One of the commonest issues investors worry about is capital gains tax. If you realized a large gain this year, you’re due for a large tax bill. But there are many ways to avoid this liability. Opportunity zone investing is one way to reduce capital gains tax liability while doing good for underprivileged areas at the same time.
What Is Opportunity Zone Investing?
The 2017 Tax Cuts and Jobs Act granted certain tax privileges for investing in specific areas. These areas, called opportunity zones, are certified by the Treasury Department as qualifying based on their low economic development. Opportunity zones are often poor, blighted, or underdeveloped. States nominate these areas specifically because they believe investment in these areas could pay off in a big way. An underinvested area is often undervalued, and thoughtful development could result in a revival of these neighborhoods.
Here’s how it works: when you realize your capital gain, you have 180 days to reinvest that gain in a qualified opportunity zone (usually through a qualified opportunity fund). If you do this, your original capital gain tax liability will be deferred until 2026, or until you sell your interest in the opportunity zone. Also, you will not have to pay tax on the appreciation of the property. So, if you buy it for $5 million, and sell it later for $10 million, you will only have to pay taxes on $5 million of the proceeds from the sale.
Investors can also receive a step-up in the tax basis of the opportunity zone investment, 10% if you hold the property for five years, and 15% if you hold it for seven years. But, since it’s already 2022 and the benefits only last till 2026, new investors won’t benefit from this perk.
When you’re realizing a large capital gain, anything that can offset that gain looks very attractive. In this case, you will not actually remove the tax liability, but only defer it. However, given the time value of money, deferring a large tax liability for several years means you can invest the money further. Remember, anytime you can pay later instead of now, without interest, it’s an advantage.
Second, opportunity zone investments can be profitable. As the neighborhood you invest in grows and flourishes, property values in the area may increase. And you won’t have to pay taxes on this appreciation!
Of course, nobody can say for sure if an opportunity zone fund will pay off or not. In some cases, the blight in the area may be too bad for the extra investment to save the day. Since the program is new, it’s hard to rate its risk or expected returns. You should probably gather as much trusted advice as you can before making an investment. How is the area doing now? How will these specific investments help the area or pay off?
If you care about renewing neighborhoods, that’s another mark in the pro column. Underdeveloped and underappreciated areas can result in a lower quality of living for the people who live there, and the desire to help out by investing there is admirable. Funds are supposed to build or renovate properties, and this can drastically improve the appearance of a neighborhood.
The opportunity zone program has its critics. Some say economic gains in the affected neighborhoods mainly go to investors, not actually improving the areas in question. Opportunity zones have attracted $75 billion in investments and created 500,000 jobs. However, they have had only a modest effect on wages within the zones, compared to areas that weren’t designated. Some also worry the program may fuel gentrification, pricing the neighborhoods’ actual residents out of the rental market.
Some investors also don’t care for the program. Deferring capital gains tax is great, but if you can’t use the money while it’s in the program, you’re still losing out on other opportunities. If you invested those gains in another type of investment with a higher return, you might counteract your tax liability by how much more you earn.
It’s also late in the game to get involved. At this point, there are only four years left to participate, meaning you’ve already lost out on the step-up in basis perk, and you won’t defer your capital gains for very long.
Still, if you spot a good investment within an opportunity zone, it could be worth the risk. The question is, is it actually a good investment, apart from the tax advantages? If not, pass it up.
Gather the Best Advice You Can
When assessing your options, both from an investing and a tax perspective, you need the best advice you can get. A financial advisor knowledgeable in both the market and your individual situation is the best ally you can have. They can help answer both whether an investment is good, and whether it’s good for you. To find the right advisor for you, contact us today to be matched with a qualified professional for free.