A Limited Opportunity

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The proposed increase in capital gain rates has been a fairly hot topic over the last few months. Current opportunity zone investors and potential opportunity zone investors will likely want to monitor this topic closely over the next few months.

Here is a quick primer on how opportunity zones work for investors. In order to qualify as an opportunity zone investor (or qualify for the benefits), a taxpayer must defer/invest capital gains into an opportunity zone fund. By rolling these gains into a fund the taxpayer is allowed to defer the capital gains until December 31, 2026. Along the way there are breakpoints which reduce the total gain that is taxed on the day of reckoning – December 31, 2026. Ultimately the big payoff is ten years from investment into an opportunity zone and the potential for exclusion of appreciation on the investment.

A commonly misunderstood element of opportunity zones is that the original deferred gain is due on December 31, 2026 at whatever the tax rates are at that time. For example, if a taxpayer deferred a $100,000 from a stock sale in 2020, that $100,000 gain would be taxed in 2026. If the capital gains rates are 20% when deferred, they will not necessarily be 20% in 2026. If capital gain rates were to rise to the proposed level of 39.6% this could be nearly a 20% increase. For investors that invested early in opportunity zones there is a chance that 15% of the original gain will be eliminated, leaving 85% of the gain at a 20% higher rate. This mitigates the risk for initial investors, but for newer investors who may not be able to invest in an opportunity zone by the end of the year, these gain elimination benefits might not be available.

Keep in mind that these rates are proposed and only kick in on income over $1,000,000 so there is a chance that even if rates are raised that taxpayers might not have to pay the highest rate, but it is important to understand that the current rate environment today is not necessarily what the future rate environment may be. Opportunity zone investments are a unique and exciting program, but they can often be oversold and investors should always examine the underlying economics before trying to chase tax benefits.