The tax advantages of Qualified Opportunity Zones (QOZs) sound great on paper—an uncapped capital gains tax that can be deferred and potentially tax-free treatment on the appreciation of your QOZ holdings. 

That’s enough to catch the attention of any high-earner, but are QOZs all they’re chalked up to be? 

The following article explores the Opportunity Zone basics, the good, the bad, and the ugly. 

What’s a Qualified Opportunity Zone (QOZ) Anyway?

QOZs debuted in the Tax Cuts and Jobs Act (TCJA) of December 22, 2017, and as a relatively new offering, they haven’t yet earned the popularity they might deserve. 

A Qualified Opportunity Zone (QOZ) is an economically distressed community where certain investments may qualify for preferential tax treatment. The noble goal is to boost the economy and create jobs in places that need it most. 

To become a QOZ, an area must be nominated by state or territory leaders and then certified by the Secretary of the U.S. Treasury, acting through the Internal Revenue Service.

Through tax incentives, the government aims to transform economic dead zones into bustling hubs of activity and employment. Officially rolling out in April 2018, these zones popped up everywhere—from Alaska to Puerto Rico. Now, every state and several territories have little pockets of opportunity waiting for their hero investors.

Residency in a QOZ isn't necessary. You can still access these tax incentives regardless of where you live, work, or conduct business. 

Typically, investors will park their cash in a Qualified Opportunity Fund (QOF); in return, they get the various tax perks the IRS offers. 

You can locate the designated Qualified Opportunity Zones by referring to the IRS Notices 2018-48 and 2019-42. You can also view a map detailing these zones at the Opportunity Zones Resources website for a more interactive approach.

QOZ Tax Incentives

Making an impact is great and all, but let’s cut to the chase– what’s in it for you?

In IRS-speak, “an investor can defer tax on any prior eligible gain to the extent that a corresponding amount is timely invested in a Qualified Opportunity Fund (QOF). The deferral lasts until the earlier of the date on which the investment in the QOF is sold or exchanged, or December 31, 2026. If the QOF investment is held for at least 5 years, there is a 10% exclusion of the deferred gain. If held for at least 7 years, the 10% exclusion becomes 15%.”

Stick with it for five years, and 10% of the deferred gain will be excluded from taxation. 

Make it seven years, and that sweetens to 15%. 

But if you’re in it for the long haul (10 years), then the real magic happens: the growth on your investment won’t be taxed. Ever. 

In IRS-speak, “If the investor holds the investment in the QOF for at least 10 years, the investor is eligible for an adjustment in the basis of the QOF investment to its fair market value on the date that the QOF investment is sold or exchanged. As a result of this basis adjustment, the appreciation in the QOF investment is never taxed. A similar rule applies to exclude the QOF investor’s share of gain and loss from sales of QOF assets.”

It seems like the financial equivalent of a cheat code, but is it as good as it sounds?

Let’s explore. 

The Qualified Opportunity Fund in Action

As noted above, the Qualified Opportunity Fund (QOF) program allows investors to defer capital gains tax from another investment by investing the gain into a QOF within 180 days of the sale. 

The amount of capital gains tax that can be deferred isn’t capped—meaning all of your capital gains can potentially be deferred if you invest the total amount into a QOF– either until December 31, 2026, or sell the holdings before then.

Suppose you bought stock for $50,000, and years later, you sell it for $150,000. 

The profit ($100,000) would typically be subject to capital gains tax. 

However, if you reinvest that $100,000 into a QOF, you can defer paying taxes on that $100,000 until you sell your investment in the QOF or until December 31, 2026, whichever comes first. 

Additional benefits arise if the investment is held for longer periods (5, 7, and 10 years), such as reduced tax owed and potential tax-free growth within the QOF.

For example, if you hold your $100,000 investment in the QOF for at least five years, you are eligible to exclude 10% of the deferred gain from taxes. This means when you calculate your taxes, you would only be liable for taxes on $90,000 of your initial $100,000 gain when the deferral period ends on December 31, 2026.

At seven years, the exclusion from taxes increases to 15%– you’d only pay taxes on $85,000 of your initial $100,000 gain if the investment is still held by the end of the tax deferral in 2026.

