entire $10,000 capital gain because it is in a qualified opportunity fund that has invested in a qualified opportunity zone property.)

Less than five years later, John Q Taxpayer sells the property for $25,000. Because of this, both the original deferred capital gain invested, as well as any capital gain made from selling the property, is subject to taxation. This means that $25,000 is taxable capital gain.

In our example, the deferred capital gain investment was $10,000. Because John Q Taxpayer sold the investment for $25,000, the appreciated capital gain of $15,000 on this investment is taxable.

Using the current tax rate of 20%, we will calculate the total tax amount owed on these capital gains.

You can calculate this in one of two ways: total taxable capital gain or individual capital gain added together.

Total Taxable Capital Gain

$25,000 x 20% = $5,000

Individual Taxable Capital Gains Added Together

$10,000 x 20% = $2,000

$15,000 x 20% = $3,000

$5,000

This means the total taxes owed on the capital gain from this investment is $5,000 because the property was sold less than five years after the investment was made.

Option #2 – Step-Up Your Tax Basis at Years Five and Seven

Let’s say you invest in a QOZ property, and somewhere between five and nine years, you decide to sell the property. You will receive a tax break on the deferred capital gains of either 10% or 15%, depending on the length of the investment. Let’s look at five years first.

Five Years After Investing in a Qualified Opportunity Zone Fund

When your QOZ investment reaches five years, you will receive a tax break of 10% on the deferred capital gains. So, what does this savings look like?

We will use the same John Q Taxpayer example as above.

John Q Taxpayer invests his $10,000 deferred capital gain into a QOZ and holds the investment for five years.

When five years is reached, he will up his tax basis by 10%. This means his deferred $10,000 capital gain is now $11,000.

Because John Q Taxpayer sold this property in five years, he will be taxed on the appreciated capital gain received from selling the investment, as well as the original deferred capital gain (but with a 10% savings taken into consideration).

First, we will take the sale price of the investment, which is $25,000 and take away the new $11,000 deferred capital gain amount to determine the taxable gain amount.

$25,000 – $11,000 = $14,000 taxable capital gain on appreciation from selling the investment.

Next, we need to calculate the 10% savings to the deferred capital gain to determine the taxable capital gain amount.

As the deferred capital gain amount is $10,000, we need to deduct the 10% tax-free amount from this total. 10% of $10,000 is $1,000, therefore…

$10,000 – $1,000 = $9,000 taxable deferred gain from the investment.

Because John Q Taxpayer has sold the investment for $25,000, we have to determine the total taxable capital gain from this transaction. Therefore, we will add these two taxable capital gain amounts together.

$14,000 + $9,000 = $23,000 total taxable capital gain.

Just like the example above, you can calculate the total taxes owed one of two ways: individually or as a whole total. We will continue to use the current tax rate of 20% for this example.

Total Taxable Capital Gain

$23,000 x 20% = $4,600

Individual Taxable Capital Gain Added Together

$14,000 x 20% = $2,800

$9,000 x 20% =   $1,800

$4,600

This means the total capital gain taxes owed on this investment is only $4,600 because you held the investment for 5 years, rather than the $5,000 amount for selling before reaching 5 years. This gives you a tax savings of $400.

So, what if you hold the investment even longer? What kind of tax savings does a 7-year investment look like? We’re glad you asked!

Seven Years After Investing

When your investment has reached a total of 7 years, you will receive an additional 5% on top of the 10%. This gives you a total tax savings of 15% on deferred capital gains.

Let’s put this into context by continuing with our example above.

John Q Taxpayer takes his $10,000 capital gain and defers the taxes by setting up a QOF and investing in a QOZ. (Remember: QOF = quality opportunity fund, QOZ = quality opportunity zone.)

At five years, he has stepped up his basis 10% from $10,000 to a new $11,000 deferred capital gain amount. Now, at year seven, he gets to step up another 5%, which is $500.

This makes his total deferred capital gain amount $11,500.

Because John Q Taxpayer sold this property in seven years, he will be taxed on the capital gain received from selling the investment, as well as the original deferred capital gain (but with a 15% savings taken into consideration).

First, we will take the sale price of the investment, which is $25,000, and take away the new $11,500 deferred capital gain amount to determine the taxable gain amount.

$25,000 – $11,500 = $13,500 taxable capital gain on appreciation from selling the investment.

Next, we need to calculate the 15% savings to the deferred capital gain to determine the taxable capital gain amount.

As the deferred capital gain amount is $10,000, we need to deduct the 15% tax-free amount from this total. 15% of $10,000 is $1,500, therefore…

$10,000 – $1,500 = $8,500 taxable deferred gain from the investment.

