Once believed to be exempt from U.S. tax law, cryptocurrency transactions are now clearly regarded as taxable, including everyday exchanges of cryptocurrency for goods and services as well as the sale of cryptocurrency in exchange for another currency – crypto or otherwise. Similar to common stock, cryptocurrency is treated as a capital asset. Consequently, holders of cryptocurrency may face tax rates anywhere from 24% to as high as 50% at the federal and state levels on these transactions.
Cryptocurrency investors and traders who thought they were sheltered from capital gains taxes now face a dilemma: comply with IRS guidelines and pay their crypto tax bills, or risk penalties and potential criminal prosecution. Fortunately, the Tax Cuts and Jobs Act of 2017 presents cryptocurrency investors with a third option in managing their crypto-related tax burden: Qualified Opportunity Zone (QOZ) investments.
What are QOZs?
Qualified Opportunity Zones were created to spur economic development in distressed communities throughout the United States by providing tax benefits to private investors who put eligible capital to work in these areas. By investing in QOZs, investors can 1) defer the payment of capital gains tax for several years and 2) completely avoid capital gains tax on the appreciation of the QOZ investment itself. There is a third benefit for investors who invest in real estate development-oriented QOZ Funds, and that is the receipt of rental income that benefits from some tax deduction based on the depreciation of the real estate.
What are the Tax Advantages of QOZ?
As stated above, QOZ investments offer two core tax benefits. Below are the specifics of how they work:
- Tax deferral. Normally, investors are required to pay capital gains taxes in the year the gains are realized. But if capital gains are deployed into a QOZ Fund within 180 days of their realization, tax payment on those gains can be deferred until December 31, 2026.
- Tax elimination: Provided an investor holds his or her interest in a QOZ Fund for at least 10 years, appreciation realized from the sale of either the QOZ investment or the investor’s interest in the QOZ Fund are not subject to tax.
To illustrate the mechanics of QOZ investments in a more tangible way, consider the following hypothetical example:
|Scenario 1: Without QOZ||Scenario 2: With QOZ|
|2014||John invests $100,000 in “Crypto,”
|John invests $100,000 in “Crypto,”
|January 2022||John’s Crypto position is now worth $1,100,000. John would like to diversify his portfolio while retaining a position in Crypto. John sells his entire investment in Crypto and deploys the proceeds to a mix of other cryptocurrencies as well as traditional stocks and bonds.||John’s Crypto position is now worth $1,100,000. John would like to diversify his portfolio while retaining a position in Crypto. John sells his entire investment in Crypto, keeps the $100,000 and deploys the gain of $1,000,000 into a QOZ Fund.|
|April 2022||John pays $300,000 in tax
(federal and state capital gains rate of 30%).
|John pays no tax.|
|December 2026||John pays no tax.||John pays $300,000 in tax
(federal and state capital gains rate of 30%).
|2032||John’s $800,000 after-tax proceeds from his investment has grown to $1,600,0000, and the investment is sold thereby creating additional tax of $240,000.||John’s $1,000,000 gain contributed to a QOZ Fund has grown to $2,000,0000, and his $100,000 of original basis and grown to $200,000. The QOZ investment is sold and John pays no tax on the appreciation. (gains from the QOZ investment are tax-free because the investment was held for 10+ years).The investment of $200,000 is sold and John pays tax of $30,000 on the $100,000 gain.|
|Total Taxes Paid||$540,000||$330,000|
|Total Proceeds Available||$1,060,000||$2,170,000|
Note: The investments shown are calculated with the same annualized gain of 7.177% for this illustration. The amounts shown are not net of fees and carry in either the traditional investment or the QOZ investment. This is to illustrate the tax benefits of QOZ investments prior to any fee structures. Rate of return used only for illustrative purposes to demonstrate taxation concepts, and investors should not expect the returns shown.
The Importance of Manager Selection
Investors should carefully consider the experience and capabilities of a QOZ Fund manager, beginning with their track record of investing in private real estate. Investor due diligence should focus on a manager’s ability to source attractive QOZ investment opportunities, build and manage relationships with high-quality project partners (such as real estate developers and service providers), and effectively manage the entire lifecycle of this long-term and relatively illiquid investment. In addition, investors should also focus on a manager’s ability to navigate the many legal and regulatory complexities associated with establishing and managing a QOZ Fund.
Cresset Real Estate Partners raised $465 million for its first QOZ Fund and is currently targeting $500 million for its second QOZ Fund. Cresset Real Estate Partners has partnered with top-tier real estate developers to build institutional-quality core real estate assets in high-growth markets across the United States, including Houston, Denver, Portland, and Nashville.
QOZ and Crypto: Innovative Parallels
Cryptocurrency investors and traders are accustomed to being early proponents of an innovative movement. Through QOZs, cryptocurrency advocates have the opportunity to support another innovative approach to finance. Qualified opportunity zone investments not only offer powerful tax benefits, they also serve the communities by bringing economic opportunity to neighborhoods often overlooked by the traditional financial system. Not all QOZs are created equal, however, which is why it is important for investors to partner with an experienced team of skilled professionals to identify and manage QOZ investments.