QOZ 2.0 - Back And Not Quite As Confusing

Taxes suck. Fortunately, there are all sorts of ways for us to reduce, avoid, and/or defer them.

Qualified Opportunity Funds allow us to potentially do all three.

“Wait a second… What are you even talking about?”

Ah, good point, let’s start from the beginning.

Qualified Opportunity Zones

In 2017, a new tax law was passed. The 2017 Tax Cuts and Jobs Act reduced tax rates across all incomes, increased things like the Standard Deduction and the Child Tax Credit, and it also created the Qualified Opportunity Zone structure.

QOZs are economically disadvantaged geographical areas, deemed as such by each state’s governor. The idea behind QOZs is to drive investment in them by offering tax advantages to investors. Most investors accessed these tax advantages by investing in a Qualified Opportunity Fund (QOF).

Tax Advantages of Investing in a QOF

The 2017 law was built as a one-time thing. Investors with realized capital gains could defer paying taxes on those gains to tax year 2026, and depending on the year they invested, they might get a 10-15% reduction in the gains they deferred. Not only did you get to defer and reduce gains, but if you hold the QOF for more than  years, your gains will all be tax free when you do sell (as long as you do so before 2047).

For example, let’s say you sold a stock for $250,000 in 2020. You bought it for $150,000, so you have a gain of $100,000. You could have taken $100,000 of those proceeds, and as long as you invested them in a QOF within 180 days of the sale, you got to defer those gains to tax year 2026 (assuming you held the QOF and didn’t sell it). Now that it’s 2026, you’ll need to pay the piper, but since you held for 5 years, you get a 10% discount on your gains, meaning you only need to report $90,000.

That’s what made the first round of QOZ funds a little more confusing. No matter when you deferred the gains, you needed to report them as taxable in 2026, but depending on when you invested, you may not have needed to pay tax on the entire thing.

QOZ 2.0 is a permanent program. Most of the rules are the same (assuming an investment after 2027):

·       You must reinvest your gains within 180 days of the sale (unless the gains come from a pass-through entity, in which case, you may have more time)

·       Your gains are deferred up to 5 years from the date of your investment in the QOF (or until you sell the QOF, if sooner)

·       If held for 5 years, your gains get a 10% reduction in the year you realize them

·       If you hold the QOF for 10-30 years, gains on the sale of the QOF are tax-free

Who Should Consider QOFs?

QOFs are best for people who have unavoidable capital gains. There are a lot of people who may fit into this category:

·       Business owners who are selling their business

·       Real estate investors who are selling a property and cannot (or don’t want to use a 1031 exchange)

·       Investors with large, highly-appreciated positions

If you’re thinking about selling something SOLELY for the purpose of deferring the gains into a QOF, might make sense to rethink. I’m not saying you should NEVER do something like this, but if it’s a diversified asset you’re thinking about selling, it may be best to defer the gain until you’re in a lower-income year or even until you pass away to receive a step-up in basis. Once gains are deferred into a QOF, they can’t receive a step-up upon the owner’s passing, and you lock in when you have to pay the tax.

It also may not make sense to defer gains if you’re in a low tax bracket. See below, long-term capital gains already have a relatively large range of 0% taxation if your income is low.

QOF Strategies

At times, deferral is a great strategy in and of itself. For instance, let’s say you have $2 million in long term capital gains, and you don’t expect to have any other income (which is highly unlikely, but I’m trying to make it simple). If you’re married, and you take the standard deduction, here’s how the tax plays out:

*Note: There is no 18.8% bracket (or 23.8% bracket for that matter), but there is an additional tax of 3.8% on investment income for income in excess of $200k for individuals and $250k for married couples, called Net Investment Income Tax (NIIT). NIIT does not always apply to capital gains.

Now, what if we take $1 million of that gain and put it into a QOF in early 2027? Immediately, we defer gains that generate $238,000 in taxes (so our tax due for this year is $178,150). Five years from now, we’ll pay tax on $900,000 of gains after the 10% reduction in gain. Tax brackets are indexed for inflation, but let’s just use the same numbers (again, for simplicity’s sake). Here’s how that stacks up in tax year 2032.

If we chose to pay the tax on the full $2 million in tax year 2026, we wind up with a tax liability of $416,150. But if we defer half of it into a QOF, we instead have a tax liability of $178,150 in 2026 and a tax liability of $154,350 in 2032 for a total of $332,500. In this case, the QOF saves the investor $83,650 in taxes.

But wait! There’s more…

What if we took that initial gain (net of year 1 taxes due) and invested in a direct indexing strategy built to harvest losses. Conservatively, we should have at least $100,000 of realized losses available to offset against the gains realized in year 5, further reducing the tax due at that time by $23,800.

Pair that with the fact that the investment in the QOF can be sold after 10 years without taxes on the gain, and we have some really tax savings here. I mean, assuming an 8% annualized return, we’re talking about over $1,000,000 of additional gains TAX FREE.

Bottom Line

QOFs, when added as a tool in your multi-year tax planning strategy, can be incredibly valuable. That said, it’s important to work with a team who deeply understands your entire tax and investment situation along with the nuances of QOF tax code and investment options. Not all funds are created equally, and it’s important to make investment decisions based on the investments themselves, not just tax strategy.

As always, keep in mind that you don't have to go it alone. I’m Austin Preece, a financial planner with offices near Eau Claire, and Madison, Wisconsin, and I work virtually with people across the US. Check out our website to see what it's like to work with us and reach out if you have any questions.

If you found this post helpful, help spread the word! Share with friends and family that you think may benefit as well. But remember, this is solely for educational purposes - it's not advice.