When the Economic Innovation Group, a bi-partisan, public-policy organization, introduced the concept of Opportunity Zones several years ago, the idea was to make use of the “trillions of dollars in unrealized capital gains in stocks and mutual funds . . .” So, when the Opportunity Zone program was made official as part of the Tax Cuts and Jobs Act of 2017, investors had a way of investing their capital gains into Qualified Opportunity Funds (QOFs), in an effort to help economic development in federally designated Qualified Opportunity Zones.
However, as is the case with many investment projects, the issue can boil down to what, exactly, can be invested in QOFs. Many times, we hear the question: “What ordinary income gain cannot be invested in an Opportunity Zone?” The answer is pretty clear-cut: All of it. In other words, the Qualified Opportunity Zone (QOZ) program is specifically geared for capital gain investment, not the investment of ordinary income.
Gain versus Gain
While ordinary income and capital gains involve monies received through various endeavors, the IRS characterizes each of these differently.
Ordinary income -- it’s a living
Ordinary income is defined as income other than long-term capital gains. Breaking this down, ordinary income generally includes wages, salaries, tips, commissions, bonuses, and other types of employment compensation. For the self-employed, net income from a sole proprietorship, LLC, or partnership is also classified as ordinary income, as are rents and royalties. Seven tax brackets are in play for ordinary income -- ranging from 10% to 37% -- with the bracket determined by the filer’s taxable income.
Another issue to remember about ordinary income, and/or ordinary income gain is that it cannot be invested in a QOF. That is the purview of the capital gain.
Capital gains -- buying and selling assets
A capital gain involves the sale or exchange of capital assets; if you dispose of an asset for more than you paid for it, the difference is a capital gain. Capital assets include stocks, bonds, precious metals, jewelry, real estate, art, stamp collections, and so on.
To make things more interesting, the IRS classifies capital gains as either long-term or short-term. Long-term capital gains come from assets you might hang on to for a year or longer before selling or exchanging them. Long-term capital gains are taxed according to taxable income, anywhere from 0% to 20%.
Meanwhile, a short-term capital gain comes into effect when you sell an asset after owning it for one year or less. Unlike the longer-term counterpart, short-term capital gains don’t receive any kind of special treatment or tax rates; they’re taxed as ordinary income. As such, there can be benefits to keeping assets for longer than a year before disposing of them. Depending on your tax bracket, you could end up paying less to the IRS for that long-term hold.
Capital Gains and Opportunity Zones
Investment in a QOF can, at the very least, help you defer short- or long-term capital gains taxes for several years. Even with the tax bill on those gains coming due in 2027, you could see a reduction in what you owe, depending on how long you hold your QOF investment.
The important takeaway here is that the Opportunity Zone program, and its tax benefits, is geared toward individuals and businesses that generate capital gains from the sale of assets, rather than earning ordinary income. Understanding the difference between these two types of income is important, not just for QOF investments, but for managing taxes, in general.
There are material risks associated with investing in QOZ properties and real estate securities including liquidity, tenant vacancies, general market conditions and competition, lack of operating history, interest rate risks, the risk of new supply coming to market and softening rental rates, general risks of owning/operating commercial and multifamily properties, short term leases associated with multi-family properties, financing risks, potential adverse tax consequences, general economic risks, development risks, long hold periods, and potential loss of the entire investment principal.
Past performance is not a guarantee of future results. Potential cash flow, returns and appreciation are not guaranteed. IRC Section 1031 is a complex tax concept; consult your legal or tax professional regarding the specifics of your particular situation.
This is not a solicitation or an offer to sell any securities. There is no guarantee that the investment objectives of any particular program will be achieved.
What is a Qualified Opportunity Zone?
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