U.S. equity markets are 11 years into a record bull market and, despite recent volatility, continue their upward trend. Supported by low interest rates and stable economic data, U.S. markets have increased nearly 340% since the market bottom in March 2009 during the financial crisis. Year to date, the S&P 500 Index has increased over 14% alone. Nevertheless, recent concerns about the impact of a trade war with China and the fallout from a hard Brexit, compounded by August’s yield curve inversion, have caused some analysts and investors to warn of an imminent U.S. recession and potential end to this record-breaking run in equity returns.
Faced with the potential of a looming recession and bear market, investors would be wise to consider ways to diversify their portfolios away from U.S. equities and monetize some of those long-held gains. The challenge, however, is taxes. The sale of highly appreciated stock can result in a significant capital gain tax liability for investors.
Enter Qualified Opportunity Zones (QOZs). Established as part of the Tax Cuts and Jobs Act and passed with bipartisan support, the Opportunity Zone program incentivizes investors to recognize potential capital gains in their portfolios and to re-invest those gains into economically underserved communities around the country, without a cap on that investment. Looking at a hypothetical traditional real estate investment of $1,000,000 in comparison to a hypothetical QOZ investment of the same amount, with an annual appreciation of 10% and 10-year holding period for both, the difference in total 10-year after-tax net gain could be just over $700,000, assuming a long-term capital gains tax rate of 23.8%.
By investing capital gains into QOZs through Qualified Opportunity Funds (QOFs), investors are able to defer and reduce their capital gain liability and create powerful tax benefits on their new investments in high-quality assets. With favorable adjustments to the capital gains rules (such as lowering capital-gains taxes by indexing gains to inflation) unlikely in the near future, present market conditions create an ideal environment to consider QOZs.
Tax incentives accessible to QOF investors include:
- Investors can defer tax on any prior gains invested in a QOF until December 31, 2026
- The program also provides a step-up in basis up to 15%, applied to the original capital gain, depending on the holding period
- Additionally, investors receive complete elimination of capital gains tax on investments held in QOFs for more than 10 years
Jack Ablin, Chief Investment Officer at Cresset Capital, notes, “Extraordinary policies have pushed equity market levels to near all-time highs. Now is a great time to diversify capital gains into long-term, stable assets offered by Opportunity Zone investments.”
Given present volatility in the stock market, concerns over the inverted yield curve, ongoing trade wars with numerous partners, and uncertainty regarding future rate cuts, the case for diversifying and de-risking portfolios is stronger than it has been for some time. Investors preparing for a potential recession and end to the current historic bull market should consider whether the tax benefits and investment value of Opportunity Zones make QOFs the right choice for them.