Should I Consider an Opportunity Zone Fund?

Thoughtware Article Published: Oct 07, 2021
Tax Advisor

The past year was a roller coaster for investors. The stock market has been on a wild ride since March 2020. There has been an uptick in business consolidations owners looking to exit their closely held businesses, and there’s a looming threat of increased capital gains rates. These factors could lead to many taxpayers recognizing a larger amount of capital gains in 2021 than usual. As a result, many clients we work with are asking what they can do to defer and/or reduce their larger tax bills, and the conversations inevitably lead to a discussion about qualified opportunity zone funds (QOF).  

A QOF generally allows you to defer and potentially reduce the recognition of gains that are reinvested into certain new trades or businesses. Although the technical requirements of QOFs are somewhat complex, which you can further explore at BKD’s Qualified Opportunity Zone Resource Center, the primary benefits you receive as a QOF investor are:

  • Deferral of Taxes – You invest your capital gains within 180 days of the capital gain and don’t pay any tax on the reinvested gain right now
  • Partial Step-Up in Basis – For investments made in QOFs on or before December 31, 2021, an investor can get a 10 percent step-up in basis for holding the QOF at least five years
  • Tax-Free Appreciation – If you hold the QOF investment for more than 10 years

The QOF investment allows investors to exchange capital gains from the sale of stocks, bonds, businesses, and real estate into new investments in a QOF. The QOF is typically structured as a flow-through entity but also can be a corporation. The QOF investment works like most any other investment in a company. You can receive flow-through treatment and cash flow distributions and structure the economics to fit your needs.

Opportunity zones were created as part of 2017 tax reform and are still a relatively new option for reinvesting gains. We’re seeing viable projects go up all over the country because of this new tax incentive. Many investments are up and performing. Capital is clearly moving toward QOF investments as a viable alternative.

QOFs are like any other investment you make—there is inherent risk. Opportunity zones are economically distressed communities. Not all QOFs are the same; some have more risk than others. An investor must consider the operational risk and viability of any project before making an investment. Further, QOF investments require a long-term commitment to achieve the maximum benefits, and the distressed areas where QOFs must invest can increase the operational risks. 

The gain deferral will be triggered at some point in the future, either when you sell the investment or on December 31, 2026. QOF investors should note that the capital gains you pay are based on the future tax rates at the time, and a lot of investors are pausing as a result. The increased tax rate risk is a real economic issue, as the capital gains rates may be much higher in the future.  

You may be asking, “Why not just pay the tax now?” Many investors are choosing to sell assets with high valuations and multiples and pay the tax now with the historically low tax rates. Deferral of taxes is a winning strategy in most cases, but the risk of potentially significantly higher tax rates in the future is an important consideration with QOF investments.

Despite the inherent risk, we see many investors moving toward QOFs as a place to invest. We also see some investors who invested early on in a QOF investment are now taking their money back off the table. Maybe their investment did not work out, or maybe they needed the money for something else.

You may find paying the tax at the current capital gains rates is better for you. Then again, you may find the tax-free appreciation after 10 years is worth the risks. No matter where you find yourself this year, a QOF may be worth considering. Please consult your trusted tax and financial planning professional to see how this tax savings opportunity might affect your specific situation. For more information, reach out to your BKD Trusted Advisor™ or submit the Contact Us form below.

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