I truly believe the best way for all of us to increase our investment returns is to get smarter about taxes. There is an incredible number of ways to legally reduce our tax burden, but often we aren’t willing to pay for the expert advice on how to do it, nor put in the little bit of extra work to get the appropriate structures in place. This is to our detriment.
And then every so often something happens that changes the landscape in the tax world, like what happened in December of last year. Sweeping changes give people reasons to cry or to celebrate, depending on which end of the changes they are on (though most people appear to have been winners with this last tax code change). Pundits praise or excoriate the changes, usually depending on their political bent. In previous versions of this very article, I did both (here and here).
But here is the truth of the matter; whether we like the changes or dislike the changes, whether they are to our benefit or to our detriment…they are the new rules under which we now have to play the tax game. It behooves us to play that game as well as we can. I am happy to provide tax accounting referrals to anyone that wants to play it better.
The “Tax Cuts and Jobs Act of 2017” doesn’t only provide us a new set of rules under which to play our personal game. There are provisions within the Act that can be not only a huge benefit to wealth creation, but the government also wants people to use, desperately. One such inclusion is the creation of Qualified Opportunity Zones (QOZ). This vehicle, created by the government to spur economic growth in underserved areas, is a massive opportunity for investors. Not necessarily because of the ability to capture increased returns (although that is also a possibility) but because of the tax deferral and elimination options it offers. Additionally, and possibly of more value for people with large and diversified portfolios, this provision in the tax code could allow for investors to restructure their investment portfolios while avoiding the massive capital gains hit normally associated with moving investment between asset classes.
I realize that tax discussions cause most people’s eyes to roll back in their heads. Don’t let this happen to you. Please stick with me. Understanding QOZs may be the most important thing you can do for your investment portfolio this year (or this decade for that matter).
What is a QOZ? QOZs are census tract areas that were submitted by each individual state to the Treasury Department. A list of the final QOZs can be found here. The Act provides for considerable tax advantages to investing within these approved zones. From the government’s perspective, the idea is to spur investment and economic growth in economically depressed areas. The investment isn’t limited to real estate, it can also be into businesses operating within those zones. To entice investment into those areas the “Act” provides substantial investor incentives.
What are the investor incentives? Because new law passed by the legislature is never passed in its completed form, there is still much up in the air, waiting for guidance/clarification from the Treasury Department.
The following is what we know:
- Capital gains from the sale of any investment asset can be reinvested into a QOZ fund with said investment deferring the taxes due on those capital gains for up to seven years. If the reinvestment into the QOZ fund stays invested in the investment for 6 years, the basis on the capital gains calculation is increased by 10%. If the roll forward capital gains stay invested for 7 years, then the basis is increased by 15%. Since taxes on capital gains are paid in arrears, this means that capital gains taxes can be deferred by close to 8 years, with a sizeable reduction in the capital gains taxes owed. All the gains earned on the deferred taxes over that eight-year period are a bonus to the investor. Let me reiterate that the capital gain can be from the sale of ANY investment asset(!). Real estate investors have long benefited from 1031 exchanges, providing the ability to defer taxes into perpetuity. The QOZs aren’t quite that powerful but still allow capital gains from stock portfolios, businesses, etc. to benefit from the deferral (and reduction) of the taxes owed.
- Possibly even more powerful, at least to me as an investor with a real estate heavy portfolio, is that the investment, once left invested for ten years, is able to take 100% of the gains over that ten-year investment period tax free. Assuming an investment with a 10% compounding return, the ten- year growth on $1,000,000 of investment is $1,593,000. All. Tax. Free.
There have to be some limitations: Of course there are, and for now we have to assume the most restrictive interpretation of the Act until the additional guidance from the Treasury is provided.
- Unlike 1031 exchanges, the gains from the sale of assets don’t have to be held by an independent third-party exchange accommodator. And unlike 1031 exchanges, there is no 45-day identification period. There is, however, clear guidance that the gains have to be reinvested within 6 months of the date of the sale of the investment that provided the gains.
