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What registered investment advisors need to know when talking about opportunity zone investments with clients

For years, real estate investors have taken advantage of using the 1031 like-kind exchange rules to defer recognition of capital gains when selling and reinvesting in real estate. Now, the opportunity zone (OZ) program offers favorable capital gain treatment that registered investment advisors (RIAs) can add to their asset diversification and estate planning strategies, but confusion and misconceptions about the program remain.

What are OZs and QOFs?

OZs and qualified opportunity funds (QOFs), i.e., the OZ investment vehicle, were created by the Tax Cuts and Jobs Act of 2017 (TCJA), and are designed to stimulate new investment in qualifying communities. Virtually anyone with substantial capital gains can receive federal, and potentially state, tax benefits by investing those gains in a QOF, which in turn are invested in real estate projects or operating businesses located within the more than 8,700 qualified OZs located across all 50 states.

The program enables investors to harvest capital gains and defer payment of capital gains taxes by investing those gains as equity into a QOF within 180 days. A QOF can invest in real estate development, redevelopment of existing real estate, a start-up business or an existing business in an OZ.

Since enactment of the TCJA, the Department of Treasury has issued two sets of proposed regulations to implement the OZ program, with the final regulations published on Dec. 19, 2019. RIAs should work with their client and their client’s CPA to assess the amount of gains eligible for OZ benefits.

Why should you talk to your clients with substantial capital gains about OZs?

Mainly because the tax benefit provides an incentive to diversify concentrated positions with large unrealized capital gains. A QOF investment offers three potential tax benefits:

  1. A deferral of the tax on the original capital gain until the earlier of the date (a) the investor sells or exchanges their investment in a QOF or (b) Dec. 31, 2026.
  2. A reduction of the tax on the original gain (10% if the QOF investment is held for five years by Dec. 31, 2026; an additional 5% if it is held for seven years by Dec. 31, 2026).
  3. No taxable gains on the QOF investment if held for 10 or more years.

How do you talk to your clients about OZs?

Teach your clients about alternative investments.

It starts with diversification and asset allocation. Have a high-level discussion about investment objectives, risk tolerance and liquidity needs. Then talk to your client about the asset allocations that are appropriate for illiquid real estate. You should help your client understand who the sponsor of the project is, what their track record is, how they have been underwritten, and how they will maintain compliance to protect your client’s OZ benefits.

Talk about illiquidity.

Since the QOF investment must be held for 10 years, talk to your client about their liquidity needs. With the QOF, the client will have an investment horizon where they will hold an illiquid position on those funds for an extended period of time. Investors looking for quick returns on their capital gains re-investment, or with other needs in the short term, may be reluctant about an investment in an opportunity zone.

Talk about the OZ “lift.”

A QOF is an alternative investment where the maximum tax benefit accrues if the investor holds it for 10 years. An RIA should help a client understand that the client would need a much higher rate of return on a post-tax capital gain investment in a non-OZ investment to equal the benefit of a QOF investment.

  • Example: An investor has a large capital gain, and the choice of investing the gain into a QOF or paying the capital gains tax and reinvesting. Assume the QOF has a projected internal rate of return (IRR) of 13% over 10 years. If the investor pays the capital gains tax and invests in a non-OZ investment, this investment would have to project an IRR of approximately 17% to provide an equivalent after-tax return as the QOF investment. Almost certainly, investing in a project projecting a return of 17% will have a significantly different risk profile than one offering a 13% return. That 400 basis point difference in the IRR – the OZ “lift” – enables investors to reduce the risk profile when comparing an investment in a QOF to an after-tax investment.

Talk about real estate assets.

Since the vast majority of OZ investment offerings are in real estate assets, each individual offering will have to stand on its own. While real estate investors may prefer to invest in places they are familiar with – where they have lived before, where they’ve travelled, where they already own property – guide your client to high quality investments with a risk-adjusted return. Emphasize the value of working with seasoned real estate developers and broker dealers that have applied rigorous due diligence on the sponsors and properties they want to develop. In addition, explain to your client the importance of working with consultants who will monitor the OZ investment’s compliance with federal tax law at the onset and over the life of the investment.

Talk about timing.

Investors need to understand that they have a certain window of time after their capital gain event to invest their money in a QOF. In general, RIAs should focus on helping clients invest their capital gain in a QOF within 180 days of the capital gain event. Note that passthrough gains (i.e., gains reported to an investor on a Schedule K-1) and Section 1231 gains related to business property are subject to special timing rules and investors should consult with their CPA before investing these gains.

Talk about single asset QOFs.

A QOF can invest in one project or multiple projects. A major problem with a multi-asset fund is that it may have few or no identified projects to invest in and subject the investor to capital calls. Since investors cannot always time gain events (e.g., the sale of a business), the investor is at risk of missing their 180-day window and left to fund capital calls with funds that do not qualify for OZ benefits.

RIAs should look for single asset funds where the underlying project has been identified, underwritten, vetted and is shovel-ready. Investors can then invest their entire gain into one or more single-asset funds to ensure compliance with the 180-day rule. Investors in single asset funds have transparency to the underlying asset, and certainty that when there is a closing, their funds are going into a qualified project.

Remember – there is no need for a “diversified OZ fund” as OZ investments are not a new asset class. OZ investments are either another real estate asset or venture capital asset (if invested into an early stage business) but with added tax benefits. The client’s investment decision should follow the client’s  agreed-upon asset allocation model.

Talk about estate planning.

QOFs have some unique characteristics regarding federal estate and gift tax consequences, which may make OZ investments suitable as part of an estate planning strategy. For example, if an investor during his or her lifetime outright gifts a QOF to a beneficiary, this triggers recognition of income and the deferred capital gains tax would have to be paid. In contrast, making a lifetime transfer into an irrevocable grantor trust (IGT) or passing the asset to an heir upon death are not inclusion events. Clients interested in a QOF investment are strongly encouraged to talk with their accountant or attorney about estate planning ramifications.

Two more things

RIAs should only suggest an alternative, illiquid investment, like a QOF, to clients that have the risk tolerance, liquidity, investment horizon and experience associated with an alternative investment. If the diversification strategy is right for a client, the goodwill generated by educated advice will solidify the relationship between client and advisor, and lead to other business.

Finally, RIAs should only work with reputable and experienced partners when recommending OZ investments. Firms that have accounting and OZ tax expertise, as well as a national real estate practice and a FINRA broker dealer subsidiary will have the resources to provide sound advice on QOF investments. Access to institutional-quality developers with projects in OZs will ensure that you can guide your clients to making the right decisions on QOFs.

For more information on this topic, or to learn how Baker Tilly opportunity zone specialists can help, contact our team.

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The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.

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