- April 23, 2019
Explaining the Tax Benefits Behind QOZs
Qualified Opportunity Zones (QOZs) address two big generational needs and trends. On the one hand, wealthy baby boomers with ownership stakes in private businesses or long-standing positions in publicly traded equities are looking to sell their interests as tax-efficiently as possible. Meanwhile, wealthy Gen X and Millennial investors are increasingly looking to make a positive social impact with their investments. That confluence of factors makes this an outstanding time to invest in QOZs.
QOZs are land tracts designated by the U.S. Treasury Department and Internal Revenue Service to be economically depressed or underserved. To incentivize private investment in these communities, QOZs were created by the Tax Cuts and Jobs Act of 2017, offering sizeable tax breaks to investors who make qualified long-term investments that have the potential to promote economic growth in these zones.
But how sizeable are those potential tax breaks?
QOZs offer investors the ability to defer paying taxes on capital gains they’ve realized in a prior investment if they commit to redeploying that capital into a QOZ investment within 180 days of the realization. Investors in QOZ funds, such as the Cresset-Diversified QOZ Fund, have the ability to defer paying capital gains taxes on the assets they sell to fund these impact investments until Dec. 31, 2026. That means investors who put money into a QOZ fund now can defer paying taxes on their original sale for as long as 8 years.
Time isn’t the only tax benefit investors receive in this case. Because investors who redeploy realized gains into a QOZ fund do not have to pay taxes upfront, they can utilize the taxable portion of their gains — which would otherwise have gone to the Treasury Department — into the QOZ investment, further leveraging the tax break.
For example, let’s assume you plan to invest a $1 million into a business or property located in an underserved community (see table). If you were to sell an existing asset and realized gains of $1 million to make that impact investment outside of a QOZ fund, you’d owe potentially $238,000 in taxes (assuming you’d be subject to capital gains taxes of 23.8 percent). That would leave you with just $762,000 for your impact investment.
In a QOZ fund, however, you’d have the ability to invest the full $1 million up front, boosting the potential gains you’d earn in the QOZ fund and the impact your investment dollars could have. Assuming your QOZ fund earns a 10 percent annual appreciation in value, your $1 million investment would grow to nearly $2.6 million after a decade’s time. By contrast, if you were investing outside of the QOZ fund, your original after-tax $762,000 investment would grow to less than $2 million over a decade’s time (again, assuming that same 10 percent annual return).
In addition to the deferral of your tax bill, the QOZ program also offers long-term investors the ability to reduce the amount of capital gains taxes that were deferred from the original asset sale. If you hold your QOZ fund investment for 5 years, the tax on your original gains would be reduced through a 10 percent step-up in your cost basis, effectively reducing your eventual tax bill by 10 percent.
If investors stay invested in the QOZ fund for 7 years, the tax on your original capital is reduced another 5 percent through another step-up in basis. That means in addition to the ability to defer your original capital gains bill by as much as 8 years, investors can reduce their eventual tax bill by as much as 15%.
Given that tax must be paid on the deferred gain by Dec. 31, 2026, investments must be made by Dec. 31, 2019, to receive the maximum 15 percent benefit, or by Dec. 31, 2021, to receive the 10 percent benefit. If the investment has not been sold by Dec. 31, 2026, the original deferred gain (subject to the potential holding period adjustments) will be included on the taxpayer’s 2026 return.
Once the deferred taxes are eventually paid in this example, investors would still wind up with an after-tax investment gain that’s more than $700,000 greater using the QOZ fund, assuming 10 percent annual appreciation.
While the tax deferral and tax reduction are both powerful incentives to investors, perhaps the most attractive component of the QOZ program relates to the gains generated from the actual investment in the QOZ. If you hold onto your QOZ investment for 10 years, you would owe no capital gains taxes on the QOZ investment itself. In other words, that $1 million QOZ investment would grow to nearly $2.6 million over a decade’s time, and that would be free of QOZ-related capital gains taxes.
By contrast, if you were subject to 23.8 percent capital gains taxes, your $2 million gain outside of the QOZ fund would be reduced to less than $1.7 million after paying capital gain taxes on that Investment.
Because this is a tax break on capital gains, the greater the appreciation of your QOZ fund, the bigger the potential tax benefits. For example, if your QOZ investments were to appreciate 20 percent instead of 10 percent, you wouldn’t double your after-tax gains. Instead, you’d enjoy additional after-tax gains of $2.2 million over a similar investor investing in a fully taxable setting, which amounts to more than three times the advantage.
Invested Capital Gain
|Less: Capital Gain Tax Investment (23.8%)||(238,000)||0|
Year 10 Value (assumes 10% annual investment appreciation)
|Less: Year 10 Capital Gains Tax (23.8%)|
Year 10 After-Tax Value
|Less: Cap Gains Taxes on Invested Gains Due on 12.31.26*|
Total Year 10 After-Tax Value
Total Year 10 After-Tax Net Gain**
*Assumes investment is held for 7 years and a 15% step-up in basis is applied to original capital gain that was invested
**Assumes 10-year holding periods, annual rate of investment appreciation of 10%, and a long-term capital gains tax rate of 23.8%.
Note: The amounts shown are not net of fees and carry in either the traditional investment or the QOZ investment. This is to illustrate the tax benefits of QOZ investments prior to any fee structures.
Learn more about the Cresset-Diversified QOZ Fund.