Opportunity Zones are among the latest tools in alternative investments, but what are the more practical applications of utilizing an Opportunity Zone fund? Two such applications include one for those who are considering selling their business, as well as investors who hold concentrated and highly appreciated stock positions.
Who Can Invest in an OZ and What Are the Tax Benefits?
You might have heard about Opportunity Zone investing, but for the uninitiated here is a quick summary: An Opportunity Zone is an economically distressed community where new, long-term investment in property or businesses may qualify for tax incentives. Congress created the Opportunity Zone program in the Tax Cuts and Jobs Act of 2017. In a rare instance of bipartisanship, Sens. Tim Scott (R-S.C.) and Cory Booker (D-N.J.) co-sponsored the legislation as an attempt to attract capital to parts of every state that could benefit.
So far so good, right? But what are the potential tax benefits and what are the practical applications?
For the purposes of this article we will discuss funds that comply with the Opportunity Zone program. Any capital gain dollars can be rolled into an Opportunity Zone fund within six months of the realization of the gain. Unlike other similar programs for real estate, only the capital gain itself can be invested, not the original basis.
Once invested, the tax due on the original gain is deferred until the end of 2026, payable in April of 2027. The second benefit is a 10% reduction in the gain itself, as long as the fund is still held as of the end of 2026. Note that the gain is taxed at the then current rate. The final and most valuable benefit is that if the funds remain invested for 10 years, any profit achieved during those years is completely tax free.
By way of example, an investor with a $1 million capital gain invested in an Opportunity Zone fund for 10 years would enjoy a seven-year deferral and a 15% haircut on the original gain. In addition, assuming a hypothetical profit of $1 million on the investment over the 10-year period, just a 7% annual rate of return, that second $1 million profit is enjoyed completely tax free by an investor maintaining the investment for 10 years. You read that right — tax free.
Two Practical Applications
1. Concentrated Stock Position with Large Capital Gain
Imagine an employee who owned a publicly traded stock for more than 20 years. He obtained the stock working as an executive for a company and truly never intended to sell it. However, the company had a different plan and sold the entire firm for cash, leaving him with a $300,000 capital gain. In this case the portfolio is large enough to justify this position size and the employee is already otherwise properly diversified. This is important, because we never want a tax motivation to skew the larger thinking around diversification and asset allocation.
He decides to invest the entire gain in an Opportunity Zone fund focused on hotel development. As a result the employee now owns Limited Partnership interest in eight different hotel developments around the country, all of which are located in Opportunity Zones. He will enjoy the deferral until 2027 and intends to continue owning the fund for a 10-year period.
Note, in this case the fund is a private partnership intending to create income from the third year onward sufficient to fund the anticipated capital gain due in the seventh year. The balance of the investment is expected to be illiquid through the 10th year in order to enjoy the tax-free treatment on the potential gain over the entire period.
What This Strategy Accomplishes for the Investor: For this investor, he substantially deferred the entirety of the estimated $60,000 Capital Gain tax on the $300,000 gain. This has the effect of keeping him in the same tax bracket, avoiding a spike in his Medicare premium that would have resulted and, most importantly, he has the opportunity to completely cover the much-delayed tax payment with new tax-free earnings. While these timeframes don’t line up perfectly (seven-year deferral vs. 10-year investment period) he takes the long view on his balance sheet and can see the connection over time. Certainly, if a particular investor did not have a large enough portfolio to suffer the illiquidity of the new investment other options should be considered. Also, it is important that the funds used fit well within the overall portfolio strategy.
2. Selling a Business
Next, think of a business owner who sold a business resulting in a capital gain of $5 million. In years past, this would have triggered a tax liability of approximately $1 million with no opportunity for mitigation. For some business owners, depending on diversification needs for the portfolio, they will be able to invest the entire gain in Opportunity Zone funds and enjoy the seven-year deferral along with the tax-free growth over the following 10 years. For others, where the gain is a large portion of the proceeds, this may not be desirable because of needs relating to diversification, income production or liquidity. Further, having too much money locked up for 10 years may not be a great idea.
In cases such as this we might recommend investing the approximate amount of the tax due ($1 million in this case) in a portfolio of multiple Opportunity Zone funds. If these funds in concert hypothetically double over the following 10 years, that taxpayer has essentially recovered the $1 million tax payment on the original gain onto their balance sheet, albeit over 10 years. We could get fancy and calculate an investment amount taking time into consideration as well, but the concept is essentially the same.
There are many things for investors to consider when reinvesting capital gains. Start by taking note that the funds considered above require Accredited Investor status, which is not typically an issue for investors involved in large concentrated positions and business sales. Individuals could also rightly worry that there is too much focus put on the tax benefit when dealing with these investments, and that they’re perhaps overlooking the underlying risk of the assets themselves. At our firm, we only invest in Opportunity Zone funds that are sponsored by the asset managers we use in our ordinary investment portfolios.
For example, the hotel fund referenced above had already underwritten 18 hotels for 2019 on a purely economic basis prior to the Opportunity Zone maps being released. Once the maps were released, they discovered eight of their projects fell into Opportunity Zones. They then took those eight projects and created a syndication that qualified within the Opportunity Zone rules. This approach focuses on the true value of the investment thesis, and not necessarily just on the tax benefits.
The article and opinions in this publication are for general information only and are not intended to provide specific advice or recommendations for any individual. We suggest that you consult your accountant, tax, or legal advisor with regard to your individual situation.
Kalos Capital Inc. nor Kalos Management Inc. can guarantee the income projections outlined in the above tax analysis and any references to growth from gains or assumed income are purely hypothetical in nature and do not reflect guaranteed results. There are a number of uncertainties related to Opportunity Zones and Opportunity Funds that have not yet been determined and are subject to change based on pending guidance that is expected to be issued by the U.S. Department of the Treasury regarding the Tax Cuts and the Jobs Act of 2017, including the types of capital gains that can be rolled into an Opportunity Fund, how much time they will have to deploy capital and the tax treatment of pass-through partnerships. Our analysis is based on various aspects of the Opportunity Zone Program, including positions that we believe to be reasonable given the statute as currently written and prior Treasury and IRS precedent. As a result, there are no guarantees that the analysis presented is correct until such guidance and regulation is provided on Opportunity Zone programs Therefore, each investor should consult with their own personal tax adviser prior to making any investment in an Opportunity Zone Program or Opportunity Fund. Kalos Capital Inc. does not provide tax or legal advice. The opinions and views expressed here are for informational purposes only. Please consult with your tax and/or legal adviser for such guidance.
George Terlizzi has worked in business for more than 25 years as an entrepreneur, consultant, dealmaker and executive for early and mid-stage companies. He has substantial concentrations in finance, technology, consulting and numerous forms of transaction work. Today George advises wealth clients individually and sets the strategic vision for SouthPark Capital. George's insatiable curiosity, action-oriented approach, and broad-ranging interests are invaluable to those he advises.
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