An Opportune Time for Opportunity Zones?
It’s the beginning of November… If you have school age children like me, perhaps you are recovering from a Halloween candy hangover and wondering where the bleep September and October went. You might also be thinking of things that start with the letter “T”, like Thanksgiving, trade tensions, Turkey (both the country and the bird), testimony, Terminator: Dark Fate (71% Rotten Tomatoes score), and tax strategies. Not surprisingly, I’d like to focus on the last one on that list. If you’ve had large capital gains in the latter half of the year (or the last 180 days, to be exact), you might want to consider investing those gains in an opportunity zone fund (“OZF”).
The Tax Cuts and Jobs Act of 2017 created a program that designated over 8,700 “opportunity zones” - economically distressed, low-income communities across the U.S. and Puerto Rico – and offered tax breaks to investors willing to put money to work in revitalizing these areas. Opportunity zone funds pool money from multiple investors to invest in real estate development projects in designated opportunity zones. In return, these investors can receive a triple tax break as follows:
1. Deferral of capital gains tax from other investments – Let’s say you sell your FaceBook stock and realize a $100,000 capital gain. If you roll that gain into an OZF within 180 days, you can defer paying taxes on the gain until the earlier of your sale of your stake in the fund or December 31, 2026.
2. Reduction on the taxes payable on the deferred portion of the capital gains – If you hold your OZF investment for five years, you’ll receive a step up in basis equivalent to a 10% reduction in the taxable gain. If you hold it for seven years, you’ll get another 5% reduction.
3. Tax free growth of the OZF investment for 10 years – Any gain on your investment in the fund is tax-free, assuming your investment was made entirely with qualified capital gains from a previous investment.
Keep in mind that this isn’t just a tax strategy. This is an illiquid, distressed real estate investment and development project that must comply with complex regulations. Given the inherently risky nature of the investment, appropriate due diligence should be done on the fund manager with special consideration given to the following criteria:
· Real estate development experience – Qualified Opportunity Zone rules require heavy re-development or ground up projects, so you want an experienced developer. If the fund manager has completed prior projects in the fund’s targeted opportunity zone areas, even better.
· Manager performance record – When reviewing the fund manager’s investment track record, the emphasis should be on the historical returns for development projects.
· A clearly articulated investment strategy with diversification by geography and asset type, e.g., multi-family, office, industrial, retail, etc.
· A robust pipeline of actionable, near-term projects – Regulations provide a short window of time to put money to work, and larger firms are more likely to have the resources to identify attractive projects in a timely fashion.
· Fee transparency – What are the fees associated with the fund and are they reasonable? In addition to the asset management and performance fees (which tend to follow the typical private equity 2% management/20% performance structure), there can be property management, financing, and development fees, to name a few.
So, in summary, if you have realized a large capital gain in the past 180 days that you can afford to re-invest for a long-term period, you may be able to use an opportunity zone fund to minimize your tax pain next April. While many funds out there require a $500,000 minimum investment, there are ways for accredited investors to take advantage of this tax strategy at a lower threshold. If you are interested in exploring specific fund options, I’d be happy to provide more details. And Happy (early) Thanksgiving!
Disclosures: Opportunity Zone investments are only available to qualified investors. Qualified (Accredited) Investors must have an annual income exceeding $200,000, or $300,000 for joint income, for the last two years with expectation of earning the same or higher income in the current year. A person is also considered an accredited investor if he/she has a net worth exceeding $1 million, either individually or jointly with his/her spouse. Opportunity Zone investments are classified as an alternative investment. Alternative investments involve a high degree of risk and can be illiquid due to restrictions on transfer and lack of a secondary trading market. They are generally offered through private placements of securities which are available only to those investors who meet certain eligibility requirements. They can be highly leveraged, speculative and volatile, and an investor could lose all or a substantial amount of an investment. Alternative investments may lack transparency as to share price, valuation and portfolio holdings. Complex tax structures often result in delayed tax reporting. Compared to mutual funds, hedge funds, private equity and other alternative investment managers typically exercise broad investment discretion and may apply similar strategies across multiple investment vehicles, resulting in less diversification. Historical results may not be indicative of future returns.
Please consult your tax and legal advisors before taking any action that may have tax or legal consequences and to determine how the general information presented in this publication may apply to your own specific situation.