One goal of the 2017 Tax Cuts and Jobs Act (TCJA) was to encourage investors to reinvest capital gains into economically disadvantaged communities. To that end, the legislation created Qualified Opportunity Zones (QOZs), which taxpayers can invest in through QOFs (Qualified Opportunity Funds). While some of the TCJA provisions are no longer available (including the reduction of some capital gains tax obligations), there are still both deferral and exemption opportunities.
Capital gains are the appreciation that an investor receives through investment. The appreciation could be in the value of real estate, the price of a stock, or the value of collectibles and art. Since these gains are taxed, the federal government distinguishes between short and long-term capital gains. A short-term gain is associated with an asset the investor has owned for less than a year, while a long-term capital gain stems from a holding period of at least one year and one day.
As an incentive, investors can qualify for advantages when directing funds into a QOZ. First, the investor can defer the capital gains taxes due while the funds are in the QOF until the end of December 2026. Second, any appreciation enjoyed by the gains reinvested into a QOF will not be subject to capital gains taxes if the investment is held for a minimum of ten years.
To illustrate, suppose you sell stock in March of 2023 and receive a capital gain of $50,000. Depending on how long you owned the stock, you will owe either short or long-term capital gains on the profit, which can take a substantial chunk of your profit. In either case, you can defer the obligation to pay the tax while the funds are reinvested in a QOF until December 2026. Both short and long-term gains are eligible for deferral.
In addition, suppose that you leave the $50,000 invested in the QOF for ten years. During that time, your investment increases in value and is worth $150,000 after the end of ten years. You would not owe capital gains in the $100,000 appreciation. However, you would be required to pay the taxes due on the original $50,000 investment in 2027 (following the termination of the deferral period in 2026).
The investor must redirect the targeted capital gains into the QOF within 180 days of realizing the profit to qualify for the deferral and exemption. Investors can direct other funds to the QOZ but will not receive the same benefits. While QOZ investments are risky, individual investors can augment their backing using additional funds. For example, in the previous scenario, if the investor's total proceeds from the stock sale were $100,000, only the $50,000 that represents the profit (gain) is eligible for exclusion from capital gains taxes. The other $50,000 in proceeds representing the original basis won't enjoy any advantages.
One of several ways this investment differs from the deferral allowed by a 1031 exchange is that only the gain needs to be reinvested, not the entire proceeds.