Opportunity Funds: Great Tax Savings, but Caveat Emptor

The Tax Reform and Reconciliation Act that passed last year contains provisions that allow for significant tax benefits for targeted investments in certain economically distressed communities. The legislation incentivizes development in these areas by allowing deferral and/ or reduction of capital gains taxes regardless of the source of the gains. The goal of this program is to spur development and the law is a descendant of enterprise zones championed by the late Jack Kemp.

An investor may invest the value of capital gains realized in a particular year into an Opportunity Fund within 180 days of the realization of the gain. Any capital gains taxes owed may then be deferred until 2026 as long as they are invested with the Opportunity Fund. The capital gain, either long or short-term in nature, decreases by 10% after 5 years in the fund and another 5% if held for an additional three years. Therefore, these investments allow taxpayers to pay only 85% of the capital gain and delay the tax payment for eight years.

A second tax benefit arises for continued investment in an Opportunity Fund. If the fund itself is held for at least 10 years, no capital gains taxes are due on any gains that result from the appreciation of the Opportunity Fund itself.

Opportunity Funds must be invested at least 90% in Opportunity Zones. Opportunity Zones are nominated by the governors of each state and must then be certified by the Secretary of the Treasury. These funds must make investments after 12/31/2017 and be active investments. Passive investment in real estate for long holding periods is not sufficient to meet the developmental threshold.

The attractiveness of these Opportunity Funds depends on the underlying investments in Opportunity Zones and how they perform relative to other alternatives. An example could help illustrate the tax benefits and to determine whether or not they make sense.

Assume Ms. Smith sells a stock she purchased 10 years ago for $200,000 and that the realized gain on this investment was $100,000. Capital gains rates vary from 0% to 37% for top earners living in California. Let’s assume a combined rate of 20% for ease of computation. Therefore, without any offsets, Ms. Smith would owe a tax of $20,000 by the tax deadline the following year.

If she invested that $100,000 gain in an Opportunity Fund, then she would owe no tax the following year. If she held the fund for 5 years, she would only owe 90% of the tax liability or $18,000 when she sold the investment. If she held the investment for another three years until 2026, her ultimate tax liability would then be $17,000. However, it would be necessary to account for the time value of money since $17,000 eight years from now is not worth $17,000 now. Using a discount rate of 3% per year, that $17,000 would then be worth 78% of what  it’s worth now or $13,260. Therefore, the Opportunity Fund investment would allow Ms. Smith to save 34% of her initial tax liability ($6,740 in savings). Finally, if the Opportunity Fund itself was sold for $200,000 after a holding period of 10 years, then Ms. Smith would not owe any tax on that $100,000 worth of gains.

These tax savings are significant and would be even greater for someone in a higher tax bracket. An alternative investment would have to return between 3-4% more than the Opportunity Fund per year over the eight years to provide an equivalent level of after tax returns. However, the program requires that one’s investment be held in an Opportunity Fund for eight years without much liquidity.

The above analysis is preliminary since no Opportunity Funds are available for investment at this time. The IRS plans to release a form this summer that will allow Opportunity Fund sponsors to self-certify that their fund meets the requirement of 90% investment in Opportunity Zones.

It will be necessary to perform extensive due diligence on any potential investments in Opportunity Funds. Investors in publicly traded common stocks and high-quality bonds are insulated from many risks associated with private investments such as inadequate disclosures and lack of liquidity. The underlying premise of the program is to invest money in economically distressed parts of the country which is a risky proposition by itself. Many well-intentioned funds will most likely lose money and the framework seems ripe for abuses from unscrupulous promoters.

The Opportunity Zones/Funds programs appears to be a creative program to boost economic activity in distressed communities. The tax benefits are also substantial, especially for high tax bracket investors. However, the program is nascent and any potential investments will need to be vetted thoroughly. We intend to keep an eye on this program as it develops.