If you hold the QOF investment for at least ten years, you also benefit from not having to pay capital gains taxes on any appreciation of the QOF investment itself.

Not only can you take advantage of the 15% exclusion on your original deferred gain, but any additional gains made from the QOF investment from its appreciation are entirely exempt from capital gains taxes.

Continuing with our example, if the QOF investment grows in value from $100,000 to $150,000, that additional $50,000 in capital gains will not be taxed at all if you sell the investment after holding it for over ten years, and only $85,000 of your original $100,000 gain would be taxable. 

This makes for a powerful tool for deferring capital gains and potentially reducing your tax liability in a relatively short amount of time. 

Sounds great, but what’s the catch?

Are Opportunity Zones Worth It?

QOZs are relatively new and have a story in motion, so it’s tricky to provide a definitive case for or against them. Each individual financial situation varies, as does each investment opportunity. 

On paper, QOZs offer some significant tax advantages but require taking on some risk.

Some high-earners actively use QOF strategies to defer capital gains taxes in high-capital gains years with shorter holding horizons, but since these strategies are new, most of the time, horizons have yet to trigger. 

For example, if you invested in a QOF when it rolled out in 2018, you’d still have four years left until you could enjoy your tax-free appreciation on the QOF’s gains— if there was any appreciation in the first place. 

It’s not uncommon for tax-smart individuals to use QOFs as a crafty pivot to defer taxes from a high-capital gains year into a future presumably lower in capital gains, as demonstrated by the r/HENRYfinance screenshot above. Source: Reddit r/HENRYfinance

Despite their tax perks, QOZs and QOFs should be viewed as investments with unique risks rather than a surefire layup tax strategy. 

The word on the street for QOZ and QOFs offers a mixed critique: 

“The most spot-on thing I've read about opportunity zones is that the tax advantages can turn a very good OZ investment into a great investment, but they'll never turn a bad investment into a good investment. There are a lot of very bad investments in the OZ space and a lot of people that have been taken advantage of as a result of the headlines concerning tax deferment.”

When evaluating Opportunity Zone investments, it's crucial to compare their potential growth against traditional investments like total market index funds, which often show better risk-adjusted returns compared to the tax benefits of OZs. 

Simply put, make sure the underlying projects in OZs are solid investments on their own merits, independent of tax advantages. 

 

Belpoint PREP, ($OZ) (source)

For example, a popular publicly traded Opportunity Zone Fund is down about 45% since its launch.

Sure, you may get to defer capital gains and earn a 15% exemption on the original gain amount, but being down 45%, for example, is a heavy counterweight. 

Concerns about the efficacy and management risks associated with QOZ investments emphasize the need for investors to conduct thorough due diligence.

Despite the cons and cautionary tales, Qualified Opportunity Zones still present some compelling advantages. Granted, their perks become increasingly less impactful as we near the sunset date of December 31, 2026, which marks the end of the opportunity to defer capital gains taxes on new investments into QOFs​.

Making Cents of Opportunity Zones

QOZs offer very attractive tax advantages but require taking on some risk. 

Overall, while OZs can be appealing for community-focused investors, they might not always be the best financial choice for those seeking the highest returns regardless of the tax benefits. 

Further, OZs may not be the best choice for risk-averse investors– especially considering the need to hold the new position for at least five years to see the benefits of tax exemption. 

Although the tax savings are appealing, I’d argue the ultimate goal should be maximizing post-tax returns, which can be challenging as many Qualified Opportunity Funds (QOFs) may already price in these tax benefits, potentially diluting the net gains.

Moreover, focusing on strategies like tax loss harvesting could be more advantageous than investing in QOZs, which may only sometimes offer competitive returns or adequate risk compensation for those with significant taxable accounts. 

Still, there’s a time and place for worthwhile Opportunity Zone Funds, particularly for those looking to defer significant capital gains. It’s unclear whether the U.S. government will continue with its QOZ direction. Still, this program could have some serious merit for high-earners with a few of the kinks worked out– not to take away from its actionable benefits accessible today.