OZ Pitch Day - Nov 14th
The 2 Hidden Benefits of Opportunity Zone Investing
Opportunity Zone investing offers two little-known hidden benefits that almost no one talks about. First, let’s review the three main tax benefits:
- When you roll over capital gains into a Qualified Opportunity Fund within 180 days, you are able to defer recognition of that gain until December 31, 2026. (The tax bill on this initial gain would be due in April 2027 for most taxpayers.)
- When the tax bill on your initial gain comes due, you are able to reduce the amount of gain recognized by 10%, so long as your Qualified Opportunity Fund holding period reaches at least five years by the end of 2026. (The ability to reduce the amount of recognized gain by 15% expired on December 31, 2019.)
- You can exclude 100% of the new capital gain that accrues within your Opportunity Zone investment, after a 10-year holding period. Essentially, you pay zero tax on your long-term Qualified Opportunity Fund gains.
These three main tax benefits are well known. But now let’s discuss Opportunity Zone investing’s two hidden benefits.
Hidden Benefit #1: Compounding gains from deferred tax liability
By deferring the tax liability on your initial capital gain until 2027, you are essentially receiving an interest-free loan from the federal government. Instead of paying taxes on a certain portion of your initial gain, you can can take the deferred tax liability and instead invest it for several years, enabling it to generate additional compounded returns.
Plus, a potential bonus: if you live in a state that taxes capital gains and conforms to the Opportunity Zone tax incentive, you are essentially receiving an interest-free loan from your state government as well.
The deferred tax liability benefit of the Opportunity Zone incentive is free money that you can put to work in generating greater returns. Here’s an example:
You sell your Apple stock and realize a long-term capital gain of $100,000. Assuming that this gain is subject to a 20.0% capital gains tax rate + 3.8% net investment income tax rate, your total federal tax rate on this gain is 23.8%. Your $100,000 gain becomes $76,200 after federal taxes.
Let’s assume that you put that after-tax amount into an investment account that compounds at 7% annually for 10 years. After 10 years, your $76,200 investment nearly doubles to $149,897. That is a gain of $73,697… Not bad.
But now let’s say that you instead roll over your $100,000 gain (pre-tax) into a Qualified Opportunity Fund. By doing so, you are able to defer recognition of your gain from your sale of Apple stock until the end of 2026. Rather than only investing the after-tax amount of $76,200, you invest the full pre-tax amount of $100,000. Compounded at 7% annually for 10 years, this turns into $196,715. That is a gain of $96,715.
Your final amount is of $46,818 (or 31.2%) greater! Compounding gains from deferred tax liability unlocks greater returns because the full amount of your gain is going to work for you, generating additional returns.
But wait, there’s more! Don’t forget capital gains taxation on your subsequent investment. In our first example, the $73,697 gain from the non-OZ investment would be subject to taxation. Your $149,897 becomes $132,357 after taxes. In our second example (the QOF investment), your $196,715 remains $196,715, as it is not taxed. After tax, the difference is even greater.
Note that even when investing in a Qualified Opportunity Fund, you do still owe capital gains tax on the Apple stock eventually. And you will have to ensure that you have liquidity to pay this liability.
Hidden Benefit #2: Eliminating depreciation recapture
Depreciation recapture allows the IRS to collect a portion of your capital gain attributable to the depreciation of your property taken during prior years of ownership. Depreciation recapture is taxed as ordinary income, typically at 25% — a rate higher than the capital gains rate. Here’s an example:
You purchase a rental property in 2013 for $700,000 and sell it in 2020 for $1,200,00. Every year, your depreciation was $25,454 ($700,000/27.5 years per IRS rules) for a total of $203,632 in depreciation over 8 years. This lowers your adjusted basis in the property to $496,368, making your total gain on the sale $703,632 ($1,200,000 – $496,368).
That equates to a capital gain of $500,000, plus an unrecaptured gain of $203,632, taxed as ordinary income. Assuming a 25% ordinary income tax rate on the unrecaptured gain, you would owe (25% x $203,632) = $50,908 in depreciation recapture.
Now here’s the best part: after achieving a 10-year holding period, depreciation recapture on an Opportunity Zone asset is eliminated forever. On top of all of the other favorable tax treatment, you won’t have a $50,908 depreciation recapture tax bill upon exiting your Opportunity Zone investment.
Taken together, the obvious and hidden benefits of the Opportunity Zone program can be a slam dunk for an investor with a large capital gain and a willingness to roll over this gain into a 10-year investment. With patience, investors can realize huge tax savings while injecting capital into disadvantaged areas.