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Opportunity Zones: A Hidden Opportunity for an Unexpected Group

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by  Keith McKenzie

The financial benefit of Opportunity Zones is a critical consideration for investors as we head into 2019. The reason: many investors with appreciated assets and unrealized gains find themselves walking a tightrope between the risks associated with a concentrated asset and paying taxes to realize a gain to reposition that asset. For those investors that have been playing the waiting game, the new tax code around Opportunity Zones may signal that your wait is over.

Opportunity Zones are a tax-saving strategy offered by the Tax Cuts and Jobs Act of 2017, with recent Proposed Regulations released by the Treasury in October 2018 that offer additional guidance. The program allows U.S. investors to sell highly appreciated assets like stock or real estate without immediately paying capital gains tax (both short- and long-term), and reinvest into low-income urban and rural communities (Check out this interactive US map showing areas classified as “opportunity zones.” Some of them might really surprise you – and feel less risky than you may have originally thought!). In return for an Opportunity Zones investment, the investor receives three key financial benefits:

  1. Capital gains deferral
  2. Tax forgiveness
  3. Tax exclusion

We’ll look at why this strategy is an opportunity for CPAs and comprehensive wealth management advisors to demonstrate collaborative value for their clients. Advisors for all types of asset classes, both liquid and illiquid, should consider exploring the benefits of Opportunity Zones on an after-taxes, risk-adjusted basis.

Capital Gains Deferral

To reap the financial benefits of this program, an individual must reinvest into a “Qualified Opportunity Fund.” These funds, by definition, hold at least 90% of their assets in “Qualified Opportunity Zone property.” Such properties are classified as low-income areas in need of revitalization (see the map for more details). The benefit to the investor is in the form of a capital gains tax deferral.

For example: an entrepreneur starts a company and, years later, ends up holding millions of dollars of low basis liquid stock. They’re facing a potentially massive tax bill if they want to sell.  Historically, an investor might contribute their shares to an exchange fund to get diversification or they might sell in a structured plan, or they may even hold the shares till death. Now there might be another option.  

Let’s assume this entrepreneur holds $10 million of stock that they’d like to deploy into real estate assets. Under this scenario, they would sell the stock and follow the guidelines to contribute the proceeds to the qualified Opportunity Fund (for most investors, reinvestment into the Fund must occur within 180 days). Or they might even establish their own fund. The obvious benefit to this is that they’re able to contribute the entire $10 million, not just the amount left after paying long-term capital gains. The capital gains taxation on this amount is deferred until the Opportunity Fund investment is sold or possibly until December 31, 2026. In addition to a potentially tax-savvy move, investors are participating in what hopefully becomes substantially restorative growth efforts in U.S. communities that need it most.

Tax Forgiveness

As the individual’s investment in the Opportunity Fund grows, he or she will benefit from a savings in the taxable gain as well. Once the investment has been held in the fund for 5 years, the investor will get a 10% reduction in the original amount of capital gains to be taxed. In our example, this means that if the investor sells after 5 years, the taxable amount of $10 million is reduced by $1 million via the tax forgiveness credit and he or she will only be taxed on $9 million of the capital gains. Beyond 5 years, this benefit will increase.

Two years later, after 7 years, the investor earns another 5% tax reduction in that deferred gain—meaning that a total of 15% of the original $10 million gain in our example is permanently forgiven. Therefore, the amount to be taxed would be reduced to $8.5 million, if sold after 7 years of being invested in the Opportunity Fund. Note that to realize the full benefit, the Opportunity Fund investment must be made by December 31, 2019.

Tax Exclusion

Finally, under the Opportunity Zones program, the investor is not taxed on the appreciation of the amount invested in the Opportunity Fund. This benefit is only available to investors who stay in the Opportunity Fund for a minimum of 10 years. Say the original $10 million Opportunity Zone investment has appreciated by $15 million when the investor sells after 10 years; the investor will pay no tax at all on that $15 million of appreciation. Investors can simply let their money appreciate over the years while knowing they will be free from capital gains tax, as long as the investment remains in the fund for 10 years or more.

The combination of tax deferral, tax forgiveness, and tax exclusion is quite powerful in this example. By investing a larger initial amount ($10 million vs. the post-tax amount of about $6.2 million for wealthy families in California) and allowing growth to compound on a larger investment, combined with a forgiveness of approximately $570K of taxes (38% of the $1.5 million excluded from gain calculations after 7 years), and then ultimately having all the Opportunity Fund gains be tax free (in this case $15 million in gain or about $5.7 million in tax), this investor is looking at a potential home run from an investment AND tax standpoint.

Appreciated Assets

This tax benefit also extends to appreciated assets in other asset classes, not just stocks. For example, Opportunity Funds allow partners in real estate that have been on the “1031 exchange highway” for several rounds to sell assets and split up to go their separate ways without everyone needing to realize gains and pay taxes. Through this program, one partner can continue to invest in Opportunity Zones and defer gains while the other settles up and pays gains. While there are probably many different scenarios where this could provide much-needed flexibility, there’s certainly no doubt that this single provision is possibly the biggest gift given to investors with partners in a 1031 exchange nightmare.

The Complete Picture of Opportunity Zones

As the future of investing presents more challenges and opportunities, investors need additional tactics for managing risks and growing their family wealth. Opportunity Zones are a new way for professional advisors to help their clients execute on their multigenerational wealth plan.

Make sure your clients have the inside track on tax savings by sharing this article with their CPAs and attorneys. Working in your clients’ best interest as a team of professionals will create value and help ensure a long-term, mutually beneficial relationship.

About the author: Keith McKenzie is a founding partner at Delphi Private Advisors. The firm offers institutional wealth management in a boutique, personalized service model for high-net-worth individuals and family foundations. Keith can be reached at keith@delphiprivate.com.

 

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