Window of opportunity zone investing still open

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From Times Square, New York to Tulare, California, revelers will be ringing in a new year and new decade on Dec. 31. It’s also when investors with capital gains will be rushing to make investments in a qualified opportunity fund (QOF) and get the “full” benefit of the program.

As I’ll explain shortly, the program will remain open for new investors after Jan. 1. It’s more important for investors to do their due diligence properly than to race to meet an incentive deadline and end up with a hasty investment hangover. Just remind your clients that they still have two more years to invest in a QOF. The main difference is that after Jan. 1, for QOF investments held seven years, the credit for deferred capital gains goes down to 10 percent from the current 15 percent.

It’s still a good deal if you ask me, and it only costs you a few percentage points in tax savings to take your time to find the right fund, projects and zones.

Jason Trenton, a trust and estate attorney in the Los Angeles office of Venable LLP’s Tax and Wealth Planning Practice, told me recently, “The passage of this act has unlocked different ways to take advantage of substantial tax savings by investing in opportunity zone funds as well as operating business located in qualified opportunity zones. We are actively forming funds and evaluating the various benefits for our clients.” There are California opportunity zones, Florida opportunity zones, and, well, 8,700 different opportunity zones in all 50 states.

While there’s a massive opportunity to save and defer taxes on the sale of an appreciated asset, and the potential to start a business and ultimately sell it tax free, due diligence on funds and fund managers is essential. You need to understand the pros and cons for each client situation.

Let’s say Tina’s company had an initial public offering . She sold her shares of stock for $1.1 million recently and the basis cost of the stock she sold was $100,000. Normally she’d be on the hook for taxes on the $1 million capital gain ($1.1 million minus $100,000). However, if Tina invested that $1 million gain in a QOF within 180 days of triggering that gain, she could defer taxes on the profits for several years.

Tina received three key benefits for rolling her $1 million gain into the QOF:

1. No capital gains taxes are due on that money until 2026.

2. In 2026, her capital gains taxes are reduced by 15 percent (10 percent if invested after Jan. 1, 2020).

3. If the fund she invests in holds the building or other asset for at least 10 years, then Tina owes $0 in capital gains tax once that asset is sold.

What I like about the opportunity zone investing program is it allows clients to put the government’s tax dollars to work by directly helping other entrepreneurs and job creators.

Can QOFs work for my clients?

Do your clients have assets that have appreciated such as stocks, artwork, your primary residence or maybe a business? Are they individuals, C corporations, partnerships, S corporations or trusts? Are they interested in making a long-term investment or starting a business? Read on.

As mentioned earlier, the tax savings from opportunity zones can be substantial whether your clients invest in a QOF or start their own fund. On the front end alone, they will receive two benefits:

1. Deferral of their capital gains tax until 2026;

2. 15 percent reduction of their capital gains tax bill if investment is made by year-end 2019 (10 percent reduction if the investment is made after Jan 1, 2020).

But opportunity zone investing gets even more interesting on the back end. Investors are not just deferring taxes when they invest their capital gains in a QOZ; they’re acquiring an asset that can potentially increase in value. Even better, if the investor holds that investment for 10 or more years, the tax on the sale of that asset is zero.

Imagine investing in an apartment complex, holding your investment for 15 years, and then incurring no taxes after you sell the building no 1031 required. Or imagine starting an operating business using gains that were made on stocks, artwork or some other asset as the seed to start the new business. If the newly formed company is sold after 10 years, the tax bill could be zero. Please note, a few states such as California, North Carolina and Mississippi do not follow the federal guidelines on opportunity zone investing. However, in California’s 2020 budget, the governor has proposed conforming for qualified investments made in green technology and affordable housing.

Time horizons and investment options

While opportunity zone investing can be a great vehicle for lowering your clients’ tax bills and helping disadvantaged areas, an investor needs to be sure this is what they want to do with their money for a relatively long time period. Do they want to defer and save taxes, commit to a long-term investment (10+ years) and give up some control (by way of entering a fund or other structure)? If you answered yes to the questions above, then opportunity zone investing may make a lot of sense for your client. If you answered no to any of the questions, or if have some hesitation, then the cons may outweigh the pros.

There are two primary investment choices for opportunity zone investors:

1. Investing in real estate assets located within a designated zone. Examples include a multifamily apartment complex in a designated zone that will require substantial rehab, a ground-up commercial development, a hotel redevelopment, etc.

2. Investing in operating businesses located within a designated zone. If your client is thinking about starting a business within a designated opportunity zone, it’s going to require some heavy lifting by you and your client’s attorneys and other advisors. In either case, there are tests that must be met beyond simply being located within a designated zone.

Opportunity zones are not found exclusively in low-income areas. Booming places like New York City’s Hell’s Kitchen and the Los Angeles Arts District are also considered QOZs. It all depends on how each individual state wants to divvy up the “opportunities” for resources and development.

There are myriad ways a QOF can make qualified investments. The fund could purchase real estate and do heavy rehab on it, or it could purchase a parcel of land and put a commercial building there. The fund could also start a bakery, dry cleaner or any other local business that’s needed in a community.

Fee opportunities for CPAs

The key is that there are two primary ways to go about investing in a QOF, and here’s where you can create great value for your clients and high-margin revenue streams for your practice:

1. Invest in an established QOF. This is the most common way for clients to invest in an opportunity zone since they cannot invest directly in a single project (unless they start their own fund). Before your client pulls the trigger, you and your client’s other advisors should do extensive due diligence on the fund, evaluating the feasibility of investing in such a fund and performing ongoing review of the fund.

Look at the general partners running the fund as well as who is doing the fund’s audit. The fund should have a large and recognizable accounting firm named as its auditor. Over 150 QOFs have reportedly been launched since the TCJA passed at the end of 2017. Selecting the right funds that align with your unique situation is best done with a skilled advisor or coordinator.

2. Form your own fund. If your client’s gain is a large enough transaction and dollar amount, you can help your client (the investor) form their own fund. The paperwork is not as burdensome as you might think, but it’s going to involve top-tier law firms, tax advisors and other specialists, plus an advisor (preferably you) who can help coordinate everyone’s efforts on your client’s behalf.

Starting an operating business within an opportunity zone

Some of your entrepreneurial clients may want to start (or help start) an operating business within an opportunity zone. The tax benefits and social impact can be substantial. Just make sure the venture satisfies the test for a new business: It needs to be located in an opportunity zone and must derive at least 50 percent of its gross income from an active trade or business conducted within the opportunity zone. This is straightforward if you operate a café selling coffee, but what if you run a startup within an opportunity zone that sell products on the internet? Are you disqualified?

Fortunately, this early stumbling block in the program has been generally removed. New regulations give your clients other ways to pass the test. Now businesses within a QOZ only need to meet one of these safe harbors below to satisfy the eligibility test:

1. At least 50 percent of the services performed (based on hours) for such a business by its employees and independent contractors (and employees of independent contractors) are performed within the qualified opportunity zone.

2. At least 50 percent of the services performed for the business by its employees and independent contractors (and employees of independent contractors) are performed in the QOZ, based on amounts paid for the services performed.

3. Or if the tangible property of the business that is in a QOZ, and the management or operational functions performed for the business in the QOZ, are each necessary to generate 50 percent of the gross income of the trade or business

I recently attended a panel discussion featuring some of the foremost experts on opportunity zone investing. A key takeaway from the discussion was that operating businesses are going to be the big winners here if we continue to get more clarity about the program. The good news is the proposed regulations so far are pointing us in the right direction. This tax incentive program will create big opportunities for many entrepreneurs, business owners and those facing a large capital gains tax.

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