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Every investor wants a tax break.
One of the newest and most specialized is called a quality opportunity fund, which is a way to avoid paying capital gains from the sale of stocks or other assets. For advanced investors with big portfolios and the enviable problem of owing taxes on large windfalls, it could be a strategy to explore with the help of a financial advisor.
But for the majority of investors, and especially beginners, experts agree it’s wise to focus on the tax breaks you can get from more established and accessible accounts like 401(k)s, traditional IRAs, and Roth IRAs.
“I’ve had one question about qualified opportunity funds in my career and it was certainly from an affluent client, not the average investor. It’s really understanding the time and place for it,” says Douglas Boneparth, Certified Financial Planner and President of Bone Fide Wealth.
Read on to know more about qualified opportunity funds, what they are, and other tax-friendly investments to explore.
What Is a Qualified Opportunity Fund?
A qualified opportunity fund is an investment strategy in which investors receive significant tax breaks on capital gains earned from selling stocks or other assets.
Qualified opportunity funds were created from the 2017 with the Tax Cuts and Jobs Act, which was enacted by former President Trump. Through it, investors use their capital gains to invest in “opportunity zones,” which are economically distressed geographical areas around the country. There are 8,700 designated opportunity zones across all 50 states and five U.S. territories. The act specifies that investors need to make “substantial improvement” to a property equal to the original value paid within 30 months in order to reap the benefits.
“If a property was purchased for a million dollars, then the opportunity fund has a 30-month window to make improvements worth at least a million dollars,” says Boneparth.
Certain businesses are excluded from the fund including golf courses, country clubs, massage parlors, hot tub facilities, and liquor stores, to name a few.
Some leaders and politicians in opportunity zones say they are disappointed with the program’s results. According to a 2019 article from the New York Times, Aaron T. Seybert, a social investment officer at a community-development group in Troy, Mich., who supported the opportunity-zone plan, said that 95% of it isn’t doing any good for the community. “Capital is going to flow to the lowest-risk, highest-return environment,” he told the Times.
Due in part to concerns about its effectiveness at driving development in disadvantaged areas, officials in the Biden administration have explored ways to significantly change the program, according to the Times.
Opportunity funds are created through real estate investors who make sure they’re in good standing with the IRS. To become a qualified opportunity fund, a company must file IRS form 8996 each year to certify that it is organized to invest in qualified opportunity zones. Rather than creating an opportunity fund, individuals can invest in one and get the same tax benefits, says Gary Botwinick, a NJ-based tax attorney.
How Are Qualified Opportunity Funds Taxed?
When investors sell assets such as stocks, they generally must pay taxes on the growth of those assets. This is the capital gains tax. Qualified opportunity funds allow some investors to bypass capital gains taxes by putting the profits of their asset sales (within 180 days) into opportunity zones.
The longer they hold in these funds, the smaller their tax burden will be. If the investor holds for more than five years, the investor will receive 10% exclusion on capital gains. If the investors hold for more than 7 years, they’ll receive 15% exclusion. But if the investor holds for 10 years, the investor will not owe any federal income tax on the appreciation at the date of sale.
“If an investor invests half a million dollars and holds it for 10 years, that fund — or property, or investment — is now worth a million dollars. It doubled. You could sell it and not have to pay capital gains on half a million dollars,” says Boneparth.
What Does This Mean for You?
Qualified opportunity funds should not be on the list of investments for young investors and people just getting started, according to Boneparth. It is an investment strategy that appeals to those with large portfolios who see higher capital gains than the average investor.
“If you have $500 to invest, that money might not move the meter in an opportunity fund, especially since you have other options to invest in like a 401(k) or an IRA and things like that. The law of large numbers in opportunity funds is where you really start to see the benefits,” says Boneparth. “There are a lot of other more diversified investments to consider first.”
Make sure you fund your emergency fund, max out your retirement accounts, and pay off toxic debt first before considering other types of investments.
These accounts offer their own tax breaks. If you have a 401(k) through an employer, any money you contribute, up to $19,500 per year, reduces your taxable income for that year by the same amount. A traditional IRA offers the same benefit, depending on your income level.
A Roth IRA is another investment account with unique tax advantages, including the ability to avoid capital gains taxes. When you contribute income to a Roth IRA, your investments will grow completely tax-free, and you’ll owe nothing when you withdraw the money in retirement. The maximum amount you can contribute to a Roth is $6,000 per year if you’re under 50 (or $7,000 if you’re over 50). You can’t invest in Roth IRAs once you make over $124,000 a year for single households, or $196,000 for married couples. You can open one through a brokerage like Fidelity or Schwab. (Pro tip: Make sure your money is being invested when you start making deposits.)
“Invest by covering your fundamental investment accounts and then get into the habit of systematically saving and being disciplined,” says Boneparth. “There’s a lot of solid work to do first to build your financial foundation. The whole point of investing is to stay invested. Once you do that — and build up your net worth — you can look at sexier options that may be out there. The list goes on and on as far as things that you can invest in.”
With reporting by Anne-Lyse Wealth.