By Eric C. Pritz, CFP®, CMFC, Senior Partner
Qualified Opportunity Funds offer a new way to defer and potentially reduce your capital gains
While most of the discussion surrounding the 2017 Tax Cuts and Jobs Act has focused on changes to corporate and personal tax rates, deductions and exclusions, there’s one potentially beneficial provision that has received relatively little media coverage but a lot of cocktail party buzz among affluent investors – a new program designed to encourage investments in economically distressed communities certified by the Treasury Department as “Opportunity Zones.”
Unlike previous efforts to create similar Empowerment Zones, this initiative is unique in both its expansiveness as well as its generous tax advantages. Not only are there a total of 8,700 certified Opportunity Zones (compared to just 40 Congressionally approved Empowerment Zones),1 the variety of qualified underlying investments has been broadened.
It presents a unique opportunity for socially conscious investors to do good while also doing well – directing much needed capital to help revitalize disadvantaged communities and getting a potentially beneficial tax break in return.
How Opportunity Funds Work
Let’s suppose that in the wake of this current 10-year bull market, you have one or more highly appreciated assets with large embedded long-term capital gains that you want to sell. Perhaps it’s an investment property, a large concentrated company stock holding, or simply a decade’s worth of portfolio growth. Rather than forking over either 15% or 20% in capital gains taxes (depending on your income bracket), you may want to consider re-investing those gains in a Qualified Opportunity Fund (QOF) which can offer a three-fold benefit:
1. A deferral/postponement of any unrealized gains for as long as you maintain the QOF investment or until your 2026 taxes (whichever comes first);
2. A reduction (i.e., step-up in basis) in taxes owed on the deferred gains depending on how long you maintain your QOF holding. If you hold you shares for five years, your deferred gain will be reduced by 10%. And after seven years, it will be reduced by another 5%;
3. A permanent exclusion from tax on any gains that arise from investing in the QOF, if you maintain your investment for 10 years or longer.
Additionally, unlike other strategies for deferring unrealized capital gains (e.g., 1031 property exchanges), with QOFs you need only reinvest the capital gains portion received from the sale of an asset rather than the entire sale proceeds. And because QOFs are real estate investments, there are also depreciation tax benefits to be gained.2
While the goal of Opportunity Zones is both noble (funneling capital into struggling, economically distressed communities) and a tremendous opportunity for certain qualified investors with substantial unrealized capital gains, it’s an investment that also carries unique potential risks.
The rules governing opportunity zone investing are complex – QOFs must invest 90% of their capital in physical assets, such as real estate or equipment, that are located in approved opportunity zones and/or ownership interests, such as stock, of businesses that operate at least partially in opportunity zones.2 As a result, investors need to be diligent in selecting an experienced specialty fund manager with a proven track record in identifying the most promising investment opportunities and structures while ensuring compliance with established IRS and Treasury rules.
Investors need to be very thoughtful about how much they’re willing to allocate to a QOF given the potential 10-year lock-up required to achieve a tax-free return on their investment. You want to make sure you set aside enough liquid cash to pay any deferred taxes. Consideration also needs to be given to potential money flows into and out of these funds (particularly around the 2026 tax deferral deadline) and the impact those flows may have on the fund’s ability to maintain its investment portfolio.
Considering investing in a QOF? We suggest you ask yourself one simple question: does it stand on its merits purely as an investment? Rather than focusing on the potential capital gains deferral, think of that benefit merely as a bonus. Make your decision instead based on the fundamental underlying investment thesis.
Given the unknowns as to what these new investments will ultimately look like, the number of unproven investment managers rapidly moving into the space to meet the growing interest and anticipated demand, as well as the unique intricacies of your personal tax situation, it’s vital that you work closely with your SEIA advisor to first determine whether a QOF makes sense given your circumstances, and then to conduct appropriate due diligence to identify an optimal fund for your needs.
1 Forbes, “Opportunity Zones May Help Investors and Syndicators More Than Distressed Communities,” August 2018
2 H.R.828 – “Investing in Opportunity Act,” February 2017 (https://www.congress.gov/bill/115th-congress/house-bill/828/text)