As we head into the final frantic quarter of 2019, I’m sure many of your clients are asking about aggressive tax saving opportunities.
Sometimes I feel like I’m going back in time. I still hear plenty of Fleetwood Mac, the Beatles, the Grateful Dead, and Crosby Stills and Nash on the radio. The Yankees and Dodgers are back on top of Major League Baseball and we have all kinds of byzantine tax shelters singing their siren song to investors.
I’ll bet many of your clients are asking about investing in qualified opportunity zones (QOZs) — one of the most talked about capital gain deferral schemes in decades. Shoehorned into landmark Tax Cut and Jobs Act of 2017 (aka Trump Tax Reform), QOZs are intended to funnel investment money into disadvantaged communities. They also have the potential to become the tax shelters of the 1970s and ’80s.
The Wizards of Opportunity Zones, the wonderful lawmakers in Washington, D. C., have passed into law a mysterious set of incentives and tax rules that is luring many unwary investors down the yellow brick road with promises of tax benefits and of making the world a better place by ridding cities of urban blight. It all sounds so good.
How does opportunity zone investing work?
On the surface, opportunity zone investing is well intended and there are now 8,700 QOZs set up in all 50 states. The zones are designed to attract private capital to rehabilitate disadvantaged and impoverished areas of America. Who wouldn’t want to rehabilitate often-overlooked areas of our community with bona fide investment dollars instead of continuing to raise taxes?
The OZ concept sounds socially responsible and almost philanthropic. But, instead of receiving a tax deduction, investors are only deferring or delaying their capital gains taxes. If you truly believe in community redevelopment, you might be better off finding a great local agency that improves the lives and opportunities of community residents who are struggling. Isn’t that better than gentrifying the area and displacing longtime residents? Local agencies help create jobs and training that will elevate the community. If you’re feeling charitably inclined, donate your appreciated assets to these local agencies.
Remember how the Tin Man, the Cowardly Lion and the Scarecrow in The Wizard of Oz already had the answers before Dorothy? Potential OZ investors who are entranced by capital gain deferral (or elimination) are ignoring several investing fundamentals:
- Very few OZ funds or developers have a proven track record when it comes to investing successfully in OZ assets. That’s not anyone’s fault. Opportunity zones are new. But many of those eager to save taxes seem to be ignoring this fact.
- Due diligence for this type of financial commitment should be rigorous and thorough. Still, projected results are based on someone’s idea of growth and revenue that are fundamentally only a guess. The fact that the government is granting a tremendous tax incentive should alert investors to the risks involved. As with most things in life, if it sounds too good to be true, it probably is.
- Opportunity zones (and funds) are long-term investment commitments that have no opportunity for liquidity without incurring an adverse tax consequence. Investments should be considered in the context of an overall portfolio. While the thought of a community improvement investment is intriguing, it should also have real investment merit on its own. Remember, putting your gains into a QOF is an investment, not a structure. This seems to be missing for many investors seeking immediate and long-term tax relief.
- In the context of overall planning, investors must consider whether the lack of liquidity and lack of control are worth the tax savings. Again, it seems that the tax tail may be wagging the dog, and that’s never good. The OZ law is not permanent; it expires in 2026. There is not much incentive for fund creators to think very long term. Essentially, you get one shot and it’s over. Since virtually anyone can form an OZ fund with almost any purpose, the danger of a long-term commitment is elevated.
- There are many other proven, legal methods to avoid or defer capital gains tax. Many of these methods entail much lower risks to investors (i.e., your clients) and have decades of legal authority behind them. Opportunity zones appear to be the next “bright shiny object” that is attracting the attention of the taxpayers while they overlook safer and often better strategies.
Alternatives to QOFs for clients’ tax planning and gain deferral
Have you considered charitable planning strategies that include charitable remainder trusts and young pooled income funds? Both strategies offer capital gains tax relief. In fact, both offer income tax deductions in addition to capital gains tax relief. Families can receive income for life, and in the case of the young pooled income fund, they can receive income for multiple generations. Further, the donor or investor can maintain control over investment management and select a money manager who has a proven track record that is ascertainable. While assets eventually pass to charity, good planning can keep the heirs “whole” if that’s desired. The tax code has allowed these trusts for 50 years (both enacted in the 1969 tax act), so no one is paving new territory.
With creative planning, the use of certain private life insurance contracts may allow the relief of capital gains tax with a conversion to tax-free income to the investor. Further the investor retains the ability to select investment advisors and investment diversification. These types of vehicles have been available for many years and their open architecture allows for great flexibility.
There are many other tax savings ideas that do not carry nearly the amount of risk that Opportunity Zones present. It would be prudent to consider and evaluate multiple strategies to evaluate the risk and reward inherent in each. For instance, using installment notes allows a seller of any capital asset to defer taxes for 30 years while getting cash at the time of sale. This is done by utilizing various installment notes in a specific, strategic methodology. While not available for all assets or for all amounts, the intention is to illustrate that there are often other, better, safer ways to reduce or eliminate capital gains taxes. Tunnel vision has many believing that opportunity zones are the best way to defer or eliminate capital gains taxes. Many will be disappointed by this approach.
In theory, QOFs are exactly the kind of commitment we hope more high net worth investors make into their communities. It’s a beautiful thing when free markets and private wealth work together to strengthen families and to make direct investment into communities, deploying wealth for social good. That’s the passion and the purpose to which we devote our life’s work.
Opportunity zones may someday be one of the most successful urban renewal programs ever devised. But until that time, clients should consult their legal, tax and financial advisors carefully before taking an OZ leap of faith, no matter how well intended.