The Tax Cuts and Jobs Act (TCJA) allowed some taxpayers to defer and even eliminate the obligation to pay capital gains tax in some circumstances. Here’s how it works:
Suppose a taxpayer reinvests a capital gain into a Qualified Opportunity Zone through a Qualified Opportunity fund. In that case, they can defer the payment of taxes on that gain until December 31, 2026 (or sooner if they terminate the investment). Furthermore, if the taxpayer reinvests capital gains and holds the QOF investment for at least ten years, they won't be subject to capital gains taxes on any profits they earn in that fund.
Let’s review an example. Suppose that you sell stock and earn a capital gain of $50,000. If you reinvest that $50,000 into a QOF within 180 days, you can defer the payment of the capital gains taxes due until after December 31, 2026. Furthermore, if you leave the investment in the fund for ten years, you won’t owe capital gains taxes on the earnings within the fund. To successfully benefit from both of these aspects of the opportunity, you will need to pay capital gains taxes on $50,000 in 2027 but leave the money in place for the remainder of the ten-year period.
Not all states conform to federal tax laws.
Individual states can and do levy taxes on income in addition to what taxpayers owe to the federal government. Some states have no income tax, and some that have income tax may not tax capital gains. States that do not tax this income include Texas, Florida, Nevada, Wyoming, South Dakota, Tennessee, and New Hampshire.
Several states with capital gains taxes conform with the federal approach to opportunity zone investments, but only if the investment is within the same state as the resident. So, Arkansas and Hawaii will follow the federal rules if a resident of that state invests in a QOF that operates within a QOZ in the same state. That can be confusing, as some funds may have activity in several states.
Pennsylvania conforms to QOZ tax regulations for individual taxpayers but not corporations, while Massachusetts allows the exemption and deferral for corporate taxpayers but not individuals.
Finally, four other states—California, Washington, Mississippi, and North Carolina—do not conform to the federal provisions. As a result, residents of those states must pay state income tax on capital gains that derive from QOZ projects.
State rules may affect the overall potential for QOZ project investments.
Taxpayers in nonconforming states should ensure that their risk/reward calculation accounts for the potential state income taxes they may pay. Investors considering QOZ investments should evaluate the project as a whole, with the potential tax benefits included as one element. QOZ Fund projects are limited to economically disadvantaged communities, which may increase their risk profile.
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.
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.
