Our Opportunity Zone (“OZ”) program has generated increasing inbound questions from our investor base. Many of these questions have centered around the impact of investing before December 31st, the last day to maximize tax benefits in the program’s timeline. To that end, we explore the considerations investors should be aware of when determining the optimal date to invest:
- 12/31/19 marks the last day on which investors can benefit from the full 15% permanent reduction of the deferred capital gains tax.
- 12/31/19 marks the first day investors with 2019 K-1 gains and 2019 Section 1231 gains can invest in a Qualified Opportunity Fund.
An Opportunity Zone tax benefits refresher
Legislators designed the Opportunity Zone program to incentivize long-term capital investment into low-income census tracts. The incentives are provided within a tiered tax benefit structure, where tax benefits are maximized for participants who invest sooner and hold for longer. And while only proposed, taxpayers can rely on the current proposed regulations, if applied consistently and in their entirety; however, numerous uncertainties remain and interpretive ambiguities may emerge as taxpayers begin to apply the current proposed regulations (see Disclaimer below).
As discussed in more detail below, investors can maximize the benefits by investing before December 31st, 2019 and holding the Qualified Opportunity Fund (“QOF”) investment for ten years. When maximized, a Qualified Opportunity Fund investment is estimated to generate 300-400 basis points higher after-tax returns and 2x+ the profits* compared to a standard taxable portfolio appreciating at the same rate. We’ve highlighted the key benefits here:
- Defer taxes on the original capital gain until the end of 2026
- Reduce the amount of deferred taxes owed by up to 15%
- If the investor has held its QOF interest for at least 5 years prior to December 31st, 2026, 10% of the deferred gain is permanently forgiven
- If the investor holds its QOF interest for at least 7 years prior to December 31st, 2026, an additional 5% (for a total of 15%) of the deferred gain is permanently forgiven. As a result, investments made into a QOF after December 31, 2019 will not be eligible for the full 15% reduction
- Eliminate tax on capital gains from the Qualified Opportunity Fund investment if it is held for at least 10 years
Why December 31, 2019 is an important date for Opportunity Zones
We focus on the December 31, 2019 date because it coincides with two key events:
- It’s the last day on which investors can benefit from the full 15% permanent reduction of the deferred capital gains tax.
- It’s the first day investors with 2019 K-1 gains and 2019 Section 1231 gains can invest in a Qualified Opportunity Fund.
As a result of this overlap, December 31st is the only day in which 2019 K-1 and 1231 gains can be invested into a Qualified Opportunity Fund while also receiving the full 15% reduction.
Opportunity Zone tax savings
The below table illustrates the potential savings on the deferred tax liability, separated into the 10% and additional 5% benefits achieved with a 5 and 7-year hold respectively. Every $1mm of capital gains invested on or before December 31, 2019 results in $12k and $20k of tax savings depending on whether the gain is a long-term or short-term capital gain.
Capital Invested Before Before 12/31/19 yields approximately 1.2% and 2.0% forgiven taxes off invested principal depending on the nature of the gain.
How investors should think about the 5% tax reduction
The magnitude of this benefit may be valued differently depending on individual investor preferences, but we see three significant takeaways on how this deadline should impact investment decisions:
- For investors who have made the decision to invest in Opportunity Zones and have existing capital gains to deploy, we believe that this dynamic should encourage deployment by year end.
- The additional 5% reduction is an exciting benefit of the Opportunity Zone program, but it’s a benefit that does not render investments made after 2019 unattractive.
- The quality of the underlying Opportunity Zone investment heavily outweighs the impact of the 5% reduction. Assuming long-term capital gains tax treatment, investing by year end locks in approximately 1.2% in tax savings relative to the investment principal. Variance in investment performance will have a much greater impact on total tax-adjusted return than this particular benefit.
One dynamic to consider in parallel to these tax considerations is the shifting capital markets landscape for qualifying Opportunity Zone projects. As highlighted in this article, an MIT research report found that assets within Opportunity Zones have begun to trade at a 15 – 20% premium relative to non-Opportunity Zone assets. Since the beginning, we’ve believed that a successful program must be grounded in the merits of the real estate, so overpaying and inflating your initial basis for a potential future tax benefit is not an attractive trade-off from our perspective.
