Capital gains distributions differ from capital gains, but the gain is taxable in each case. A capital gain can be short or long-term, depending on whether you owned the asset for over a year. Good examples of capital gains include selling stock, real estate, or collectibles for more than you paid.
A capital gains distribution is paid to the investor by a mutual fund or ETF (exchange-traded funds) that sells assets the fund holds. For example, if you own shares in a mutual fund that holds Apple stock, and the fund sells the Apple stock for a profit, it will distribute the capital gain to the fund shareholders. If the fund had the Apple stock for over a year, it would be a capital gain.
The investor treats the distribution as a long-term capital gain regardless of how long they owned shares in the fund. Also, if you opt to reinvest the distribution back into the fund from which you received it, you still owe long-term capital gains taxes on the distribution amount. However, if you hold the mutual fund or ETF shares in a qualified retirement account, the tax obligation is deferred until you take withdrawals.
Can I invest these distributions into a QOZ?
The Tax Cuts and Jobs Act of 2017 created Qualified Opportunity Zones to encourage investment in lower-income areas. Investors can direct capital gains into Qualified Opportunity Funds (QOFs), which then invest in projects that meet the QOZ criteria. For this purpose, capital gains distributions are treated the same as other capital gains.
QOZ investment deferrals differ from 1031 exchange deferrals in several important ways:
- A capital gain from any source can be invested in a QOZ, while 1031 exchanges are only useful for deferring gains on the sale of real estate investment property.
- A 1031 exchange requires the investor to reinvest the entire proceeds from the sale of the qualifying asset, while deferring capital gains through a QOZ investment requires only reinvestment of the gain.
- Using a 1031 exchange requires reinvestment in “like-kind” investment property, while a QOZ investment can defer capital gains taxes from any qualified source and be directed to any eligible QOF project.
How does a QOZ investment work?
An investor wishing to defer capital gains taxes must reinvest the gain into a QOF within six months of realizing the gain. The legislation allows deferral of gains through the end of 2026. At that time, the investor will owe the deferred taxes.
However, investing in a QOZ has another potential tax advantage. If the investor maintains the investment in a QOZ for at least ten years, any gain earned in the QOZ will be exempt from capital gains taxes.
So, suppose you receive a capital gains distribution of $100,000 in 2023 from a mutual fund investment. If you reinvest that gain into a QOZ fund within 180 days, you can defer paying taxes on that distribution until you pay taxes in 2027. Furthermore, suppose you keep the money invested for ten years, and during that time, you earn a capital gain of $50,000. You won't have a capital gain tax obligation for that $50,000.
What should I watch out for?
QOZ projects may be at a higher risk due to the economic conditions in the area. That's one reason many funds limit their investor pool to those with accreditation. However, that requirement is not universal, and some QOFs accept smaller investments from any investor. The Tax Cuts legislation does not specify any minimum or maximum investment amounts.
Potential QOF investors must perform due diligence on the investments they are considering. In addition to the risks associated with the economic environment in QOZs, the projects must reach specific milestones to remain eligible for deferral and exemption of capital gains taxes.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
The actual amount and timing of distributions paid by programs is not guaranteed and may vary. There is no guarantee that investors will receive distributions or a return of their capital. These programs can give no assurance that it will be able to pay or maintain distributions, or that distributions will increase over time.
Hypothetical examples shown are for illustrative purposes only.
Investors in QOFs will need to hold their investments for certain time periods to receive the full QOZ Program tax benefits. A failure to do so may result in the potential tax benefits to the investor being reduced or eliminated.
If a fund fails to meet any of the qualification requirements to be considered a QOF, the anticipated QOZ Program tax benefits may be reduced or eliminated. Furthermore, a fund may fail to qualify as a QOF for non-tax reasons beyond its control, such as financing issues, zoning issues, disputes with co-investors, etc.
Distributions to investors in a QOF may result in a taxable gain to such investors.
The tax treatment of distributions to holders of interests in a QOF are uncertain, including whether distributions impact the aforementioned QOZ Program tax benefits.
A QOF must make investments in Qualified Opportunity Zones, which carries the inherent risk associated with investing in economically depressed areas.