That loud breeze blowing through the country around April 16 was most likely our collective sigh of relief at having put the tedium of tax filing behind us for another calendar year.
True, it’s possible to file for an automatic extension that kicks the can down the road another six months (though that’s seldom advisable unless absolutely necessary since Uncle Sam is as kind about interest and penalties as Tony Soprano). But by most estimates, roughly nine out of 10 of us have finished up the task of making sure our federal and state tax returns are filed and paid for.
Sizable capital gain for 2023?
But if you’re an investor sitting on a sizable capital gain for 2023 and facing the grim reality of paying a hefty capital gains tax, you might want to take a fresh look. Because depending on the source of your capital gain, there might still be time for you to devise a strategy that defers the payment of these taxes through the end of 2026 … and perhaps longer.
For certain partnership gains, the deferral can still be effectuated using one of our favorite strategies: a new investment in a qualified opportunity zone (QOZ).
Let’s review how to defer capital gains tax
Regular readers of this space know the basics well enough by now: The Tax Cuts and Jobs Act of 2017 created an opportunity to reinvest realized capital gains into any of over 8,500 QOZs in the U.S. and its territories. The twofold aim of a QOZ investment:
- Tax-exempt growth on the new investment
- The deferral of capital gains taxes on the original gain through at least December 31, 2026 (or at the time the QOZ investment is sold, whichever comes first)
The deferral of the initial gain is valuable, of course: A new QOZ investment today lets investors keep their money out of the tax man’s pockets and at work for them for another two to three years. The longer the payment of taxes can be deferred without penalty or interest, the better it is for investors.
The most significant benefit of a QOZ investment is the opportunity to not only let that new investment grow but also cash out of it completely free of any further capital gains taxes. Any QOZ investment that’s held for at least 10 years can subsequently be sold free of federal (and, in most cases, state) capital gains taxes, at least through 2047 (the current date of expiration of the QOZ program). It’s important to note that this exemption also extends to depreciation and tax credit recapture.
But what about the timelines?
As astute readers know, receiving these tax benefits generally requires the QOZ investment to take place within 180 days of the sale of the original asset.
But final regulations (released in December of 2019) provided an added benefit for partnerships, whose partners receiving a Schedule K-1 (Form 1065) can choose to initiate the 180-day window on any of three dates:
- 180 days from the date the asset is sold by the partnership
- 180 days from the last day of the partnership’s tax year (December 31 for calendar-year partnerships)
- 180 days from the date that the partnership’s (nonextended) tax return is due (March 15 for calendar-year partnerships)
The ramifications for 2023?
Let’s say a partnership realized a substantial gain in January 2023 and passed it through to its partners via a 2023 K-1. Using the first (best-known) methodology, it’s already more than 180 days past the date the gain was realized and thus too late for the tax benefits of a QOZ investment.
However, partners remain eligible to participate in the QOZ program by redeploying their capital gains in a new QOZ investment by June 28, 2024 (using the second methodology), or by September 11, 2024, using the third methodology. The later deadline is particularly important when considering that partnerships frequently issue late K-1s as late as the summer in some cases, which often makes either of the first two deadlines inoperable.
Just a few caveats
While a QOZ investment offers significant advantages, especially given its extraordinary tax benefits, some qualifiers must be considered.
Most important, QOZ investments generally occur within the context of a qualified opportunity fund, a pooled investment that can include a single property or project or multiple properties. In either instance, QOFs should be considered illiquid investments, especially since the tax benefits of ownership require a 10-year commitment; certain QOFs may expect an even longer commitment.
Of course, QOFs are not generically wonderful investments, any more than one stock is as good as the next or bonds are interchangeable; returns can and do vary from one QOF to another, based on any number of factors, and there are no guarantees for any of them.
Some QOFs focus on a specific sector, including oil and gas, health care or consumer retail; all QOFs have a geographic component as well, and investors may seek to concentrate in a specific state or city or to diversify according to their needs.
Selecting a qualified opportunity fund is decidedly not “amateur hour,” and it’s wise to consult with experts whose experience can guide you in the right direction (and, just as important, away from the wrong direction).
Deadlines
Finally, as with any tax benefits, it’s critical to observe the relevant deadlines, to submit all paperwork correctly and to perform all due diligence related to the investment itself. The financial team you choose to work with should be well-versed in the ins and outs of QOF investments and should be able to keep you on task in meeting these deadlines; while K-1 partners have more time to use this strategy, the existing deadlines remain firm and inflexible.
Your advisers should be able to show you a wide variety of possible investments to choose from and explain the pros and cons of each one.
Given the thousands of available QOFs in existence, there’s likely to be a good fit for you and still time to mitigate your 2023 capital gains taxes, but you must act promptly.
