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Is an Opportunity Zone Fund the Right Fit for You?

After a down year in 2018, stocks are once again on a tear this year. Just this past week, the S&P 500 hit another all-time high, marking five straight weeks of gains.

​​Many investors have seen their stock portfolios swell this year from the bull market, but is it time to cash out? ​​And what are the options for reallocating that cash?

Cashing out your stocks could stick you with a significant capital gains tax bill, but for those cashing, you might consider investing in an Opportunity Zone Fund to reduce that tax bill.  

Before we get into the tax benefits of Opportunity Zones, first ask yourself if now is a good time to cash out of the stock market.

​​We can’t answer that question for you. Still, if the ultra-wealthy (ultra-high-net-worth investors with liquid investable assets of $5 million or more) and institutional investors are any indications, it’s something all investors might seriously consider.

In 2019, the ultra-wealthy and institutions have been shedding stocks like crazy. ​​Why?

​​It’s because an overwhelming majority of them think a recession is due to hit in 2020. ​​The signs are there: inverted yield curve, weakening of the manufacturing and housing sectors, record income inequality, just to name a few. Add to that geopolitical unrest, impeachment and trade wars, and the ultra-wealthy and institutions have good reason to be concerned, and that’s why they’re selling off their stocks.

It’s only a matter of time before the mainstream investing public follows suit and begin divesting themselves of stocks as well. The ultra-wealthy are almost never wrong about these things and they always lead the pack. 

So where to put this money? One option for serious consideration should be an Opportunity Zone Fund. The Opportunity Zone program was launched by the recent Tax Cuts and Jobs Act of 2017 to benefit both investors and the distressed urban and rural communities the program was designed to lift.

The program incentivizes investors who have capital gains from the sale of appreciated assets such as stock, real estate or a business by allowing them to defer capital gains tax by reinvesting those gains into a Qualified Opportunity Fund. Qualified Opportunity Funds use the capital invested in making equity investments in businesses and real estate in Qualified Opportunity Zones.

Here is how an investor who sells stocks and is facing a large capital gains bill can benefit from the program – by taking advantage of a golden trio of tax benefits – deferral, basis step-up, and elimination.

An investor has a $1 million gain from the sale of stock. He’s in the 20 percent tax bracket so that the sale would trigger $200,000 in capital gains tax. But instead of paying the tax, she reinvests the $1 million gain in a Qualified Opportunity Fund. Here is how she would benefit from the Opportunity Zones program.

  1. Deferment of gains: By investing those gains in the Opportunity Fund, the tax due on those gains is deferred until the earlier of the investor selling her interest in the Fund or December 31, 2026.
  2. Step-up in Basis. If the investor holds the investment for five years, that payment of $200,000 is completely deferred, plus the investor gets a 10 percent step-up in basis (i.e., discount) on the original gain deferred – saving $20,000 in capital gains. If the investor holds for seven years, she receives an additional 5% on top of the 10% she already qualified for, reducing the capital gains from $200,000 to $170,000. That’s a savings of $30,000, and that’s not even taking into consideration the time value of money.
  3. Elimination. If the investor holds his interest in the Qualified Opportunity Fund for more than ten years, the investor pays ZERO capital gains tax on any new appreciation of that asset.

Is it a Good Fit for You?
Tax benefits aside, is an investment in a Qualified Opportunity Fund a good fit for you? If the fund’s not a good fit or a good investment, it doesn’t matter what the tax benefits are.  

First of all, you should know that Qualified Opportunity Funds are structured much like private equity funds and private funds in general, which are typically structured as limited partnerships or limited liability companies with investors participating as limited partners or members with little to no voting power or management authority.

If you’ve never invested in a private equity fund, here are some of the principal factors to consider:

  1. Transparency: Private companies offer greater transparency than typical equity investments in the form of access managers since the managers are in direct contact with potential investors at every stage of the investment life cycle and typically make themselves available to potential investors to answer any questions or address concerns.
  2. Investor Qualification: As exempt offerings, private funds have restrictions on who can invest – unlike equities where anybody can invest. In most cases, you must be an Accredited Investor. On rare occasions, where a limited number of non-Accredited Investors are permitted those, investors still have to demonstrate sufficient financial sophistication to invest.
  3. Minimum InvestmentTypically, $50,000 or more.
  4. Liquidity: Minimum holding periods typically 5-10 years with strict prohibitions on resale.
  5. Volatility: Because of illiquidity and non-correlation to Wall Street and the broader market, private funds are less volatile than their public counterparts.
  6. RiskOpportunity zones are distressed communities. In the case of real estate, these are not Class A core properties in Manhattan that these Qualified Opportunity Funds will be investing in. They could be investing in affordable housing or low rent office and retail space that inherently carry more risk than core properties that are leased to national corporations. However, along with this risk comes a greater opportunity for returns. In the right hands, value-add and opportunistic properties have the potential to double the returns of low cap rate core properties.

The tax benefits of investing in an Opportunity Zone Fund can be substantial, but those benefits won’t mean much if you lose your investment.

​​Before deciding if it’s the right fit for you, understand what you’re getting into and all the pros and cons that come with this type of private investing.

These investments can be risky, but you can mitigate your risks through your due diligence.

​​Remember that the overriding factor that will determine the potential success of a fund will be who’s steering the ship. ​​What is the background and experience of the management team? Do they have the expertise, processes, and infrastructure to be successful in the asset class they’re proposing to invest in? Do the numbers make sense?

Ultimately, it will be up to you to decide whether an investment in an Opportunity Zone Fund is the right fit for you.

​​By asking the right questions, you may find an opportunity that aligns with your investment objectives and risk tolerance.

​​With the right fit, the financial and social rewards could be substantial.

Investing for growth,

Michael Foley

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