Taxes Coming Due In 2026 For Investors In Qualified
Opportunity Zones. What To Do Now In Anticipation.
As part of the 2017 Tax Cuts and Jobs Act, Congress established the Qualified Opportunity Zone (QOZ) program to provide federal income tax incentives for investment in certain economically distressed communities. Investors who reinvested capital gains into a qualified opportunity fund (QOF) and met certain requirements were afforded tax deferral on these capital gains until the earlier of (1) Dec. 31, 2026, or (2) the date that the investment in the fund is disposed of.
Taxpayers were able to defer tens of billions of dollars of capital gains under the QOZ program, knowing that the gains must be recognized at the end of the deferral period and an end game must be considered. As the “day of reckoning” quickly approaches for many investors when these gains can no longer be deferred, systematically accumulating capital losses in advance of this recognition event may help to alleviate the forthcoming tax hit and mitigate potential liquidity concerns.
Capital gains that are deferred through reinvestment in a QOF are not deferred indefinitely and maintain their original tax character (e.g., short-term capital gain, long-term capital gain). QOZ investors will be subject to whatever capital gains tax rates are in effect in the year of inclusion.
According to a 2023 U.S. Department of the Treasury tax analysis, the total amount of capital gains deferred by investing in QOFs and electronically reported to the IRS on Form 8997, Initial and Annual Statement of Qualified Opportunity Fund (QOF) Investments, was approximately $27 billion in 2019. This amount increased to $39 billion in 2020. It’s possible that total deferred capital gains have increased since 2020.
With all these anticipated gains coming up, what steps can taxable investors take to mitigate the tax bite?
Harvesting Capital Losses To Offset QOZ Gains
Taxable investors frequently seek to reduce their overall tax burden and boost after-tax returns by selling securities that have declined in value, a strategy known as “tax-loss harvesting.” Such a methodical accumulation of capital losses may be used to offset capital gains that were previously deferred under the QOZ program.
For individual investors, capital losses may offset capital gains and up to $3,000 of ordinary income on a federal income tax return. Excess capital losses carry forward and may be used to offset capital gains in future tax years, including future QOZ capital gains.
Turning to which assets work best for loss harvesting, individual stocks may present greater opportunities for loss harvesting than bonds, equity mutual funds, or equity exchange-traded funds (ETFs), due to greater volatility and wider distributions of investment returns. Accordingly, tax-loss harvesting with individual stocks in a separately managed account (also known as “direct indexing”) may boost overall loss-harvesting opportunities.
Employing margin and shorting in a tax-managed public equity long-short strategy may further boost opportunities to harvest losses while adhering to an investor’s pretax investment thesis. In such a long-short strategy, the use of leverage increases the overall gross exposure by introducing margin long exposures and short exposures, augmenting opportunities to loss-harvest both on the long and short side, in both upward- and downward-trending markets.
Loss Harvesting In Advance Of QOZ Gains
Although most of the benefits of tax-loss harvesting are delayed until individual investors have capital gains available to absorb the losses, accumulating losses in advance of QOZ or other upcoming gain recognition events over multiple years may allow such investors to offset considerably more capital gains than if systematic loss harvesting occurs only in the year of the recognition event.
Stockpiling losses ahead of expected future gain recognition events tends to be more advantageous when losses will offset short-term capital gains or the portfolio will be contributed to charity or passed through an estate.
Conclusion
Although much has been written about the QOZ program and related tax incentives, little attention has been given to planning for the end of the deferral period. Under current law, tens of billions of dollars of previously deferred capital gains under the QOZ program must be recognized over the next few years. Implementing a loss-harvesting program in advance of this recognition event may help to offset some or all of these gains and mitigate the impending tax hit. Should future legislation extend the deferral period, the extension would likely boost the quantity of capital losses that could be harvested before such a recognition event.
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The information presented here should not be construed as legal, tax, accounting, or valuation advice. No one should act on such information without appropriate professional advice and after a thorough examination of the particular situation.