If you’ve realized a substantial capital gain, you may be looking for the right investment vehicle to protect your earnings. What if you could reduce your tax liability on that capital gain and eliminate capital gain tax liability on future earnings for the next decade? These benefits are now available to investors through the Opportunity Fund investment vehicle created under the Opportunity Zone program.
While these tax advantages can offer immense after-tax returns for investors, how to access them may not be immediately clear. This article offers a practical step-by-step guide to help investors identify their qualifying gains, and understand the considerations needed when investing in an Opportunity Fund.
An Opportunity Fund provides a powerful set of immediate and long-term capital gains protections that isn’t found in any other investment vehicle. Capital gains earned from several investments vehicles — such as stocks, bonds, real estate, and cryptocurrency — are eligible for tax-advantaged treatment an Opportunity Fund. However, there are rules governing how and when a gain can be rolled into an Opportunity Fund investment. These rules must be followed in order for investors to access the full set of tax advantages available.
- What are the Tax Advantages of Opportunity Funds?
- How to Roll Over a Capital Gain into an Opportunity Fund
- Choosing the Right Option for You
What are the Tax Advantages of Opportunity Funds?
The Tax Cuts and Jobs Act of 2017 established the Opportunity Zone program to create an investment model designed to stimulate private investment in the development of identified economically distressed areas known as Opportunity Zones, which comprise roughly 12% of all census tracts throughout all 50 US states, the District of Columbia and five US possessions.
In exchange for investing in Opportunity Zones through an Opportunity Fund, investors can access an exclusive set of capital gains tax incentives designed to reduce tax burdens and boost investors’ after-tax return potential:
- Capital gains tax deferral until 2027: By investing your capital gain in an Opportunity Fund, you can defer tax payment on that gain until as late as 2027. In order to access this tax incentive, the gain must be invested in an Opportunity Fund through December 31, 2026. If it’s sold before then, the gain becomes taxable in the year that the Opportunity Fund investment is sold. By deferring capital gains tax payments, an investor is able to invest more of their capital gain up to several years longer to boost earning potential in a way that wouldn’t have been possible had they been liable to pay capital gain taxes the year that the gain was realized.
- Capital gains tax liability reduction by up to 15%: If you hold an Opportunity Fund investment for at least five years prior to the end of the deferral period (December 31, 2026), your tax liability on the capital gains invested in an Opportunity Fund can be reduced by 10% through a step-up in basis. If you hold that same investment for at least seven years prior to the end of the deferral period, you can reduce your tax liability by a total of 15%.
- Capital gains tax liability permanently eliminated: Investors who hold their Opportunity Fund investments for at least ten years can expect to zero capital gains tax liability on any appreciation earned from their Opportunity Fund investment.
These tax incentives make Opportunity Funds one of the most powerful investment vehicles available to investors to improve their tax treatment for several types of capital gains. And, they may be the single best option for investors to protect capital gain returns for the next decade or longer.
But, Opportunity Fund investments come with a timetable that investors must follow if they want to maximize the tax advantages available to them.
How to Roll Over a Capital Gain into an Opportunity Fund
Fortunately for investors, the Opportunity Zone program was designed to reduce red tape and encourage investment. There is no limit on the number of Opportunity Funds that can exist, which means that there’s no cap on the number of investors who can participate or the amount of money that can be invested through an Opportunity Fund.
Instead of operating through a tax credit system, which limits the number of investors who can participate and relies on annual allocations from Congress or a tax credit allocation authority, the Opportunity Zone program is governed by Internal Revenue Codes (IRC). IRC section 1400Z-1 governs Opportunity Zones and section 1400Z-2 governs Opportunity Funds.
Here are the steps to rolling over a capital gain into an Opportunity Fund under IRC section 1400Z-2:
1.) Identify gains that qualify for deferral.
Pursuant to Prop. Reg. §1.1400Z-2(a)-1(b)(2), a gain is considered eligible for deferral under section 1400Z-2 if it meets the following criteria:
- The gain is treated as a capital gain for federal income tax purposes;
- It would be otherwise recognized before January 1, 2027, if not applying for deferral; and
- It does not arise from the sale or exchange with a related party.
In general, gains that are eligible to be treated as a capital gain for federal income tax purposes include short-term capital gains, long-term capital gains, net section 1231 gains, and unrecaptured section 1250 gains. It’s worth noting that gains retain their character (short-term vs. long-term) for the entire duration of the deferral period.
The definition of a “related party” under section 1400Z-2(e)(2) includes the relationships defined under IRC section 267(b) or IRC section 707(b)(1) and requires a 50% threshold when evaluating vote or value.
2.) Invest the eligible capital gain into a Qualified Opportunity Fund (QOF) within 180 days of realization.
