If you’re an advisor with clients in need of a capital gains tax break over the long term, the federal government’s Opportunity Zone program still may be a good fit.
When the Tax Cuts and Jobs Act of 2017 was signed into law two years ago, it included the Investing in Opportunity Act establishing “qualified opportunity zones” (QOZs)—census tracts made up of communities designated as economically distressed—as well as qualified opportunity zone funds (QOFs), which can be either a U.S. partnership or corporation that has invested at least 90% of its holdings in one or more of the opportunity zones.
To stimulate private investment in these distressed communities, lawmakers provided program participants with a capital gains tax incentive. While there has been sharp criticism that the programs extend far beyond what most people consider distressed communities, the laws remain in effect. Program participants who invest their realized capital gains in a qualified opportunity zone fund can within 180 days of realizing them defer payment of taxes until April 2027 on investments held through December 31, 2026.
Program participants who hold their investments for at least five years before December 31, 2026, can reduce their liability on the deferred capital gain principal invested in the opportunity zone fund by 10% through a step-up. However, program participants who invested in a fund before the December 31, 2019, deadline and hold their investments for a minimum of seven years before December 31, 2026, can reduce their liability by a 15% step-up. Investors who can hold onto a QOF investment for at least a decade can expect to pay no capital gains taxes on any appreciation of it because they qualify for permanent exclusion under the program’s benefits.
Although the December 31, 2019, deadline has elapsed for a 5% step-up after seven years, Andy Kapyrin, a partner and research director at RegentAtlantic in Morristown, N.J., asserts that qualified opportunity zone funds are still a good investment in 2020.
“The three primary benefits will still apply and continue to make QOZ funds an opportunity worth considering for anyone with a substantial capital gain,” he said in an e-mail last week.
For some investors, however, the length of time required to realize a tax benefit may not make sense, Kapyrin cautioned would-be program participants.
“QOZ regulations are not well-suited for older investors,” he said. “Anyone with a shorter life expectancy may not benefit from a QOZ investment.”
For those investors comfortable with the prospect of a long-term investment, however, Kapyrin said the Opportunity Zone program provided incentives, but also unseen pitfalls.
“One of the most important things to keep in mind is that your tax break depends on the manager following [government] regulations,” he said. “It’s important that they have the regulation/tax compliance down to a ‘t.’”
He stressed the importance of screening fund managers for experience and competency before investing in any fund.
“By investing with a less-established emerging manager, you give someone the chance to learn to shave on your face,” he said.
“There are a shocking number of first-time fund managers in this space looking to do just that,” said Michael Pappachristou, a RegentAtlantic wealth advisor. “These managers may have real estate development expertise, but not necessarily the knowledge to run an investment fund. That is a risk to investors.”
Kapyrin said that in order to manage the risk of real estate development, investors and their advisors should identify a fund with a solid track record; good discipline about making investments; and, most importantly, a diversified portfolio of multiple assets.
Not only is an experienced fund manager key to a successful investment in a qualified opportunity zone fund, so is the oversight of the U.S. Treasury Department. Since 2018, the department has clarified the program’s parameters through the release of new regulations that serve as a guide for investors and their advisors, as well as for fund managers. Two years ago, the department released the first round of new regulations, and last year it released two more rounds.