Opportunity Zone Funds and Considerations for Your Portfolio
$12 Billion in Near-Term Tax Benefits Await Savvy Investors
The Tax Cuts and Jobs Act of 2017 includes a provision (effective 2018-2026) encouraging private sector investment in certain lower-income communities designated by the U.S. Treasury Department as “qualified opportunity zones” (Opportunity Zones). The Treasury designed nearly 9,000 census tracts as Opportunity Zones across the U.S., District of Columbia, and all U.S. possessions.
The law creates a new investment vehicle called a Qualified Opportunity Fund (Opportunity Fund) to invest in businesses in Opportunity Zones. Under the law, taxpayers who invest in an Opportunity Fund enjoy two significant tax breaks:
- Taxpayers may elect to defer taxes on a portion of the capital gains from the sale of appreciated assets (like real estate and securities) when the gains are reinvested in Opportunity Funds. The size of the tax deferral depends on how long the investment is held in the Opportunity Fund (see chart below).
- Capital gains from investments in Opportunity Funds can be fully excluded from tax if the investments are held for at least 10 years.
This provision received little attention in the popular press until the U.S. Treasury Department issued taxpayer favorable proposed regulations a few weeks ago.1 This tax cut is extremely valuable to investors who plan to sell appreciated real estate, securities, and other tangible property and reinvest the capital gains in Opportunity Zone Funds. Taking full advantage of the full tax benefits of this provision can significantly increase an investor’s post-tax returns.
The new law is scored as a $12 billion near-term tax break for investors by government economists. The law is effective through December 31, 2028 subject to a host of rules regarding investment deadlines. Treasury Secretary Steven Mnuchin predicts the opportunity zone tax break will generate $100 billion of investment.
The proposed regulations provide much needed clarity on key issues such as what taxpayers are eligible for the gain deferral, the type of gains eligible for deferral, the kind of investment in Opportunity Funds that qualify for the tax break, and the holding period needed to maximize the tax benefits.
After the Opportunity Zones were designated by the Treasury Department in early 2018, the Boston Private investment team began to evaluate the Opportunity Funds new to the market and how we can help our clients take advantage of the associated tax benefits, says Shannon Saccocia, Chief Investment Officer of Boston Private Wealth. Because these funds are new and untested it is critical to do a thorough evaluation of the firm and the fund structure to ensure it complies with the law and fits into your investment strategy.
Are You Eligible for the Tax Breaks?
Taxpayers eligible to elect to defer gains under this provision include individuals, C corporations, regulated investment companies (RICs), real estate investment trusts (REITs), and most pass-through entities like partnerships, common trust funds, qualified settlement funds. Taxpayers are required to make a deferral of gain election on their federal income tax return in the year the gains would be recognized for taxes but for the deferral into an Opportunity Fund.
Gains Eligible for Deferral and Deadlines.
Capital gains from stock trades, capital gain dividends received by REITs and RICs shareholders and the sale of tangible property like real estate are eligible for reinvestment in an Opportunity Fund. Investors have 180 days from the date of the sale to invest the capital gains in an Opportunity Fund. Capital gains recognized after December 31, 2026 do not qualify for tax benefits under this provision. Capital gains from sales in 2017 (before the effective date of the provision) would qualify for deferral if the gains were reinvested in an Opportunity Fund by June 29, 2018.
The Structure of the Opportunity Zone Matters.
Taxpayers planning to invest in Opportunity Zones must pay attention to the organization and structure. Rule violations may result in losing the tax benefits. An Opportunity Fund must hold at least 90 percent of its assets in Opportunity Zone property such as owning stock or a partnership interest in Opportunity Zone businesses. In turn, businesses operating in Opportunity Zones must have at least 70 percent of its tangible property in an Opportunity Zone. Combining these rules means from a practical standpoint, an Opportunity Fund will qualify with a minimum investment of 63 percent of its assets in an Opportunity Zone. The proposed regulations provide Opportunity Funds up to 30 months to deploy capital related to construction projects if certain conditions are met.
How to Maximize Your Tax Breaks.
Investors can defer the tax on capital gains they roll into an Opportunity Fund until the investment is sold by the Opportunity Fund. In addition, taxpayers may exclude part of the gain depending on how long the investment is held in the fund—see chart below. The deferral of gain is structured as a step-up in basis of the taxpayers’ Opportunity Fund investment.
In addition, the new law includes a special 10-year holding rule. Taxpayers who hold their investment in the Opportunity Fund for at least 10 years can exclude 100 percent of the gains earned from the Opportunity Fund.
The Market Place for Opportunity Funds is Expanding Rapidly.
Shortly after passage of the new law, several investment firms began offering a variety of Opportunity Fund investment options. The speed to market reflects the generous nature of tax benefits associated with the new law and their anticipated popularity. The proposed regulations provide much needed clarity for investors and Opportunity Fund creators. More regulations are expected in the coming months and I expect them to be favorable to investors. It’s worth noting again, the tax benefits are generous but carry complications. Maximizing the tax benefits requires upfront planning with your tax and investment experts.
Boston Private is Ready to Help.
As you consider the impact of how these investments might benefit your portfolio we encourage you to consult with your financial advisor. Our team of wealth management professionals have been hand selected for their depth of experience and are committed to helping you achieve your unique financial goals.
Boston Private is pleased to announce a partnership with Doug Fisher, a Washington Policy expert, who will offer a series of insights into a number of reform proposals making their way through Congress in 2017. Doug is Director of Retirement Policy at the American Retirement Association. In this role, Doug works with the ARA membership to protect, advise and grow their businesses through ideation and advocacy in the benefits area. Before joining ARA, Doug led Fidelity's legislative policy and thought leadership development teams involving retirement, health and welfare benefit plans. Doug has advised many Fortune 1,000 companies on the impact of legislation and regulation on the design and delivery of benefits. Before joining Fidelity, Doug served as tax counsel to the U.S. Senate Finance Committee and was involved in writing the pension, health and insurance provisions of the Small Business Job Protection Act of 1996; the Balanced Budget Act of 1997, including the Roth IRA, Simple retirement plan, medical savings account (predecessor to the health savings account); and the Health Insurance Portability and Accountability Act of 1996 (HIPAA).
- Tax Planning