Investing in Opportunity Zones has many advantages from tax perspective. I’ve listed three of the most common below:
- When you roll over capital gains into a Qualified Opportunity Fund within 180 days, you can defer their recognition until December 31, 2026. For most taxpayers, the tax on the gains would be due in April 2027.
- When the tax bill on your initial gain is due, you can reduce the recognized amount by 10% if your Qualified Opportunity Fund holding period reaches five years by the end of 2026. The ability to reduce it by 15% expired on December 31, 2019.
- You can exclude 100% of any new capital gains accrued within your Opportunity Zone investment after a 10-year period. You won’t have to pay taxes on any long-term Qualified Opportunity Fund gains.
These tax benefits are well known, but there are some little-known benefits of investing in Opportunity Zones as well.
Compounding Gains from Deferred Tax Liability
If you defer the tax liability on your initial capital gains until 2027, you will be getting an interest-free loan from the federal government. Instead of paying taxes on a portion of your initial gains, you can take the deferred tax liability and invest it for several years. This will allow you to generate more compounded returns. If you live in a state that taxes capital gains and complies with Opportunity Zone tax incentives, you will be getting an interest-free loan from the state government as well.
How about some Math to help illustrate the power of tax deferral… 😊
Let’s say you decide to sell your Tesla stock and receive a long-term capital gain of $200,000. Assuming that it’s subject to a 20% capital gains tax with a 3.8% net investment income tax rate, your total federal tax rate on this amount will be 23.8%. This will turn your $200,000 profit into $152,400 after federal taxes. If you put this after-tax amount into an investment account that compounds at 7% annually for ten years, it will double your $152,400 investment to $299,794. This is a gain of $147,394 which is great, right?
But what if you roll over that $200,000 gain (before taxes) into a Qualified Opportunity Fund, and defer the recognition of the money you made from selling your Tesla stock until the end of 2026? Instead of investing the after-tax amount of $152,400 you can invest the pre-tax amount of $200,000. And if it’s compounded at 7% annually for ten years, it will turn into $393,430. This is a gain of $193,430!
Therefore, by deferring your capital gains tax and putting ALL of your funds to work you have a 30% larger gain in the second scenario vs the first.
$193,430 vs $147,394
Eliminating Depreciation Recapture
Depreciation recapture allows the IRS to collect part of the capital gains that are attributable to the depreciation of any properties taken during previous years of ownership. This amount is taxed as ordinary income (typically at 25%), which is higher than the capital gains tax rate.
If you purchased a rental property in 2013 for $700,000 and then sell it in 2020 for $1,200,000, according to the IRS, your annual depreciation was $25,454 ($700,000 divided by 27.5 years) for total depreciation of $203,632 over the past eight years. This will lower your adjusted basis on the property to $496,368, which will make your total gain on the sale to be $702,632 ($1,200,000 – $496,368).
This equals a capital gain of $500,000, plus an uncaptured gain of $202,632 that’s taxed as ordinary income. Assuming that the tax rate on the uncaptured gain is 25%, you would owe $50,908 in depreciation recapture.
But if it’s an Opportunity Zone investment all depreciation recapture is gone forever as long as you have held the investment for 10 years or more!
When you put it all together, the advantages of the Opportunity Zone program can be a no-brainer for any investor. If you have a large capital gain that you can roll over into a 10-year investment and some patience, you can see huge savings by injecting more capital into underserved areas.
For more information about how you can get into Opportunity Zone investing, get in touch with Trevor Shakiba at Shakiba Capital.