If you are familiar with short and long-term capital gains, you already know that long-term gains are taxed at a lower rate for most people. The IRS rewards you for holding an investment longer. For Qualified Opportunity Zone Fund (QOZF) investors, they are also rewarded for long-term holdings. But how does that affect short and long-term capital gains? In this article, we’ll dive into all aspects of how taxes affect your QOZF gains.
Which Capital Gains Qualify For QOZF Deferral?
There are two main categories of capital gains — short-term and long-term. Both types of gains qualify as an “eligible gain” for the QOZF deferral. Short-term capital gains are held for one year or less. Long-term capital gains are held for more than one year.
A QOZF allows investors to defer the gains tax from the sale of stocks, bonds, business sales, real estate, and various other assets. However, not all capital gains are eligible, such as those recognized on a sale or exchange of property to a related party, whether before or after the sale. (A related party is one that has a 20% common ownership.)
Gains Must Be Reinvested Within 6 Months Of Being Recognized
Gains must be reinvested into a QOZF within 180 days of recognizing a gain on the sale. Recognition is defined differently depending on the source of gains. There are two types:
- Partnership Gains – recognized either at the time of the gain or at the end of the partnership tax year (Dec. 31). Also, if the sale is from earlier in the year, the 180-day deadline starts when the gain is recognized at the end of the year.
- Stock of Business – six months from sale date. For example, if you bought a stock at $50,000 and sold it for $65,000, you can defer the $15,000 gain by investing it into a QOZF.
Now we will look at how holding periods affect QOZF capital gains taxes. All eligible QOZF holding periods are considered long-term.
How Gains Are Taxed Upon Sale Of A QOZF
There are three tax benefits that investors can capture at different stages during their investment holding period. Deferred QOZF capital gains taxes come due on Dec. 31, 2026, and that tax bill can be further reduced by the five-year holding period benefit. Only the ten-year holding period benefit impacts how capital gains are taxed upon the sale of the QOZF. To capture this benefit, the investor must also sell the QOZF before Dec. 31, 2047. Note that the percentages mentioned below reflect a step-up in basis, and not an adjustment to the capital gains tax rate.
- Five-year Hold — 10% step-up in basis
- Ten-year Hold — dismissal of any capital gains tax derived from the fund itself and after the initial investment.
Which tax rate will be applied in 2026?
Looking at when the deferral ends in 2026, what tax rate can we expect? Short-term gains will still be at your ordinary income tax rate. What those rates will be is anyone’s guess. Another unknown is what will happen to long-term capital gains rates. Without a crystal ball on hand, that’s a risk you have to assume when dealing with a future that is a few years away.
How do investors decide if the deferral is worth the risk of potentially increased tax rates seven years down the road? The five-year hold benefit will reduce the actual impact of a higher tax rate. The step-up in basis may not impact the tax rate, but it will reduce the amount of gain that is taxable, thus reducing the tax burden overall.
Since 1992, we haven’t seen tax rates fluctuate over 10% in any bracket. In fact, most rates have come down. Taking nearly 30 years of data into account, deferring capital gains taxes through the QOZ program could even have the additional benefit of lower tax rates.
Getting the most out of QOZ program’s tax benefits depends on how long you hold the investment for. If you have questions and want to learn more about QOZ investments, please call a Realized financial professional at 877-797-1031.
This material represents an assessment of the market at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results.
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. Information presented herein is subject to change.
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