Because John Q Taxpayer has sold the investment for $25,000, we have to determine the total taxable capital gain from this transaction. Therefore, we will add these two taxable capital gain amounts together.

$13,500 + $8,500 = $22,000 total taxable capital gain.

Just like the example above, you can calculate the total taxes owed one of two ways: individually or as a whole total. We will continue to use the current tax rate of 20% for this example.

Total Taxable Capital Gain

$22,000 x 20% = $4,400

Individual Taxable Capital Gain Added Together

$13,500 x 20% = $2,700

$8,500 x 20% =   $1,700

$4,400

This means the total capital gain taxes owed on this investment is only $4,400 because you held the investment for 7 years, as opposed to the $4,600 tax amount for 5 years and the $5,000 tax amount with no tax break.

By holding the investment for 7 years, you saved a total of $600 on capital gain taxes.

Option #3 – Ten Years After Investing in the Opportunity Zone

To avoid paying taxes on the appreciated capital gain from your QOZ investment, you must hold the investment for ten years. The Qualified Opportunity Zone program ends on December 31, 2026, so to maximize the tax savings on your deferred capital gain investment, you must invest in a QOZ by December 31, 2019. (Seven years is the magic number to receive the maximum 15% tax savings on deferred capital gains.)

Risk vs. Reward

As in any investment, there are always risks associated when investing. You may look at the above examples and think, “Why would I want to pay $5,000 in capital-gain taxes by investing in a QOZ, as opposed to paying $2,000 in capital-gain taxes outright when received?”

This is where the reward comes in.

When you received your $10,000 capital gain, you had to pay $2,000 in taxes; therefore, the total “bring home” amount was $8,000. That’s still a nice amount, right?

However, ten years later, you could have taken that $8,000 bring-home amount and turned it into $25,000, $50,000, or $100,000. Fair market value is determined by the price a willing seller and knowledgeable buyer can agree on when making a transaction.

Therefore, if you invested your capital gain of $10,000 in a QOZ by December 31, 2019, and the property appreciated after 10 years and sold for $1,000,000, you will have made an appreciated capital gain of $990,000, while paying capital-gain taxes on the deferred capital gain amount of $8,500 because you were able to take advantage of the 15% tax savings!

Sure, that may be a steep example, but it is possible.

So, while you may look at today’s $2,000 tax bill as being better than a $5,000 tax bill, you have to consider the future return of the investment.

At the same time, it is understandable if ten, seven, or even five years is too long to be wrapped up in an investment; especially if you feel you will have to dip into those funds relatively soon.

Takeaways to Remember About QOZ’s

  • The Qualified Opportunity Zone program will end on December 31, 2026, unless Congress extends the deadline. This means that you must realize and make your capital gain investment in a QOF during the 2019 year to receive the full seven-year 15% tax break on the deferred capital gain.
  • There is always a risk associated with investing, so you should thoroughly consider your options when deciding how long to invest.
  • There are approximately 8,700 Quality Opportunity Zones, and you do not have to live or work in a QOZ to invest. To find a map of the current quality opportunity zones, you can visit the IRS website here.
  • You must create a Quality Opportunity Fund in order to invest in a Quality Opportunity Zone. You can self-certify (meaning, create your QOF) by filing a timely IRS Form 8996 along with an income tax return (this includes amended returns or returns with extensions granted, as well).
  • Real estate investments in a QOZ will bring economic growth through expenditures and jobs within the impoverished community. The growth of the community will help bring spending, and the new residential or commercial investments will also bring jobs. These investments provide tax incentives to qualified investors. This is why the Qualified Opportunity Zone program is part of the Tax Cuts and Jobs Act.
  • Ten years is the magic number for avoiding appreciated capital gain taxes on your QOZ real estate investment. If you sell prior to ten years, you can still receive a nice profit, so long as the property and investment has appreciated; but you will have to pay appropriate capital gain taxes associated with the transaction.
  • You must invest the capital gain in a QOF within 180 days after realizing the capital gain.
  • If you are considering making a capital gain investment within a community that will also help avoid paying capital-gain taxes, then the Qualified Opportunity Zone is worth discussing with a financial or real estate advisor.  

About the Author Eric Bowlin

Eric is an investor that achieved financial independence at the age of 30. He started in 2009 with the purchase of his first triplex and now owns over 470 rental units. He spends his time with his family, growing his businesses, diversifying his income, and teaching others how to achieve financial independence through real estate. Eric has been seen on Forbes, Trulia, WiseBread, TheStreet, Yahoo Finance and other financial publications. You can contact Eric by emailing him at [email protected] or with this contact form

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