Reduce the tax liability on your extended tax return

Taxpayers that are patiently waiting for schedules K-1 should have them by (or shortly after) September 15, 2020, which will leave another month to make an investment into a qualified opportunity zone fund (QOF) to reduce their income tax bill before the individual extended tax filing deadline. Either way, the taxpayer will part with funds on October 15, 2020. A QOF puts those funds towards an opportunity zone (OZ) investment, rather than it going straight to the government.

Example:

A taxpayer with a long-term capital gain of $1 million will have a federal capital gain tax liability of $200,000 (20%). If the gain is from the sale of marketable securities, the tax is $238,000 (inclusive of the 3.8% net investment income surtax). By rolling the $1 million gain into a QOF, the capital gain is deferred, and reported on the 2026 tax return with a 10% discount at $900,000(1). In essence, the deferral functions similar to an interest-free loan to make the investment in the QOF. If you live in a state that conforms to federal tax rules, the amount of your deferral and discount benefit will be greater.

In addition, the most significant opportunity zone benefit, particularly from an investment in real estate, is realized by holding the opportunity zone fund investment for at least 10 years.

An investment in real estate generates significant depreciation deductions, which shields income from that investment from ordinary income taxes. If the depreciation exceeds taxable income from the investment, the excess depreciation deduction can be used to shield income from other passive investments. In other words, an investor may be able to use losses from a QOF investment to offset income from other passive investments. Ordinarily, depreciation deductions are recaptured when the real estate investment is sold, thus making the deduction from depreciation a timing difference. However, depreciation deductions from a QOF investment are not recaptured and become a permanent tax savings. Additionally, appreciation in the market value of the OZ real estate is not taxed – another permanent tax savings(2).

Example:

A taxpayer makes a $1 million investment in a QOF. Over the 10 year holding period, the investor is allocated $900,000 of depreciation deductions, which shield the taxpayer from $356,400 of federal income taxes (39.6%). At disposition, the QOF investment returns $2.2 million, the market appreciation of $1.2 million is not taxed, saving the investor another $240,000 in federal taxes (20% capital gain rate), for a total of $596,400 permanent tax savings. The permanent savings will be greater for taxpayers residing in a state that conforms to federal tax rules.