The Light at the End of the Tunnel…is a Tax Train Coming Our Way?

Long time readers of the Altus Insight will know what a big fan I am of the qualified opportunity zone (QOZ) provisions that were a bipartisan part of the Tax Cuts and Jobs Act of 2017. Detailed information explaining the provisions can be found at the IRS’s website (click here), but from an investor’s perspective, there were a couple key benefits:

1. Gains, regardless of how they were created (short term or long term), or on what assets (stocks, businesses, crypto, real estate, etc.), could be invested into a qualified opportunity fund (QOF) within 180 days of the realization of the gain to defer the gain realization until the 2026 tax year. That is to say, the taxes on those gains would not be due until when the 2026 taxes are due to be paid in 2027. This deferral was, and to some degree still is, a powerful tool:
   
   
   • Assume $1 million in gains.
   • If long term gains, the federal tax bill would be $200,000, and if short term gains substantially higher.
   • If in 2020 that $1 million in gains was reinvested into a qualified opportunity zone investment, any return above 12% meant that the returns generated solely from the deferred taxes would pay for the taxes in their entirety.
   • As each year passes towards 2026, the returns required to have the deferred taxes fully pay for themselves increases due to the shrinking timeline, but even still today with only two and half years remaining until the tax is due, that is still 2.5 years of free use of what would otherwise be the “government’s” money.
     
     
2. If the reinvestment is held for ten years, 100% of the gains earned on the originally invested gains are 100% tax free (federally). If we use the same 12% example as above, that $1 million of reinvested gains will create $2.1 million of gains, entirely tax free, saving $420k, or 42% of the original investment amount, in taxes. To be fair, the original $200,000 has to be paid in 2027. Once we include that payment in the analysis, a 12% gross return QOZ investment outperforms the same 12% gross return non QOZ investment by a whopping 80% post tax, equating to a $643,000 difference in after tax proceeds.
   
   
3. The third part of the provisions that is consistently overlooked by investors is hugely powerful in its own right. With the same requirement of a minimum ten-year investment life as the tax-free gains, there is no recapture of depreciation. I am continually astounded this doesn’t receive more attention from tax professionals and larger investment funds. For investors (like most Insight readers) that can benefit from depreciation, this is HUGE. Let’s use the same example as above but now add in leverage. For simplicities sake let’s assume the debt for improvements (outside of land) is 2x that of the cash invested. This is effectively 65% loan to cost. The same $1 million of invested gains returns the same 12% to the same $2.1 million in tax free gains. But the $2 million of debt is used to build an apartment complex, or some other investment with a high percentage of components for which depreciation can be accelerated. Using cost seg and accelerated depreciation, somewhere close to 60% of the cost basis should be able to be depreciated. Let’s use 50% to be safe. Fifty percent of $3 million is $1.5 million in phantom losses. Most readers are at the higher end of the tax bracket, so let’s assume a 35% marginal tax rate. That $1.5 million in depreciation equates to $525,000 in tax savings. Normally depreciation has to be recaptured at asset sale, though at a still favorable 25% rate. Using the 25% recapture rate to compare the investment to a non QOZ investment, there is a net benefit of $375,000. In real life, the depreciation benefits can be so beneficial that on one of our QOZ deals even if 100% of the investment capital is lost, it will work out to roughly a breakeven investment.
   
   Add it all up, and the same investment inside of a QOZ structure versus outside a QOZ structure, assuming the 12% returns, provides an astounding increase in post-tax returns of over $1 million dollars. Remember, this is based on an initial $1 million investment. On a non-compounding basis, that is an increase in returns of 10% a year, almost as much as the gross returns (12%) used in this example.
   
   And while results vary and each individual investment has its own return profile, we have several QOZ investments that are returning well in excess of 12%.

But all good things must come to an end, including the QOZ benefits. The step up in basis (reduction in originally taxable gains) is already expired. The ability to invest for the benefits outlined in bullet points #2 and #3 above sunset at the end of 2026. Take advantage of it while you can.