To navigate this landscape, we took a view early on that being a first-mover would allow us to participate in transactions at more attractive pricing levels. While the 5% benefit alone may not expedite an investment decision, participating while capacity remains on Cadre offerings that were secured in 2019 is potentially a larger impetus to investing sooner.
As we look to 2020, we’re firm believers that we can selectively source attractive Opportunity Zone investments, but patience and rigor will be critical.
Investing 2019 K-1 Gains
The second time-sensitive stipulation that investors should be aware of in the Opportunity Zone regulations is that it’s possible to invest 2019 K-1 and Section 1231 gains and benefit from the full 15% reduction if gains are invested on December 31, 2019. December 31, 2019 is the first day for investors with 2019 K-1 gains and Section 1231 gains to invest in a Qualified Opportunity Fund. While investors will not have an exact accounting of their K-1 gains by year end, investors with identified gains may want to take advantage of the one-day overlap.
(Read more about deferring and reducing K-1 capital gains.)
Begin investing in Opportunity Zones
We maintain our position that the Opportunity Zones program is one of the most impactful government programs in recent history. To that end, we’ve developed a strategy centered on efficient diversification, data-driven market selection, and a unique single-asset fund structure to deliver investors an attractive portfolio of qualifying Opportunity Zones investments. As the program develops and matures, we’ll keep investors informed of key developments and dates to consider when financial planning.
*Drawing a corollary from the bond market, a tax-equivalent yield is the pretax yield that a taxable bond needs to earn for its yield to equal that of a tax-free municipal bond. In the context of O-Zones, the tax-equivalent IRR is the annual return needed for an investment taxed at standard capital gains rates to generate equivalent profits to an O-Zone investment. Cadre assumes the long-term capital gains tax of 23.8% (federal capital gains tax of 20% and net investment income tax of 3.8%) and no state income tax.
The views expressed above are presented only for educational and informational purposes and are subject to change in the future. No specific securities or services are being promoted or offered herein.
This communication is not to be construed as investment, tax, or legal advice in relation to the relevant subject matter; investors must seek their own legal or other professional advice.
Performance Not Guaranteed
Past performance is no guarantee of future results. Any historical returns, expected returns, or probability projections are not guaranteed and may not reflect actual future performance.
Risk of Loss
All securities involve a high degree of risk and may result in partial or total loss of your investment.
Liquidity Not Guaranteed
Investments offered by Cadre are illiquid and there is never any guarantee that you will be able to exit your investments on the Secondary Market or at what price an exit (if any) will be achieved.
Not a Public Exchange
The Cadre Secondary Market is NOT a stock exchange or public securities exchange, there is no guarantee of liquidity and no guarantee that the Cadre Secondary Market will continue to operate or remain available to investors.
Opportunity Zones Disclosure
Any discussion regarding “Opportunity Zones” — including the viability of recycling proceeds from a sale or buyout — is based on advice received regarding the interpretation of provisions of the Tax Cut and Jobs Act of 2017 (the “Jobs Act”) and relevant guidances, including, among other things, two sets of proposed regulations and the final regulations issued by the IRS and Treasury Department in December of 2019. A number of unanswered questions still exist and various uncertainties remain as to the interpretation of the Jobs Act and the rules related to Opportunity Zones investments. We cannot predict what impact, if any, additional guidance, including future legislation, administrative rulings, or court decisions will have and there is risk that any investment marketed as an Opportunity Zone investment will not qualify for, and investors will not realize the benefits they expect from, an Opportunity Zone investment. We also cannot guarantee any specific benefit or outcome of any investment made in reliance upon the above.
Cadre makes no representations, express or implied, regarding the accuracy or completeness of this information, and the reader accepts all risks in relying on the above information for any purpose whatsoever. Any actual transactions described herein are for illustrative purposes only and, unless otherwise stated in the presentation, are presented as of underwriting and may not be indicative of actual performance. Transactions presented may have been selected based on a number of factors such as asset type, geography, or transaction date, among others. Certain information presented or relied upon in this presentation may have been obtained from third-party sources believed to be reliable, however, we do not guarantee the accuracy, completeness or fairness of the information presented.