Diversifying your portfolio by investing in an Opportunity Zone Fund

 

From think tank to law to fresh opportunity

The conversation around opportunity zones began in earnest a few years ago. In April 2015, two distinguished economists (Jared Bernstein and Kevin A. Hassett) from the bipartisan think tank Economic Innovation Group (EIG) authored a paper called “Unlocking Private Capital to Facilitate Economic Growth in Distressed Areas.”1 

In it, they discuss a few key points impacting the growth and development – or lack thereof – of select U.S. communities:2

    • Uneven economic recovery
      Since the U.S. Great Recession from 2007 to 2009, not all communities have bounced back. Over 50 million Americans live in areas where economic opportunities, capital investment, and job growth are still sluggish.

    • Slow business formation
      In many of these areas, local business growth and creation has slowed or declined compared to recovering communities.

    • Dependence on metropolitan areas
      Just a few major metropolitan centers are national economic powerhouses. The business and job growth in these urban hubs is shouldering the economic burden nationwide.

This paper sparked a much-needed policy discussion, ultimately leading to bipartisan initiative H.R. 828 the “Investing in Opportunity Act” and Congress’s Tax Cuts and Jobs Act of 2017.3


Targeting for economic impact

Although QOZs and QOFs were introduced to the Internal Revenue Code in December 2017, the first opportunity zones weren’t designated until April 2018. Regulations and developments to the tax code are also still in progress—the IRS issued additional policy clarifications in October 2018 and in April 2019 about what kinds of capital gains qualify for deferral in this new program.4 Given the recent creation of QOZs and QOFs, new policy developments and IRS clarifications will still be introduced, especially in areas where the law is unclear.

But even as regulations continue developing, encouraging long-term investment in communities that are falling behind economically is the clearest ongoing solution for boosting local housing, commerce, and jobs—targeting resources to have the greatest impact.

In a follow-up report, EIG’s analysis reveals that governors prioritized areas based on their need and their “real potential for revitalization.” This is key. In a New York Times piece on this topic, Senior Director of Wealth Planning for Wells Fargo Private Bank, Chris Pegg notes that, “areas with high growth potential that need a boost” are where real estate investors will find the greatest returns.5 

Most opportunity zones are chosen in exactly these kinds of areas, with three-quarters in places that have seen post-recession employment and business growth from 2011 to 2015.6 While these areas might be seen as struggling, they aren’t completely stagnant. The ideal end result is that both communities and investors benefit.

“One great thing about Opportunity Zones is that the money has to stay there. It’s different than when you fix something up and sell it [immediately]. The money stays in the communities that need it.”

- Taylor Lembi, Founder & CEO, M31 Capital


What goes into a QOF? Diversification.

Opportunity Zones are tracts of land in areas that have fallen behind but are designated as having high growth potential. To entice investors, they now offer revolutionary tax breaks through QOFs – investment vehicles through which people to invest in real estate located in QOZs, businesses, and stock.

More specifically, Opportunity funds are partnerships or corporations (C or S corps) with 90% or more of their assets in qualified opportunity zone business property.7 8 9 

Of course, it’s a little more nuanced than that. Take note that the IRS has clarified that this 90% requirement is flexible when a QOF holds other property and assets inside the opportunity zone, including qualified opportunity zone stock and/or qualified opportunity zone partnership interest.10 11

Because they represent a collection of multiple real estate (and potentially other) assets, adding this kind of fund to an investment portfolio is an excellent diversification opportunity, both because it’s a different asset class, and also because the fund itself can be well-diversified by an experienced fund manager like those at M31 Capital.

Since QOZs are identified by census tracts, it’s quite simple to diversify QOZ real estate assets based on data-driven analytics, selecting for desirable attributes and areas poised for growth. Additionally, data already shows that local governments have been selecting QOZs in areas with high growth potential.12 And diversifying through careful selection of QOZ properties is just the start. Depending on the structure, the remaining 10% to 37% of non-business assets balance out the fund.


Defer, Reduce, Eliminate: 3 key tax benefits

Whether an individual or corporation, the only requirement is having capital gains and investing in the fund within 180 days of either realizing those gains by selling the assets or getting an allocation from a K-1, or capital gain dividend from a REIT. And as the IRS has increasingly limited the applications for 1031 exchanges, investors have looked elsewhere for tax-advantaged investment opportunities.

Here are three main benefits you can count on:

 

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1. Defer Gains Tax

Temporarily defer taxes on initial capital gains.13 Capital gains from property, stocks, and other assets can be reinvested into a QOF within 180 days of sale to an unrelated entity. Unlike a 1031 Exchange, you can pull out the basis from any rollover into a Qualified Opportunity Fund and invest the gains only.

And capital gains taxes are deferred until 12/31/26 on those gains that are rolled into Morpheus 1 fund.

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2. Reduce Gains Tax

Reduce capital gains taxes up to 15%. QOF tax advantages increase at the five, seven, and ten-year marks of holding an interest in the fund. At five years, Opportunity Fund investors get a 10% basis increase for tax deferral. At seven years, if the investment is made by December 31, 2019, they get a 15% basis increase.

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3. Eliminate Tax on Future Gains

Pay zero taxes on fund profits by holding the fund for ten years or more. One of the most exciting investor benefits of QOFs is paying zero taxes on future appreciation. Investors who hold their QOF investments for ten years or more pay zero capital gains taxes on capital gains from their fund holdings.

What began in earnest as a think tank white paper, conversation around positively impacting the development of select, struggling communities has evolved into a strategic new investment vehicle. The team at M31 Capital are committed to realizing these incredible opportunities in the tax code, looking to optimize diversification while locking in previously unheard of tax benefits.

 

 

Footnotes
[1] https://eig.org/wp-content/uploads/2015/04/Unlocking-Private-Capital-to-Facilitate-Growth.pdf 
[2] https://eig.org/opportunityzones/history
[3] https://www.congress.gov/bill/115th-congress/house-bill/828
[4] https://www.irs.gov/newsroom/treasury-irs-issue-proposed-regulations-on-new-opportunity-zone-tax-incentive
[5] https://www.nytimes.com/2018/11/09/your-money/tax-breaks-opportunity-zones-investment.html 
[6] https://eig.org/news/opportunity-zones-map-comes-focus 
[7] https://www.irs.gov/newsroom/opportunity-zones-frequently-asked-questions 
[8] https://www.taxequitytimes.com/wp-content/uploads/sites/15/2018/10/ARTICLE-Window-of-Opportunity_IRS_Issues_Initial_Guidance_on_Qualified_O....pdf 
[9] https://www.irs.gov/pub/irs-pdf/i8996.pdf 
[10] https://www.irs.gov/pub/irs-pdf/i8996.pdf 
[11] https://www.grantthornton.com/library/alerts/tax/2018/Flash/opportunity-zone-guidance-offers-flexibility.aspx 
[12] https://eig.org/news/opportunity-zones-map-comes-focus 
[13] Some states don't qualify.