Retirement Investor

Investing in Opportunity Zones Could Compliment a Diversified Retirement Income Strategy

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Section 1031 of the Internal Revenue Code provides an exception that allows you to defer payment of capital gains taxes when you sell business or investment property if you reinvest the proceeds in similar property through a like-kind exchange. A like-kind exchange means you can exchange property used in your trade or business or held for investment for property to be used in your trade or business or held for investment. 

These have worked fairly well for investors who have a good strategy in place. The concept of defer, defer, die allows gains to be deferred and then, under current tax law, all the deferred gain is eliminated at the death of the owner for whoever inherits the property. In fact, many of our clients have done one or more 1031 tax-free exchanges over several years, generally with real estate. 

However, some issues have made tax-free exchanges less attractive in the recent past. These issues include diminishing depreciation tax benefits available upon each exchange. Other factors include:

  • The challenge of finding equally attractive properties quickly after the initial property’s sale
  • The fact that many investors also desire more property diversification as they become older
  • It has become more challenging to find good replacement options given the changes in the 2017 tax law which caused many 1031 diversified real estate funds to stop accepting new exchange money

Today, current tax law proposals would eliminate the stepped up cost basis at death, changing the strategy to defer, defer, pay deferred tax – possibly even upon death under some tax change proposals. 

A new option to consider now is Opportunity Zones and Qualified Opportunity Funds.

Opportunity Zones (OZ) and Qualified Opportunity Funds (QOFs) are a relatively new option for investors with capital gains of any kind, and a viable alternative to 1031 exchanges for real estate. OZ also creates tax planning opportunities for capital gains from other investments, as long as the OZ investment is made within 180 days from the gain being realized. 

Investments held in LLCs have an added OZ feature as the 180-day time frame for reinvestment usually begins from the end of the fiscal year. 

Opportunity Zones were created by Executive Order 13853 on December 12, 2018, with bi-partisan support in Congress. Economically distressed communities were given special tax incentives for investment. Opportunity Zones were created to spur economic development and job creation by encouraging long term investment in low income communities nationwide. 

The Opportunity Zone designation provides tax incentives to rural census tracts (40%), urban tracts (38%), and suburban tracts (22%). 

Instead of deferring gains on the new investment, OZ provides a major benefit: tax free gains if held for 10 years. You’re probably thinking, who invests for ten years in today’s uncertain environment? Answer: If you have big capital gains and 5-10% of your portfolio that you will likely never touch in your lifetime, then OZ could be added to your list of investment options. 

Most of the best OZ investments we see are real estate in areas where there is a higher likelihood that the area will be as attractive or ideally more so in ten years. 

Also, most OZ properties are not pure growth investments. Most have an income component that is attractive relative to current alternatives and represent a significant portion, often 50% or more, of the properties’ total return potential. 

Income received from OZ investments over the ten years may be partially or fully tax deferred, but then even this deferral becomes tax free under OZ rules. Depending on the property or fund, some portion of total return may be taxable, but most will be tax free. Depending on what state you live in, this results in pre-tax equivalent returns of 15% to over 25% for high tax states like New York and California. It’s tough to rival these returns today, especially considering the more conservative nature of most OZ investments – they often have lower leverage (debt).

It should be noted that some state legislatures like California have been debating whether to be “conforming” to OZ rules, allowing state taxes the same tax deferral potential as federal taxes. In these non-conforming states, if you invest in an OZ property or fund, you will still have to pay the state income tax within your normal current tax horizon on the capital gains you’ve incurred today. 

That also brings us to another OZ feature: a deferral of the current capital gain (and tax) to 2026, with 10% gain forgiveness if you invest in an OZ property through 12/31/2021. After 1/1/2022, there will be no gain forgiveness. In 2022, the focus on the economics of the OZ property or fund will be the primary driver in the value equation, although tax deferral through 2026 can still be valuable, and the tax-free returns are enticing in a rising tax environment. 

One of the concerns with OZ investing is gains are deferred to a year when no one knows what the tax law will be for capital gains. For most people, the 10% gain forgiveness provides a good margin of safety for the future 2026 gain. 

If you decided to simply pay the capital gains tax and reinvest, whatever you invest in will be subject to the higher future tax rates as well, although you have more control on the timing of those gains, an important consideration depending on what type of investor you are. We often use both tax timing as well as tax diversification in our “it’s not what you make, it’s what you keep” tax efficiency strategies. 

