Even with the big drop this week, some people have made a lot of money in the stock market this year.

Certain small-cap technology and pharmaceutical stocks, for example, saw gains up to 2,000% from the beginning of the year to their top in mid-September.

Some investors continue to hold those stocks, of course. But in some cases, there is a compelling argument to sell.

One is that small-caps are suffering along with the rest of the market … even the up-and-coming growth stocks. It may be time to take the gains and reinvest in those positions later.

But there’s another reason to consider harvesting gains: taxes.

The capital gains tax system can be confusing. But the bottom line is that if you realize gains, you pay tax on them. If you hold a stock for less than a year, you pay the same rate as for ordinary income.

But a recent little-known change to the tax code has created a spectacular opportunity to take gains, pay no tax on them … and use those gains to make even more money — potentially tax-free.

Opportunity Zones … for Your Money

Buried in the revisions to the tax code passed last December is a provision that can turn your stock market wins into much bigger profits over time.

The tax bill created more than 8,000 tax-advantaged “opportunity zones.” They include parts of big cities, rural areas … and the entire U.S. territory of Puerto Rico.

The zones have multiple tax benefits. Anyone with capital gains from any source — stocks, real estate or any other source — can defer taxes on them until 2026 if they use those gains to invest in these opportunity zones.

When you eventually pay tax on those capital gains in 2026, you’ll get up to a 15% discount on them.

And if you hold the opportunity zone investments you made with those capital gains for at least 10 years, any profits you make from them won’t be taxed at all. The IRS will step up the basis of your investment in the opportunity zone to the date you sell it.

That means you could potentially take capital gains this year, invest them in an opportunity zone fund, hold that investment for a decade and pay no taxes at all.

Safe as Houses

The new tax benefits apply to most equity investments in the zones, including real estate development and businesses such as restaurants, stores and technology startups.

Most of the initial investments are expected to be in real estate. That’s because the faster investors get going, the more they can potentially save in taxes … and real estate is a fast investment that can absorb a lot of capital.

To qualify, real estate investments must be ground-up projects or major rehabilitations of existing property.

Real estate, of course, is ideal for another reason: There’s a well-established system — real estate investment trusts — that can absorb money from many small investors and aggregate it into big projects.

That’s why there are close to 20 firms already raising money for “opportunity zone funds,” ranging from $100 million to $500 million.

All This … and No U.S. Income Tax!

The opportunity zone program covers underdeveloped areas in all 50 states.

One unknown, however, is how these states will approach taxation of opportunity zone investments. Most will probably grant matching tax relief at first, but eventually the temptation to tax successful projects will grow.

There is one part of the U.S., however, which already offers massive tax benefits relative to the 50 states — Puerto Rico.

Practically the entire island has been declared an opportunity zone. But this new opportunity comes on top of Puerto Rico’s existing tax incentives.

I’ve written about these tax benefits before. They have their pros and cons, but one big pro is the potential to avoid paying any U.S. federal income tax at all.

It’s early days yet, but I have a feeling my friends on the island are going to be cooking up some highly attractive opportunity zone fund opportunities out of these ingredients.

Put Your Money to Work

U.S. households hold $2.3 trillion in unrealized capital gains on stocks and mutual funds. The new opportunity zone system is designed to tempt some of that money into concrete development.

If you’re lucky enough to be sitting on a big capital gain, capital gains taxes can be a big downer.

Opportunity zones may be just the thing to turn that tax frown upside down.

Kind regards,

Ted Bauman

Editor, The Bauman Letter