Opportunity zones became a hot investment topic following the passage of the Tax Cuts and Jobs Act of 2017, and market chatter and interest continued to increase when the Internal Revenue Service and U.S. Department of the Treasury issued guidance on tax benefits for opportunity zone investors earlier this year.
However, even bigger news than the official guidance on opportunity zones is the extra tax break high-net-worth investors can receive if they invest capital gains in this recently created asset class before January 1, 2020.
Opportunity zones were developed as incentives to encourage private investment in low-income or underdeveloped communities across the country. Investors whose total net worth is at least $5 million (excluding personal residences) are permitted to defer taxes on capital gains by rolling them into opportunity zone funds (also known as “qualified opportunity funds”) that specifically invest in the three types of opportunity zone projects—developing new commercial real estate properties, fixing up older ones, and opening start-up businesses such as dry cleaners or restaurants.
Capital gains on opportunity zone investments which have a duration of between 10 years and 20-and-a-half years are completely tax-free. As an added incentive, investors who allocate capital gains from other sources into opportunity zone funds can exempt 10 percent of those assets from taxation, if the investments are held for five years.
But if investors defer capital gains into opportunity zone funds by December 31, 2019, they are eligible for an additional tax exemption of 5 percent. On top of enjoying the 15-percent decrease in taxes on deferred capital gains, investors who take advantage of this “opportunity” have seven years, until December 31, 2026, to invest and grow their deferred taxes.
Those who miss the year-end deadline, and roll capital gains into opportunity zone funds during the two years between January 1, 2020 and December 31, 2021, forfeit the additional 5-percent tax exemption—and don’t receive a deferral extension beyond December 31, 2026.
A Free Loan from the Federal Government
Essentially, the U.S. government has agreed to lend opportunity zone fund investors the amount of deferred tax they will owe on April 15, 2027. That gives investors six-and-a-half years to invest the savings from deferred capital-gains taxes, and use the returns they accrue as they see fit.
For example, if investors place their savings from deferred taxes into a bank savings account, they would receive seven years of interest payments on top of the lump sum the government lent to them—for free. Similarly, investors who put deferred capital-gain tax savings into another investment would accumulate seven years’ worth of returns on top of the initial free “loan” from the Tax Man.
Not All Capital Gains are Eligible for Investment
Although the prospect of free money is always desirable, investors would be wrong to assume they can allocate all of their recognized capital gains to opportunity zone investments. The amount of opportunity zone investment depends on the state where they reside, and the types of capital gains they wish to reinvest.
For example, business owners who sell their businesses generally don’t receive a single check which can be reinvested to defer taxes on capital gains. Some of the capital gains on the sale of a business are long-term capital gains, while other gains can come from accounts receivable or bank accounts.
A business owner who sells their business and receives a $5 million check at closing may only be able to recognize $4 million, or less, as a capital gain they can defer through opportunity zone investments. And if the business owner lives in California, they can’t defer taxes on any capital gains they invest in opportunity zones!
The business owner’s financial advisor can play an important role in educating them about how much they can actually invest in opportunity zone funds.
How to Properly Evaluate Opportunity Zone Funds
The Treasury Department granted opportunity zone certifications to 8,766 economically depressed areas throughout the U.S., including all 50 states, the District of Columbia, and six territories, in the summer of 2018. As of October 22, 2019, 287 opportunity zone funds seeking to raise a total of $64.85 billion in investment for opportunity zone development have launched, according to Novogradac, a national certified public accounting, valuation, and consulting firm which tracks opportunity zone funds.
Investors need to be cautious when choosing from the extremely broad selection of opportunity zone funds available in the marketplace. Investors and their financial advisors need to perform the same degree of robust due diligence on opportunity zone funds that they would undertake on any other prospective investment.
Don’t be fooled by attractive artist renderings of what opportunity zone development projects will look like, or the glowing expected returns advertised by fund sponsors—check that the expectations are accurate, and that the projects have a high likelihood of completion. The best method for digging below the surface to evaluate a deal’s true value is to evaluate the fund manager’s track record and expertise.
Opportunity zone deals are more complex than other real estate investments. They involve building new commercial real estate properties as well as massively overhauling existing spaces. Investors and their advisors should make sure opportunity zone fund sponsors have a solid track record of managing large projects before, during, and after completion, and staying on budget and obtaining proper permits. Sponsors that possess a bit of real estate or fundraising experience, but have never fully developed a big commercial real estate property, should probably be avoided in favor of those with extensive knowledge and experience in institutional real estate development.
Furthermore, opportunity zone projects span the entire country. They can vary broadly depending on municipal and state regulations, community demographics and geography, and a host of other factors. Investing in opportunity zones isn’t like investing in a certificate of deposit (CD) at the bank—each proposed project is different. Investors and advisors should make sure they understand the risks involved in each individual opportunity zone deal they evaluate, and check that fund sponsors are familiar with local laws, community history and culture, and other factors which are key to a project’s success.
On December 31, the ball won’t just drop in Times Square. It will also drop on a lucrative window for taxpayers to maximize capital-gain tax savings by making a positive contribution to disadvantaged communities throughout the country.