How Opportunity Zone Investing Can Reduce An Investor’s Tax Liability
Investing in an Opportunity Zone can significantly reduce an investor’s capital gains tax liability, which is important if the investor owns one or more assets that they plan to sell in the near future. Capital gains tax is the tax charged on profits that are made when an investor sells an asset, such as a piece of real estate, stock in company, or an expensive collectable.
Capital gains tax can come in multiple varieties; short term capital gains taxes, which are levied against assets that are purchase and sold within a 12 month period, and long term capital gains, which are levied against assets held longer than 12 months. Fortunately, Opportunity Funds allow investors to defer both short and long-term capital gains taxes until December 31st, 2026, and to reduce the amount of their capital gains exposed to taxes, provided that they keep the money in the fund for at least 5 years. To do this, an investor must re-invest their funds within 180 days of the gain being recognized.
Long Term vs. Short Term Capital Gains Taxes
Short term capital gains are generally taxed the same way as ordinary income. So, for instance, if an individual bought stock for $40,000, and 8 months later, sold it for $50,000, and they were in the 24% income tax bracket, they would have to pay 24% tax on those $10,000 of gains, or $2,400. In comparison, long-term capital gains taxes are either 0, 15, or 20%, depending on an individual’s income for the year they are selling the asset.
In 2019, single filers earning $39,375 or less pay 0% taxes on long-term capital gains, single filers earning between $39,375 and $434,550 pay 15%, and single earning $434,550 or more pay 20%. These rates change slightly for married couples filing jointly or married individuals filing separately.
When an individual sells business property and makes a profit, it is generally treated as a 1231 gain, which, like short-term capital gains, is taxed at an individual’s ordinary tax rate. 1231 gains also be deferred until December, 31, 2026 via investing in an Opportunity Fund.
Another type of gain, the unrecaptured 1250 gain, occurs when depreciable real estate (i.e. rental property and certain business real estate) is sold. Unrecaptured 1250 gains are typically taxed at 20% (the maximum long term capital gains tax rate), though they may be taxed at lesser rates under some conditions. They are only realized when 1231 gains are not recognized as ordinary income. If the 1250 gain is unrecaptured, it’s eligible to deferred until December, 31, 2026 via investing in an Opportunity Fund. However, 1245 and recaptured section 1250 gains do not qualify for deferral.
Capital Gains Taxes and Partnerships
Partnerships and other pass-through entities (such as most LLCs) have slightly different rules when it comes to the investment timeline required to defer capital gains taxes via an Opportunity Fund. If the partnership/LLC as a whole is deferring capital gains, than they have 180 days after the gain was recognized to reinvest into an Opportunity Fund (just like individual investors). However, if the deferral is being made by an individual partner, they can decide to begin their 180 day period on the final day of the partnership or LLC’s taxable year.