Remember when markets tanked in March and April as panic spread over the coronavirus’ impact? Many investors, including savvy ones, offloaded stocks after years of strong gains, saddling themselves with hefty capital gains tax liabilities.
In the search for alternatives to paying the tax immediately, a growing number of investors have homed in on opportunity zones as a way to buy time, give themselves a chance for further gains and do some social good while they’re at it.
Opportunity zones, which number more than 8,700 throughout the United States, were born out of the 2017 tax reform bill.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
The idea is that by allowing investors to defer any capital gains tax they owe until 2026, dollars will flow into these economically disadvantaged areas and help create a virtuous cycle of jobs and higher incomes.
Investors in these zones also have the opportunity to reduce the deferred capital gain they originally invested, and the reduction increases the longer they hold the investment. Better yet, any appreciation in the investment is tax-free if they stay invested for 10 years.
The strategy has inadvertently been given a boost by those COVID-19-related market plunges. What’s more, in response to the pandemic the IRS recently loosened requirements on opportunity zone investors, including the deadlines to deploy their capital and begin construction on projects.
In the last few years, dozens of opportunity zone investment funds have sprung up, some boasting war chests of several hundred million or even a billion dollars. Alongside those are many one-off projects worth maybe a few hundred thousand dollars backed by individuals or small groups. An estimated total of $12 billion in equity had been raised for opportunity zones by April this year, with about half of that coming in the previous six months.
Most of the attention and funds have flowed to property construction or rehabs, but we’ve seen growing interest in investing in businesses. Businesses that need cash can potentially boost their attractiveness to investors by basing themselves in opportunity zones.
So, what’s not to like about this opportunity? The attractiveness of the benefits is real, but that doesn’t mean that investors shouldn’t be practicing plenty of caution and forward planning before they jump into an opportunity zone fund or project.
Here are some key things to consider:
Do it for the right reasons
Tax-free capital gains sound great, but if your fund or project flops then there’ll be no gains to enjoy. Opportunity zone investments should be based on the same criteria as any other investment, with the focus on the strength of the underlying investment itself rather than the potential tax break. The best way to look at the tax benefits is as an extra bonus that will juice up your after-tax returns if they’re successful, rather than a reason to invest by itself.
Due diligence
Before making a decision on investing in a fund, it’s vital to carry out some thorough checks to make sure you’ll be eligible for all the benefits. The opportunity zone rules are complex and contain plenty of pitfalls that can invalidate the benefits if requirements aren’t met, such as funds having 90% of their assets in qualified zones. Funds are subject to a biannual test to make sure they meet the key standards.
It’s important to be confident in the fund’s compliance standards. For example, is it just monitoring itself or has it hired a trusted third-party to come in and perform that role? Actions that you take can also cause you to lose opportunity zone benefits on your investment. For example, failing to time your investment in a manner that allows you to trace your investment back to deferrable capital gains can result in a non-qualifying investment. Tax advantages can also be lost if you dispose of your opportunity zone investment prior to the 10-year holding period, including a transfer by gift. So careful planning with good advisers is key.
Stay flexible
Opportunity zones come with an opportunity cost of missing out on potentially superior regular investments. If you’re investing in opportunity zones through funds, you’re likely tying your hands in terms of the investment types that will be available to you and how long you may be required to maintain your investment in the fund. With that in mind, it’s important to have the right conversations upfront to ensure that you aren’t restricting yourself more than you intended.
Location
Not all opportunity zones are created equal. Some are located near vibrant, expanding central business districts in cities, while others are in deep rural areas whose economic prospects may be very different. Investors need to understand the inherent risks that come with a fund’s geographic focus.
Choose the right partner
The time frame needed to qualify for the tax breaks means you need to prepare for a long-term relationship with the fund you choose. That raises the importance of assessing the fund’s depth of knowledge and track record. A fund manager could be an experienced developer, but do they have a track record of holding properties for this long? Do they have an asset management infrastructure that goes beyond the traditional developer’s three- to seven-year hold period of “fixing and flipping” and are they able to enhance value over the entire investment period?
Once you start treating opportunity zones with the same rigor and standards as any other investment, rather than as simply a tax-break bonanza, you’ll be on firmer footing to make decisions.
When it comes down to it, the opportunity zone incentive doesn’t make a bad deal good, but it can it make a good deal better.
Contributing: Valerie Grunduski is an Opportunity Zone Consultant and Real Estate and Wealth Management Tax Principal at Plante Moran.
-
The $1 Million Retirement Question: Are You Being Tax-Smart About Your Pension?A financial planner raises some key considerations for navigating retirement with a pension and recommends four strategies.
-
The Costly Mistake You Might Be Making With Your First 401(k)Most people start contributing to their retirement savings later in life. That could be a big-time mistake, literally costing you thousands of dollars.
-
An Estate Planning Attorney's Guide to the Importance of POAsRegularly updating your financial and health care power of attorney documents ensures they reflect your current intentions and circumstances. It's also important to clearly communicate your wishes to your chosen agents.
-
Divorce and Your Home: An Expert's Guide to Avoiding a Tax BombYour home is probably your biggest asset, so if you're getting a divorce, the stakes are high. Keep it? Sell it? You need to have a good plan in place for how to handle it.
-
Fewer Agents, Fewer Audits: How IRS Staff Cuts Are Changing EnforcementSignificant reductions in the IRS workforce appear to be increasing the number of 'no change' audit closures. The shift could potentially increase the overall tax gap — the difference between taxes that should have been paid and those that were.
-
What if You Could Increase Your Retirement Income by 50% to 75%? Here's HowCombining IRA investments, lifetime income annuities and a HECM into one plan could significantly increase your retirement income and liquid savings compared to traditional planning.
-
Here's Why You Shouldn't Do an Estate Plan Without a Financial PlannerEstate planning isn't just about distributing assets. Working with a financial adviser can ensure you've considered the big picture — and the finer details.
-
Trump Tariffs and Taxes: Waiting to See What Happens Is Not a StrategyLike presidents, tariffs come and go. Policy changes also shift about every two years with the election cycle. If you're paralyzed by uncertainty, you could be missing opportunities to benefit your financial future.
