Opportunity Zone funds confront potential tax hikes, hot property market

The clock is ticking for wealthy investors to grab one particular morsel of a colossal tax incentive.

Meanwhile, the incentive, Opportunity Zone funds, may face a time bomb in the Biden administration’s proposed tax increases.

The funds, which invest in real estate in low-income or economically distressed communities, sport three lucrative benefits — two that shrink and defer old tax bills on an investor’s prior gains that are rolled into the funds, and a monster one that eliminates future tax on the fund’s eventual profits.

One perk, a 15% reduction in capital gains tax that is deferred on dollars poured into a fund, already disappeared for investors who jumped in after 2019. Now it’s only a 10% reduction, and it’s available only if investors who didn’t buy in 2019 or earlier invest by the end of this year. Regardless of when an investor gets into a fund, their skinnier, postponed tax bill comes due at the end of 2026.

Bloomberg News

The third benefit, the biggest of them all, isn’t going away until 2027. It allows investors who hold onto their stakes for at least 10 years to avoid all capital gains tax on the fund’s profits — a perk dubbed “the tax incentive of a lifetime.”

Spanner in the works
Some financial advisors say that the potential spanner now in the works is President Joe Biden’s proposal to nearly double the current capital gains rate, now 23.8% (including the 3.8% Affordable Care Act surcharge). The administration wants a 43.8% rate to kick in once an investor has $1 million in taxable income. While some experts think things may instead settle around 25% to 28% once Congress gets through haggling, any increase could mangle the economics of an OZ investment.

“It’s very possible that people may be at a higher capital gain for the invested part” in an OZ fund, said Scott Bishop, the executive director of wealth solutions at Avidian Wealth Solutions, a registered independent advisor (RIA) in Houston. As such, “it may not make sense” to put money into a fund.

Tax

The $1 million question of higher capital gains taxes under Biden, answered

August 25, 2021 7:40 PM

Bishop said he was pausing putting high net worth clients into the funds until late fall.

“I’ve stopped recommending them until we know more about the tax changes,” he said.

A key date
Regardless of how well they perform, an investor has to pay the taxman on the deferred, reduced amount when she files her 2026 returns the next year (or earlier, if the fund goes belly up). Which means she has to have substantial cash on hand to write a check to the IRS, because the fund won’t yet have been in existence for the 10 years required to throw off tax-free profits. That threshold comes in 2028 at the earliest.

Still, some funds have structured themselves so that they can refinance any debt they take on to give cash to investors to pay their deferred tax bills, according to Aaron Leak, the founder of ECL Private Wealth Management, a hybrid RIA and broker-dealer in Rockford, Illinois.

In the three and a half years since Qualified Opportunity Zone funds, known as OZ or QOZ, emerged in the 2017 tax code overhaul, investors have poured $17.5 billion into 853 funds, according to Novogradac, an accounting, valuation and consulting firm in San Francisco that tracks the industry.

Under the OZ incentive, investors can invest only dollars that are profits from other investments. They have to do so within 180 days of realizing those prior gains.

The gamble
The funds have attracted capital in part because there’s so much money sloshing around after many pre-pandemic years of a strong economy and booming stock market. At the same time, Biden’s potential tax increases have spurred many small business owners to “accelerate” their plans to sell their businesses this year.

Practice and client management

Financial advisor vs. planner: what's the difference?

August 27, 2021 7:00 AM

“Some people say, ‘let’s lock in the lower rate now,’” said Sean Gould, a senior wealth strategist at Waddell & Associates, a fee-only firm in Memphis, Tennessee. But not every client wants to defer the tax owed on a business sale — particularly if rates are going up — and so an OZ fund isn’t for them, he said.

Meanwhile, not every advisor thinks potential tax increases would torpedo the funds’ economics. Nick Parrish, a partner and managing director at Cresset Partners, part of $14.8 billion Cresset Capital Management in Chicago, said that “it’s counterintuitive: You may have a higher liability in seven years, but you’re putting new capital to work and it’s going to be sheltered from taxes at a higher rate. You end up better off.”

For some affluent clients, defined as those worth between $250,000 and $1 million, investing in an OZ fund has the image of being more akin to getting a piece of the action in an initial public offering or a behind-closed-doors private placement. Wall Street’s private banks, including JPMorgan Chase, Morgan Stanley and Goldman Sachs, offer their wealthy clients the chance to plow money into the funds. Minimums can be $250,000 and up.

A piece of the action
Avidian’s Bishop said that “very few” RIAs offer access to the funds, and those that do are typically affiliated with brokerages. The reason, he said, was that OZ investments involve tax advice, something the majority of the more than 13,000 RIAs in the U.S. don’t provide. “It’s not like you can call your financial advisor and ask, ‘what do you got?’” said Chris Catarino, a CPA and shareholder at Drucker Scaccetti, an accounting and tax advisory firm in Philadelphia.

Social Security

COLA increase still won’t cover Medicare, income tax for retirees, report says

August 25, 2021 5:08 PM

But it’s easier than perhaps commonly thought, if an advisor and client are in the know. Both Cresset and Bridge Investment Group, a real estate investor in Salt Lake City, accept investors who aren’t already clients. Some independent advisors use CAIS, a marketplace for alternative investments.

Easy to screw up
The IRS has very specific and complex rules governing OZ investments. A fund, usually a partnership created specifically for the purpose, has to invest in property or land located in one or more of 8,700 designated zones across the U.S. Investors have to make “substantial improvements” to the fund’s underlying structures, whether warehouses, office buildings or apartment complexes. It’s easy to mess things up and void the tax benefits.

There’s another risk as well: the blistering property market. Avidian’s Bishop said he worries that some funds are investing at peak prices — and that in 10 years, they could be worth less.

Bloomberg News

“The question is whether the forgiveness of a small piece of tax and the potential for higher capital gains will offset the growth of those funds at very high prices,” he said.

And whether tying one’s money up in an illiquid real estate investment for a decade is a good idea. “You have to be wealthy enough to take the risk,” said Rosalind Sutch, a CPA at Drucker Scaccetti. “You’re talking about development deals, which are a gamble.”