Another important component of the QOZ regulations approaching at the end of 2026 is the realization of the previously postponed capital gains tax, meaning those taxes are due to be paid April 15^th, 2027. I fear that many people that have deferred those gains, realizing the benefits in the meantime, are overlooking the impact of that impending tax. With only two years (and three tax filings) remaining before that tax is due, it is time to be thinking about the tax now, and hopefully putting a plan in place to mitigate the impact. On a personal level I have invested in QOZ opportunities liberally and am well aware of the upcoming tax. While my wife and I haven’t made any particular moves yet, we are researching and considering several different possibilities. Everyone’s tax situation is different, so please discuss your particular situation directly with your tax professional, but here are a few options to consider:

1. Accelerated Depreciation: One of the huge benefits of the QOZ regulations is the lack of depreciation recapture as outlined above. But the benefits of depreciation can be used outside of the QOZ as well. If an investor is able to line up a large depreciation benefit for 2026, it could offset the tax impact of the gain realization. For those that can claim being a real estate professional, the depreciation carries a larger benefit in that it can be used to reduce taxable earned income, which in most cases is taxed at a higher rate than capital gains. So technically it wouldn’t be offsetting the gains, but the net benefit is still there. With the phase out of the QOZ benefits, bonus depreciation is also phasing out, reducing the benefit of doing a cost segregation study, but 2026 will still benefit from 20% bonus depreciation.
   
   
   • A subset of this route is the retirement/disposal of components of real estate, which can happen over a very short time frame. For instance, if an apartment building is purchased in 2024, and then in 2026 ownership decides to upgrade all the unit interiors by pulling out and replacing all the carpets and cabinets, whatever portion of the cost basis that is tied to the carpets and cabinets at the start of 2026 that is replaced can be written off in full in the year it is replaced.
     
     
2. Oil/Gas (with acknowledgement some investors have an aversion to hydrocarbons): I am not an expert in taxation, and even less so in areas outside of real estate, but I have been able to benefit from some of the oil/gas tax provisions in the past. Intangible drilling costs, which generally are over 50% of the cost of a new well, are 100% deductible in the year incurred. Tangible drilling cost are also 100% deductible, but over a 7-year life. The combination of the two can make for a substantial tax benefit in the year of the investment. There are additional niche tax benefits that can be obtained with additional research and investment specificity (i.e. small producer exemptions).
   
   
3. Tax Credit purchase/participation: Tax credits can be bought and sold, and in fact, the sale of tax credits is a common way of funding various sorts of capital-intensive projects. Generally, these credits transact not far below par, meaning the tax savings are minimal for each dollar transacted, but still a benefit for the buyer. But tax credits can also be created on a taxpayer’s/investor’s behalf. The tax credit through the “Inflation Reduction Act” for installing clean energy production (solar) on homes is 30%. There are credits available and all sorts of creative ways to create investment value while also corralling the tax credits. 
   
   
   • There are also tax credits which have not yet been issued an IRS opinion letter. These credits can be purchased for far more favorable prices (60 – 70%) but the buyer takes the risk of the IRS invalidating the tax credit, which then means the credit buyer has to go back to the credit seller for a refund on the purchase price. Each investor has their own level of risk tolerance as it pertains to such scenarios.
     
     
4. Agricultural (Orchard) Land: Like many tax provisions, this is pretty niche, but unlike real estate QOZ funds or oil well investments, this can be a little harder to access for people not involved in the industry. Like with real estate components, permanent crops can be disposed of and written off in a single year, but preplanning is required. Some aggressive investors will buy and rip out orchards in the purchase year to take the tax benefit, but more conservative tax advisors suggest three years of crop income before disposing of the orchard. If the disposal needs to be done in 2026 to offset the QOZ 2026 tax impact, that means the orchard needs to be purchased within the next 3 months, a very short time frame to be sure. For contrarian investors, look to California nut orchard land, which has seen substantial price declines over the past year or two due to plummeting nut prices. While lower prices mean reduced write offs, it also should mean higher overall investment returns in the future.
   
   
5. Charitable Giving/Estate Planning: In addition to the 2026 QOZ tax impact, there are substantial estate tax changes that occur at the end of 2025. Regardless of QOZ tax exposure, we should be reviewing our estate planning within the next fifteen months. But also, for those that are of the mind and time of life to do so, incorporating charitable giving plans into estate planning can be a great tool to mitigate the QOZ tax liabilities.
   

Most people view the goal of investing as obtaining the highest possible returns. The next level of investors understand that returns have to be viewed within the context of the risk assumed to earn those returns. And then still the next level higher of investors understand that while gross investment returns are important, it is the net investment returns that truly matter. If you are reading this Altus Insight you are almost certainly in that third level of investor. It isn’t what we make, it is what we keep.

Happy Investing.