As an investor, your primary goal is to use the money that you already have in order to make more money. Kevin O’Leary, star of ABC’s Shark Tank describes his investment strategy of sending out his dollars like little soldiers. Every day, he expects those soldier-dollars to come back with new dollars that they’ve captured. While your personal investment strategy may not be so ominous, the fact remains that you want your money to turn into more money with every investment.
However, equally as important as finding successful investment opportunities is doing so within the framework of the law and some of the laws that are the most relevant to investors are those that concern taxation. Depending on the state or states in which you reside or invest, there may be state taxes to consider. Regardless of the state (or states) that you have invested in, there are almost always federal taxes that must be considered.
However, as part of the Tax Cuts and Jobs Act of 2017 (TCJA), policymakers in Washington came together to create an unprecedented opportunity allowing for investors to potentially enjoy tax-deferred investment opportunities that may ultimately generate truly tax-free returns via a program dubbed ‘Qualified Opportunity Zones.’
The government expects you to pay taxes on any income that you earn and, in most cases, on capital gains where your invested capital grows over time. There are different tax brackets that certain incomes fall into, requiring varying percentages to be paid based on how much income you earn in a given year, and there are various capital gains tax you must pay depending on the type of gain.
Investments in the stock market, real estate, and other income-generating assets generally always have taxes on income derived through dividends (from stocks) or distributions (in real estate) and typically there are also tax liabilities when a stock or real estate investment increases your basis above the original purchase price.
You may have heard that retirement accounts, such as 401(k)s and IRAs are tax-free. While that may technically be true on the front end (when you put money into these accounts), you will eventually be taxed for the funds unless you meet some very specific requirements that we will discuss in a moment.
If you’re looking for tax-free investment opportunities, there are several options available to you. For instance, municipal bonds, also referred to as muni bonds, are investment opportunities presented by local governments. The funds that you invest are used to fund various projects, and the interest that your investment generates are often tax-free.
If there are no attractive municipal bonds options available to you, you still have other potential options for tax-free investments. Tax-exempt mutual funds are a great tool for investors who want to invest in mutual funds while still receiving tax benefits. Some mutual funds receive tax-exempt status, which means that you aren’t responsible for paying taxes on the returns generated by these mutual funds.
In addition to tax-exempt mutual funds, there are also tax-exempt exchange-traded funds, also referred to as ETFs which are, for the most part, a lot like mutual funds. However, they are traded on an exchange in the same way that stocks are traded on the New York Stock Exchange. Some ETFs are broken down into short-term, mid-term, and long-term tax-exempt status, meaning that if you only invest in them for a specified period of time, the returns that they generate are not taxable.
However, none of the tax-free investment opportunities described above present anything like the same sort of benefits associated with Qualified Opportunity Zones (“QOZs”). Investments made into QOZs allow investors to defer and even reduce their existing capital gains tax liabilities from realized investments, provided that they are reinvested into a Qualified Opportunity Zone Fund (“QOF”) and held for a minimum of five years. Moreover, provided that investors hold their investment in a QOF for a minimum of ten years, any future gains from the investment may be completely tax-free.
This is an extraordinary instrument for completely eliminating capital gains tax liabilities that, as far as we know, has never been seen before in the history of tax policy in America. By investing in an Opportunity Zone, you can increase your net worth by, under certain conditions, completely eliminating all capital gains tax liabilities.
While some investment instruments described above offer some tax benefits, they are only tax-free on income derived from the investment which, while important, does not generally constitute the bulk of any wealth generation investment strategy.
Tax Deferred Investments
Obviously, there is a difference between tax-free and tax-deferred investments. While tax-free investments are subject to no taxation, tax-deferred investments allow you to delay the payment of taxes. When money is invested or re-invested in a tax-deferred instrument, such as those we discuss below, your wealth can grow because any income and gains are earned on the entirety of your capital, and not the after-tax capital, which optimizes the impact of compounding. Even if tax is ultimately owed at some time in the future, it will be owed on a larger capital base than if taxes were paid earlier in the lifecycle of the investment.
As we discussed earlier, many people believe that 401(k)s, IRAs, and other retirement accounts are completely tax-free – but this is not really the case. While the money that you invest in these accounts is tax-deferred, and you don’t have to pay taxes on the interest that they earn annually, unless you meet specific requirements (length of the investment, your age, and more), you will be responsible for paying taxes on the funds once you pull your money out. Additionally, if you take money out of these accounts, you may be responsible for paying taxes on the interest generated by your investment as well as other early withdrawal penalties. Because of that structure, those investments actually fall under the tax-deferred heading.
There are other areas where tax-deferred investments come into play, most notably in the world of real estate investing. The federal government allows for something referred to as a 1031 exchange. In a 1031 exchange, you can defer the taxes owed on the capital gains generated by the sale of an investment property by purchasing another like-kind property. The phrase “like-kind” doesn’t mean that you have to purchase another apartment complex if you sell an apartment complex and there are requirements that pertain to the type of asset, level of debt and other factors that must be adhered to. That said, when you sell an income earning real estate asset at a profit from the original purchase price, you can use the funds generated to transfer into another similar income earning building without being subject to capital gains tax at the moment of transfer. As long as you purchase a new property within 180 days of selling the first property, capital gains taxes otherwise due on the funds that you earned from the sale (and used for the purchase) can be deferred. Taxes will not be owed until you sell a property for the final time and decide to keep the realized gains generated.
Imagine that rule applying to stock trading (which it does not). That you could invest in a stock, see it’s price rise, then sell it to buy another stock and not be liable on the gain until you cash out finally at some point in the future would change the world of stock trading forever. The 1031 Exchange is one of the most powerful tools used to build wealth and income and is uniquely available to real estate investors.
Qualified Opportunity Zones can also be used as a tax deferral tool. For instance, investors can defer taxes owed on any prior capital gains if they invest the earned capital into a Qualified Opportunity Fund. If an investor holds his or her investment in the QOF for more than five years, he or she may receive a 10% exclusion of the deferred gain, while investments that were scheduled to last at least seven years were to have received a 15% exclusion of the deferred gain.1
What makes QOZs stand out is that by holding on to an investment for 10 years or more, there is no capital gains liability at all making it truly one of the most extraordinary vehicles available to investors today.2
Understanding the difference between tax-free and tax-deferred is paramount. Not only is it crucial that you manage all of your investments according to the law but knowing how to utilize tax-deferred and tax-free investments can put you in a better position to keep more of your money.
Qualified Opportunity Zones are the only true tax-deferred and tax-free investment vehicle available in the market today which is what makes them an opportunity not just in name, but in nature too. As always, it’s a good idea to seek the advice of a financial professional when determining the tax status of any investment. To learn more about the StarPoint Opportunity Zone investments, please contact our investor relations team at IR@starpointproperties.com
Please note that the content included in this article should not be considered tax or investment advice. Please seek counsel with a qualified financial advisor, tax attorney, or accountant before making any investment decisions.
 This benefit has already expired and the 10% reduction benefit expires at 12/31/2021.
 While this applies to Federal regulations; States are dependent on conformity.