For very high income investors with over $1 million in taxable income, if current personal tax law proposals are enacted, there may be some reverse benefit of deferring rather than paying the tax at today’s rates. In other words, you might pay more capital gains tax in 2026 even taking into consideration the 10% forgiveness. That takes the OZ investment analysis to an even higher level of scrutiny since the tax-free return will, in this case, be the main investing benefit.  

Some fund and property managers intend to refinance OZ development projects before 2026, providing cash to cover some or all of the deferred taxable gain. This mitigates the impact of the gain deferral and boosts net returns, but is not guaranteed to occur. 

The COVID-19 pandemic has reinforced the urgent need for supply chain re-domestication and manufacturing re-onshoring, to reduce our reliance on foreign entities. Opportunity Zones are a part of this strategy in many communities, creating additional incentives to onshore manufacturing facilities into OZs to boost economic development, job growth, and national security.

We have analyzed many single property and diversified OZ funds and have found that less than 10% of opportunity zone areas have above-average investment potential with modest risk of location deterioration. In these cases, the risk of some of the neighborhoods is simply not worth the potential tax-free gain. In other cases, industrial parks and areas being gentrified provide neutral to good risk benefits, given the long-term nature of OZ investing. 

Other opportunity zone considerations and risks include: 

  • You or your investment manager must 1) understand the complex rules associated with a qualified opportunity zone investment (including the improvement to property rules) and 2) have the ability to comply with the rules required to operate a viable Qualified Opportunity Zone Fund.
  • The rules are more onerous doing an OZ deferral into an operating business. It’s estimated that only 4% of all OZ investments have been into businesses (versus real estate) as a result of the complex rules to stay eligible for tax-free gains for the 10-year lifecycle. 
  • If you are focused on “doing well while doing good” ESG or socially conscious investing, know that not every OZ investment is raising the standard of living in a poor neighborhood. Some OZ investments we have analyzed are good on the ESG scale, others score lower. The OZ federal rules fall short from a social impact perspective because there are no requirements that investments have to do any good – no assessments, documentation, or measure of social impact are required.
  • Disruptive techno-industrial trends can affect the attractiveness of the neighborhood or the type of property. For example, we have shied away from hotels and motels in OZ areas for a variety of reasons, including the increasing use of Airbnb and VRBO rentals by visitors to an area, who also don’t want to be adjacent to neighborhoods that make them uncomfortable. 
  • Shifting consumer habits can torpedo an OZ development over the 10-year horizon that seemed good at the time. One of our managers in the OZ space is focusing on the buying habits of millennial women, a large population who will be as important in 10 years as they are today. 
  • Titling your OZ investment differently than the source of the capital gains. Titling must be the same as the source of the gain. 
  • Business owners who sell warehouses in hot areas and relocate to OZ locations that are sometimes less accessible to their supply chain or viewed as downright dangerous for night deliveries in more dicey OZ areas. 
  • “Rookies” who have jumped on the OZ bandwagon who don’t have experience investing in opportunity zone areas. Will they still pay attention to management issues, which sometimes are more intensive than non-OZ real estate properties, long after they collected their up-front development fees? 

It goes without saying that “it’s complicated,” but the OZ strategy could be worth discussing with your financial adviser and tax counsel. As you get closer to retirement age and are determining your cash flow needs and legacy plan, mistakes are best avoided – but for those who will have more than enough money to fund the lifestyle of their choice once they retire, an OZ strategy that compliments a diversified retirement strategy could make sense.

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Dennis Stearns, CFP

Dennis Stearns, CFP®, is a financial planning practitioner at Stearns Financial Group (SFG) (www.StearnsFinancial.com), with offices in Chapel Hill and Greensboro, N.C. and clients around the country. Dennis has been called “One of the leading scenario experts and futurists” by the Financial Planning Association. He is a regular contributor to many publications, including the peer reviewed Journal of Financial Planning. Stearns is a chess expert and played on one of the winningest Pan-American chess teams in history. He coaches an inner-city chess club and has also earned two national community service awards. His latest book is Fourth Quarter Fumbles: How Successful People Avoid Critical Mistakes Later in Life. SFG is a member of Hightower Advisors. Hightower Advisors, LLC is a SEC-registered investment adviser.

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