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There’s a lot of hype surrounding the December 31, 2019, qualified opportunity zone (QOZ) deadline. This deadline represents the last day for investors to place capital gains in a qualified opportunity zone fund (QOZF) and receive the maximum 15% step-up in basis benefit. For investors up against either the 180-day deadline or pressure to beat the year-end date for other reasons, let’s take a step back to fully understand the 15% QOZ step-up in basis.
What’s Happening?
Capital gains invested in QOZ funds are deferred as taxable income until December 31, 2026. The taxable capital gain amount is reduced via a step-up in basis by 15% if the investment is held for at least seven years prior to December 31, 2026. Thus, investors who want to maximize their tax savings must invest capital gains into a QOZF on or before December 31, 2019. Investors who miss the 2019 deadline may still benefit from a 10% step-up in basis by holding investments in a QOZ fund for at least five years prior to December 31, 2026.
For investors who have a suitable QOZ investment and perhaps are close to the 180-day deadline, there is generally less risk. There’s a plan in place, and you aren’t under any pressure to make quick but high-impact decisions. On the opposite end, if you haven’t identified a property or opportunity, dumping funds into a QOZF by year end just for the incremental 5% step-up in basis may not be the wisest decision.
Rushed investors may have a higher chance of making bad decisions. They should perhaps instead take more time to evaluate a fairly high-impact decision with relatively low overall economic impact (i.e., the incremental 5% step-up in basis).
Evaluating The 5% Difference
For those in contemplation mode, the question becomes: Is the 5% step-up difference worth it? For investors in a rush to beat their 180-day deadline or who don’t want to miss a compelling opportunity, completing the investment by year end 2019 may be well worth it. On the other hand, making a rushed decision driven by a nominal tax incentive may potentially result in a bad investment from a lack of due diligence.
When assessing the impact of the 2019 deadline, it is important to consider that the 5% figure is not a return to investors, but rather a reduction in the amount of capital gains that will be subject to taxation on December 31, 2026. More simply stated, the benefit equals 5% times your then-current (2026) capital gains tax rate. Since 2026 tax rates are not yet known, the actual benefit to an investor is not yet completely quantifiable.
You Can Still Receive a 10% Step-Up In Basis
If you miss the December 31, 2019, deadline, not to worry. There is another opportunity with a December 31, 2021, deadline. This is a 10% step-up in basis for holding QOZF investments for at least five years prior to December 31, 2026.
Let’s run a few numbers on $1 million of capital gains invested. For the sake of comparison, we’ll assume the current 20% capital gains tax rate for high-income taxpayers plus the Medicare surtax of 3.8% for a total of 23.8%. Without the QOF tax benefit, in this case taxes come to $1,000,000 x 23.8% = $238,000.
With the 15% step-up benefit, instead of $1,000,000 being taxable, only $850,000 is subject to taxation because the investor’s basis is “stepped up” from zero (100% gains invested) to $150,000 (15% of the gains invested). In this case, $850,000 x 23.8% = $202,300. That’s a savings of $35,700.
Now for the 10% step-up benefit. Taxes come to $900,000 x 23.8% = $214,200. Between these two QOF benefits, the difference is $214,200 – $202,300 = $11,900. By taking more time and missing the 2019 deadline, an investor would only be able to utilize the 10% benefit, and would miss out on an incremental $11,900 in tax savings.
Now let’s look at this from a different angle. In this example, although the investor misses out on forgone tax savings, the investor still saves $23,800 in taxes that would have otherwise been due and still has the benefit of deferring those gains until December 31, 2026.
Next, consider that the main benefit of the QOZ program is permanent exclusion of capital gains generated from the QOZF investment, provided that investment is held for at least 10 years. The bulk of total returns to an investor in a QOZF are projected to come from back-end appreciation, not the step-up in basis. In our example above, the incremental step-up of 5% resulted in an incremental $11,900 to the investor compared to only receiving the 10% step-up benefit. Considering an investment of $1,000,000 of gains, the $11,900 figure is only an additional 1.19% of total return over a multiyear time frame. In the greater context of the investment, it’s probably not enough to sway a decision.
If you’re still contemplating rushing to meet the 2019 year-end deadline for the 15% step-up benefit versus taking more time and “settling” for the 10% step-up benefit, consider the larger picture of the investment. Have you done your homework? Would this still be a good investment if it weren’t for the tax incentives? Are you comfortable with having your money tied up for an extended period? It may not be worth it just for the incremental tax saving.
The 15% step-up benefit is great for investors who are ready to go by December 31, 2019. For those who need more time, the 10% step-up may still be very attractive, especially when paired with the other benefits of the QOZ program.
Full disclosure. The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.