Pursuant to Prop. Reg. §1.1400Z-2(a)-1(b)(4), the 180-day window begins on the day in which the gain would have been recognized had it not been deferred under section 1400Z-2. It should be noted that the determination of net section 1231 gains can only be made on the last day of the taxable year which means that the 180-day window would also begin on the last day of the taxable year.
If the gain was recognized by a partnership (or another pass-through vehicle), the deferral election may be made by either the partnership or the partner. Under §1.1400Z-2(a)-1(c)(2)(iii), if the election is made by the partner, the 180-day window may begin on either the last day of the partnership’s tax year or the date in which the partnership would have recognized the gain.
It’s important to note that it’s possible to make a deferral election under section 1400Z-2 even if the 180-day window straddles two tax years. For example, a capital gain realized on December 31, 2018, is eligible to be invested into a QOF until June 29, 2019. However, an investor would be required to extend their 2018 return beyond the standard April deadline in order to make the appropriate election on IRS Form 8949, as we discuss in the next step.
No intermediary is required to roll over a gain into an Opportunity Fund. An investor can invest their realized gain into an Opportunity Fund.
3.) Indicate that you’ve rolled over your capital gain into a QOF when reporting income taxes to the Internal Revenue Service (IRS) through IRS Tax Form 8949.
As with other realized gains, eligible gains are required to be reported on an investor’s tax return using IRS Tax Form 8949. For example, a gain from the sale of stock would be reported on Form 8949 and Schedule D (1040) for individual taxpayers. The newly updated Form 8949 is then used to adjust the investor’s total gain to reflect the deferral election under section 1400Z-2. The QOF investment is included as a negative number in column (g), so that eligible deferred gains are not included in taxable income for the current tax year.
As noted above, capital gains eligible for deferral retain their character (i.e., short-term vs. long-term) and thus, need to be reported separately. Short-term capital gains are reported on Part I of Form 8949 and long-term capital gains are reported on Part II.
If an investor makes an investment in multiple QOFs, or makes multiple investments in the same QOF on different dates, each investment is required to be listed separately. Gains from different transactions invested on the same day into the same QOF may be grouped together.
As described above, IRS form 8949 needs to be filed in the year in which the gain would have been recognized. In the above example, Form 8949 would be included in the investor’s 2018 tax return, even though the QOF investment was made during 2019, because the eligible gain would have otherwise been realized in 2018.
4.) Pay deferred capital gains when they become due.
Deferred tax payments for eligible capital gains invested into a QOF will be due eventually, but that date can vary based on how long an Opportunity Fund investment is held. If a QOF investment is held through at least December 31, 2026, the gains will become taxable in the tax year of 2026, and tax payment will be due when an investor’s taxes are filled in 2027. Pursuant to section 1400Z-2(b)(1), if a QOF investment is sold prior to December 31, 2026, it will become taxable in the tax year that the gain is realized.
Tax treatment on the eligible gain rolled into a QOF depends on how long the gain had been invested in a QOF prior to December 31, 2026. As mentioned above, if the QOF investment is held for at least five years prior to December 31, 2026, tax liability on the gain can be reduced by 10% under section 1400Z-2(b)(2)(B)(iii). If it’s held for at least seven prior to December 31, 2026, tax liability on the gain can be reduced by a total of 15% pursuant to section 1400Z-2(b)(2)(B)(iv).
5.) Possibly permanently eliminate capital gains tax liability on any appreciation earned from your QOF investment.
Section 1400Z-2(c) provides that if an investor holds a QOF investment for a minimum of ten years, they can expect to owe zero capital gains taxes on any appreciation earned from that investment. If this threshold is met, the appreciation earned from this investment should qualify for permanent exclusion from federal capital gains taxes.
If an investor exits a QOF investment before the ten-year holding period threshold is met, the investor forfeits the benefit of capital gains tax elimination on their QOF investment, and that gain becomes taxable in the tax year that the gain is realized.
Choosing the Right Option for You
Thanks to the exclusive set of capital gains tax incentives available only under the Opportunity Zone program, Opportunity Funds offer great potential for long-term investors to earn significantly better returns than they would following a traditional investment path. Choosing the right long-term investments will be key in not only reducing tax liability now, but also potentially earning sizeable future capital gains with zero capital gains tax liability if held for at least ten years.
We believe that real estate, in particular, represents a unique opportunity for investors to preserve and build their wealth while also supporting revitalization projects in developing neighborhoods. As the first real estate investment platform to create a simple, low-cost way for anyone to invest in real estate, Fundrise has a history of embracing new investment structures that offer the potential for lower fees and higher net returns for our investors. Our adoption of the Opportunity Fund investment model gives our investors a useful tool to protect capital gains earned from several types of investments by rolling them into real estate investments held within our Fundrise Opportunity Fund.
Are you curious what your after-tax returns could be if you invest in an Opportunity Fund? Use the calculator below to estimate how much an Opportunity Fund could impact your returns.
If you have any questions about investing in Opportunity Funds, our team is available at email@example.com.