- The reinvestment has to be made into a QOZ fund. This sounds more difficult than it actually is, but it does require some government filings by the investment sponsor and certain inclusions in the investment documentation. Make sure to verify with the sponsor of any investment claiming to be QOZ eligible that the correct filings are being done and the documents are crafted appropriately.
- The Act stipulates that for a fund to qualify for QOZ treatment that “substantial” investment needs to be made into the asset with 36 months after purchase (or start up in the case of a business). While there is not a definition of “substantial” yet, everything I have read, or discussed with accounting firms, indicates that it is expected “substantial” will mean $1 of improvements required for each $1 of purchase basis. This requirement will eliminate many repositioning-type investments. Even true development investments will have to be careful because development timelines can easily run longer than 3 years.
- The fund can hold only 10% of its value in cash as measured at the end of each rolling 180 day period. This further complicates development and construction strategies.
- There are still a lot of outstanding questions. For instance, if the asset being sold is a real asset that has been substantially depreciated, does the deferral of gains include the depreciation recapture? Likewise, if the investment is held for ten years is the depreciation written off over that period included in the tax-free gains or will it be taxed as it has been historically, as depreciation recapture. If the Treasury Department allows depreciation recapture to be included as capital gains, a wonderful opportunity becomes mind-blowingly great.
So what does this mean to me? The best way to illustrate is to show a comparison between two different scenarios. The first is the investment of $1,000,000 of gains into a new, non-QOZ investment versus investing that same $1,000,000 in gains into a QOZ qualified fund/opportunity. The dollars invested may change depending on your particular situation, of course, but the percentages should hold true. This assumes 8% appreciation per year on each of the investments and calculates a sale at each of five, seven, and ten years.
As the above graphic shows, the impact of the tax savings on the ongoing investment are substantial. Granted, it could be argued that it will be harder to find opportunities in the QOZ zones that are equivalent to opportunities outside of the QOZ zones. Maybe, maybe not. Altus will be rolling out an opportunity next week that has excellent returns and we think is a solid stand-alone investment irrespective of QOZ qualification. It just happens to also qualify as a QOZ investment for an added bonus. But, if we give credence to the idea that QOZ investments could mean lower risk adjusted returns due to the location of the investments within underserved areas, using the scenario above the QOZ investment return would break even versus the traditional investment return at an annual growth rate of 5.7% (versus the 8% in the traditional investment calculation). This equates to reduction in the required investment returns of just under 29% on a comparison basis. This is a huge difference and a massive tailwind for the QOZ investor.
Now what? As mentioned above, much of the tax code as relates to QOZ remains to be written but there are still great resources available on the web. Just make sure what you are reading is from a credible source. When we first discovered this as part of the tax code I spoke with several different accounting firms to get their take on it. When I asked the QOZ questions to partners of those accounting firms only two tax firms even knew what QOZ was.
One of those that knew answers, and with great detail, is Chris Paris, Tax Partner with Moss Adams LLP. Chris is one of the smartest tax real estate minds I have ever met. With a little arm twisting, I convinced Chris to agree to a QOZ Q&A session specifically for Altus Insight readers. The call will occur one week from today, on Tuesday, August 7th at 3:00 PST.
Altus believes the QOZ tax allowance provides a huge opportunity to investors and we are diving in headlong. As mentioned above, our first QOZ opportunity is already in process. If you have interest in investing in QOZ opportunities, please contact us so we can add you to our “shortlist” that gets first crack at any new opportunities we discover.
About the Author: Forrest Jinks is CEO of Altus Equity Group Inc and a licensed real estate broker. Forrest has decades of experience as principal in a variety of alternative investment segments including real estate (residential rehab, in-fill development, multi-family, office and retail), debt, and small business start-up (online marketing and site retail). He can be reached at firstname.lastname@example.org.