ELEVATE-ANDREW P. DOUP • October 11, 2022

Amid the economic turmoil of Covid-19, investors in cryptocurrency and volatile meme stocks may generate a substantial amount of wealth on paper at any given time. However, the looming tax liability on these gains may cause the unprepared investor to unduly delay the realization of their newfound wealth. Opportunity zones present a striking choice for investors and business owners alike to defer capital gains tax by reinvesting into their next business venture.

A primer on capital gains tax liabilities

Investments held for fewer than 366 days are treated by the IRS as short-term in nature, meaning they are taxed at ordinary income rates. When coupled with an additional net investment income tax and state income tax, an Ohio taxpayer is subject to a maximum combined tax rate upwards of 45% on short-term capital gains.

This tax rate imposes a clear asymmetric tax disadvantage for short-term investors when compared to the maximum combined tax rate of approximately 29% on long-term capital gains. Furthermore, the Biden administration has proposed parity by increasing an Ohio taxpayer’s maximum combined tax rate to over 48% for both short-term and long-term capital gains, meaning investors and business owners alike could see the government reduce their gains by almost half. Nevertheless, savvy taxpayers may defer, reduce, and eliminate their capital gain tax bills by looking to a relatively new subchapter of the federal tax code governing opportunity zones (OZs).

Venturing into the Land of OZ

A taxpayer typically pays their capital gains tax on their annual return. However, in 2018 Congress authorized a new option: If a taxpayer invests their capital gain into a “qualified opportunity fund (QOF),” and the QOF then invests into real estate or business property located in an OZ, then:

the taxpayer may defer their capital gains tax bill until payment in 2027; and

any investment sold after a minimum 10-year holding period is eligible for 100% tax-free treatment.

Based on data indicating certain parts of the country have not shared in the economic recovery since the Great Recession, the U.S. Treasury Department has designated over 8,700 OZs across every state and territory. The public policy behind the OZ legislation is to incentivize private investment into the communities that need it most.

“Opportunity zones present a compelling strategy for capital gain taxpayers, especially for those faced with paying higher short-term tax rates,” said Azra Nakicevic, a CPA at accounting firm GBQ. “It provides flexibility for taxpayers to form and manage their own QOF as a limited liability company treated as a partnership, or to make a passive investment into an emerging class of professionally managed QOFs.”

Abe Nixon, president of Columbus-based Infinity Square OZ Fund, has organized a QOF for investment into real estate and digital assets. “Cryptocurrency is now being acquired by institutional investors and publicly-traded companies at scale, which is expected to increase the value of certain digital assets over time,” said Nixon. “We view opportunity zones as a striking proposition where investors in stock, real estate, Bitcoin or otherwise can defer their capital gains tax, invest in local communities and gain some exposure to cryptocurrency assets, and participate in this growth free from the burden of tax erosion.”

An investment example

On January 29, 2021, Ohio taxpayer Stella sells Bitcoin and Gamestop stock that she acquired over the previous six months for a $1 million profit. Subject to a 45% combined short-term capital gains rate, Stella’s total tax liability in 2021 is $450,000.

Rather than pay this tax on her 2021 return, Stella properly establishes and operates an Ohio limited liability company (LLC) as a QOF and transfers the $1 million profit to her QOF’s bank account within 180 days. Stella then uses the QOF to invest $500,000 into her side hustle duplex renovation project, and $500,000 into a business startup that her brother Theodore operates as a qualified opportunity zone business (QOZB), each located in an OZ.

On Stella’s 2027 tax return, her deferred tax bill becomes due and payable. Stella pays the bill with investment revenue that she wisely saved.

Beginning in 2031 (the tenth anniversary of her investment), Stella becomes eligible for a tax-free exit on her OZ investments. If Stella sells both assets for $6 million, then she can elect to step up her basis to an amount equal to the sale price of each asset, resulting in zero tax on her $5 million profit.

Additionally, since Stella invested before year-end 2021, she was eligible to apply for a 10% Ohio OZ income tax credit in 2022 and to reduce her deferred tax liability by 10% on her 2026 annual return. In this simplified example, Stella has converted her short-term “paper” gain into generational wealth by optimizing the OZ tax benefits.

Beware the Ides of March

Opportunity zones offer compelling tax incentives to investors and business owners alike; however, there are strict rules that govern the timing, establishment and operation of OZ ventures. For example, taxpayers generally have only 180 days from the date of sale to transfer capital gain proceeds to a QOF. The following investment deadlines are exceptions to this general rule:

March 31, 2021, for investors with individual gain from Oct. 5, 2019 to Oct. 2, 2020.

March 31, 2021, for investors with Schedule K-1 gain in calendar year 2019.

September 10, 2021, for investors with Schedule K-1 gain in calendar year 2020.

To mitigate the risk of incurring unintended tax consequences, capital gain taxpayers should consult with their professional advisors to determine the suitability of OZ tax and business planning strategies.

Learn more about opportunity zones from Andrew P. Doup.

Andrew P. Doup, Esq. is a corporate attorney in the real estate and emerging businesses practice group at Kegler Brown Hill + Ritter. He advises taxpayer-investors, developers, entrepreneurs and fund managers on private investment finance, including tax-advantaged opportunity zone strategies.