Have you already sold an investment and are worried about getting killed by capital gains tax? If you are regretting the incoming tax bill and aren't sure what to do about it, Opportunity Zones might be part of the solution to your tax problem.
What is an Opportunity Zone Fund?
This is a question I hear often. Opportunity Zones are relatively new in the tax planning and investment landscape. Opportunity Zones were part of the 2017 Tax Cuts and Jobs Act to incentivize investors with some juicy tax savings. Investors can benefit from reinvesting their capital gains from other areas.
Investments into Opportunity Zone Funds are most often in the form of real estate. Apartments, office buildings, and shopping centers are common projects for development and investment. Direct investments into businesses located in Opportunity Zones are also eligible.
Where are these Zones located?
Opportunity Zones are special low-income areas designated by each State’s Governor and the U.S. Department of the Treasury. These areas present the need for investment into the community to help it grow. According to the Treasury Department, nearly 35 million Americans live within designated Opportunity Zones.
The idea is that investment in these communities will help the areas grow and flourish. In turn, this raises the standard of living for the residents and the growth of the community. Meanwhile, investors enjoy the income generated from their investment and the tax benefits.
What are the tax benefits?
If you decide an Opportunity Zone is a good investment for your situation, you will receive the following tax benefits & incentives:
- Defer paying federal taxes on your capital gains: (short term, or long term) until either December 31, 2026, or whenever you sell out of your Opportunity Zone investment, whichever comes earlier. Many states (but not all) also allow the deferral of paying state-level capital gains taxes when reinvesting into Opportunity Zones.
- Eliminate further capital gains taxes: If you hold the Qualified Opportunity Zone investment for greater than 10 years, any growth of that investment is tax-free. (e.g. you invest $200,000 of your gains into an OZ Fund and pay taxes on the deferred gains in 2026. A little over ten years later your investment is now $350,000 (hypothetical, not a guarantee or suggestion of performance). You could then sell the fund and pay 0% in taxes on the additional growth. Normally, you would need to pay capital gains on the extra $150,000 of growth from the example)
- Defer capital gains from previous sales: Normally, once you receive the sales proceeds from an investment, the doors have closed on many of your tax-deferring strategies such as a 1031 exchange. Not the case for Opportunity Zones. You have up to 180 days AFTER the sale to reinvest and defer your capital gains.
- Tax-efficient income: Most OZ funds are structured so investors can enjoy many of the same benefits they find when investing directly into real estate themselves. This means depreciation from the buildings and properties you invest in can offset a large part of the income generated each year. (e.g. you received $10,000 of distributions from your OZ fund, but only need to pay tax on $3,000 of that income. This is due to depreciation offsetting the other $7,000 you received for tax purposes)
- Assets do NOT need to be like-kind: You can defer gains generated from almost any investment by reinvesting into an Opportunity Zone. This includes gains from a primary home, publicly traded stocks, investment real estate, collector cars, business, etc. This is unique since 1031 exchanges have to be like-kind swaps (i.e. real estate to real estate) and Deferred Sales Trusts can't defer gains from publicly traded stocks. Not the case for Opportunity Zones.
Access to Opportunity Zone Funds
While Opportunity Zone Funds present some great benefits, there are also things to consider before investing in one yourself. Most Funds are structured as private investments. This means that you usually have to be an accredited investor. (net worth of $1mm+ excluding your residence, and/or earning $200,000 - $300,000+ annually, at the time of this writing)
Private funds can also lock up your money for around 10 years. On the one hand, this can help investors stick through for the long haul. But on the other hand, you have very limited access to your money until the manager decides to liquidate the fund and send your money back.
Finding a publicly-traded Opportunity Zone Fund can help reduce many of those issues. A publicly traded fund doesn’t have the issue with locking up your money since shares can trade on the open market. Public funds usually have lower fees than private funds as well. This is due in part to public funds having better economies of scale than private funds. Public investments usually have an easier time raising funds for expansion.
Things to consider
Another thing to consider is that the deferred capital gains will still need to be paid no later than when you file your tax return for 2026. If you are deferring a large capital gain, you could still spike into a higher capital gains bracket or be subject to the extra 3.8% Medicare Surcharge. But, you do have time to prepare for it instead of it being a surprise.
If you are investing in a publicly-traded fund, this unlocks a unique benefit. You have the ability to sell sleeves of your investment to realize pieces of your capital gain each year leading up to 2026. This could reduce your overall tax bill paid before 2026. But will also reduce the invested amount that will receive tax-free growth after 10+ years.
The last thing to consider is not investing a large amount of your net worth into a single fund, or type of fund. For example, let's say you sold your business and had a capital gain of $3mm and your total net worth is $4mm. It would not advisable to invest all your capital gains into an OZ Fund.
In general, it’s a good idea to keep an investment under 5% - 10% as a percentage of your net worth. In our example, you would be investing about 75% of your net worth into one investment. Not great, or recommended.
Opportunity Zone Funds can be great tools for deferring a tax bill and potential future tax-free growth. As with any investment, be sure to do your research to understand what you are getting into. How do the fees work, what are the expectations, and what types of investments are made?
Consult your advisor with questions on if an Opportunity Zone Fund makes sense for you. Be sure to determine how much capital gains you have, and what other strategies could pair together.
The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.