Opportunity Zones are special investment zones designated to provide tax deferment or tax-free returns depending on the length of the investment. Opportunity Zones are usually more rundown areas that could use some outside capital to boost the environment.
When I traveled to China in the early 2000s for business, I frequently explored Special Economic Zones (SEZs) that received preferential tax and incentives for businesses. With most of the economic growth centering around Beijing and Shanghai, the central government wanted to spread the wealth. As a result of tax incentives, business streamlining, foreign investment, and technology, SEZ cities such as Shenzhen and Zhuhai are now a couple of the richest and fastest growing cities in the country.
I've always wondered why the United States didn't do the same. Sure, on a state level, governors can provide economic and tax incentives for businesses to set up shop in their respective states. But there was no such program on the federal level, where taxation and regulation are often the highest.
Until December 2017 that is when a new tax law was passed called the Investing In Opportunity Act. The law is designed to lure capital that faces heavy capital gains tax into Opportunity Funds, or O-Funds, which invest in roughly 8,700 Opportunity Zones, or O-Zones. These O-Zones are generally considered struggling cities or towns that are in need of redevelopment.
What's exciting about this tax law is that potentially hundreds of billions, if not trillions of dollars of “smart money” capital could be pumped into our country's poorer regions. Opportunity Funds would be created to invest in anything from real estate to tech startups to help bring jobs and prosperity to low growth areas.
Over the long run, if the capital can stay in the region, Opportunity Zones should benefit tremendously.
Tax Benefits Of Investing In Opportunity Funds
Think about investing in an Opportunity Fund like a 1031 Exchange for real estate investors looking to defer their capital gains tax, but with more options. For example, you might be looking to diversify your company stock holdings after it went IPO. Instead of paying a hefty capital gains tax, you can invest the proceeds in an Opportunity Fund focused on real estate redevelopment in what you think will be the next Silicon Valley.
Here's how the tax benefit would work.
1) Deferral of capital gain. A tax deferral for any capital gains rolled over into an Opportunity Fund. The deferred gain would be recognized on the earlier of December 31, 2026 or the date on which the investment in the Fund is sold.
2) A step-up in basis for capital gains rolled into an Opportunity Fund. The basis of the original investment is increased by 10% if the investment is held by the taxpayer for at least 5 years, and by an additional 5% if held for at least 7 years. In other words, if by December 31, 2026 an investor has held an investment in an Opportunity Fund for 7 years, then the tax on the initially deferred gain will be reduced by 15%, or reduced by 10% if by then held for only five years.
3) No tax on any capital gains from an investment in Opportunity Fund. In the case of any investment in an Opportunity Fund held by a taxpayer for at least 10 years, the basis of such property shall be equal to the fair market value of such investment on the date that the investment is sold or exchanged. In short, after a 10-year holding period, there would be zero federal capital gains tax on profits from the sale of an investment in an Opportunity Fund.
The figure above illustrates how an investor’s potential after-tax returns compares assuming a 10-year holding period, annual investment appreciation of 7%, and a long-term capital gains tax rate of 23.8% (federal capital gains tax of 20% and net investment income tax of 3.8%).
After 10 years an investor would see an additional $44,000 for every $100,000 of capital gains reinvested into an Opportunity Fund on December 31, 2018 compared to an equivalent investment in a more traditional stock portfolio generating the same annual appreciation. Tax efficiency basically doubles the investor's returns in this hypothetical scenario.
Real Estate Opportunity Fund Investing
Real estate is inherently a long-term asset class, and therefore, one that fits well with an Opportunity Fund's 10-year holding period in order to avoid paying any capital gains tax.
Because real estate provides shelter, produces income, and is a physical asset, I've been much more comfortable investing more of my assets in real estate over the years than I have in the stock market. Unlike the stock market, real estate doesn't just go * POOF * during a downturn.
One of the fundamental long-term real estate investment strategies is the acquisition of properties at a low-cost basis in an emerging urban neighborhood. As surrounding popular neighborhoods grow and become more expensive, people begin moving into more affordable adjacent neighborhoods, driving new demand and growth.
One such example is Los Angeles's Koreatown neighborhood and South Los Angeles overall. Before doing research for this article, I had no idea an expensive city like LA had Opportunity Zones. Due to spillover demand, this part of Los Angeles has benefitted from strong price appreciation.
If Zillow's forecast for a 5.9% increase in South Los Angeles home prices comes true, then having real estate investments in South Los Angeles O-Zone neighborhoods will prove to be a shrewd investment move.
Fundrise Opportunity Fund
The only Opportunity Fund I'm aware of at the moment is the Fundrise Opportunity Fund. Based on the presentation they sent to me, the Fundrise Opportunity Fund intends to acquire, improve, and manage a portfolio of real estate properties based on the following criteria:
- At least 90% of assets must be located and invested in qualified opportunity zone property;
- Properties only qualify if acquired after December 31, 2017
- Qualifying assets must be equity investments, not debt; and
- The original use of such property must commence with the Opportunity Fund, or the fund must substantially improve the property within 30 months of acquisition
Over the coming months, the IRS and Treasury Department plan to release guidance on the implementation of the new program. Interested investors would simply input their e-mail to be placed on the waiting list for more detail.
Here would be the steps to investing in an Opportunity Fund.
1. December 31, 2018: Invest in Opportunity Fund (Day 1)
2. April 15, 2019: Make election on your tax filing showing capital gain rollover into an Opportunity Fund
3. April 15, 2027: Pay deferred capital gains tax 4.
4. December 31, 2028: Opportunity Fund now becomes eligible for tax-free sale (10-year hold)
Pros And Cons Of Opportunity Funds
I love tax-efficient investing, hence why I've always maxed out my 401(k) and contribute to my son's 529 education savings plan. I also enjoy investing a good chunk of change in a long-term fund so I don't have to constantly think about my investments. Money is best when it's out of sight and out of mind since it's only a means to a better life.
Not only can investors reduce or eliminate their capital gains tax burden with Opportunity Funds, they can potentially make money in new investments, while helping underserved communities. What's not to like?
Here are some negatives I can think of:
1) The Opportunity Fund manager might make bad investments.
2) Some Opportunity Zones might face structural challenges that will outlast your patience or the fund's holding period.
3) Opportunity Funds are illiquid and may have unfavorable terms if you want to pull your money out early.
4) The government might change the law and start taxing capital gains again.
5) More investment paperwork come tax time.
No Taxes Sounds Great
Given Opportunity Funds and Opportunity Zones are new, it's not 100% clear what the final rules will be. But all indications point to favorable tax treatments for investors looking to roll their capital gains to underserved areas of the country.
Finally, in addition to Opportunity Funds, an entrepreneur can set up shop in an Opportunity Zone where costs are cheaper to take advantage of tax benefits as well. It often takes 10 years for a business to become successful. Too bad Opportunity Zones didn't exist when Financial Samurai started in 2009. If it did, I’d probably sell my company in 2019 and ride off into the sunset!
As investors, it's our job to try and get smart on potential long-term opportunities so that when the time comes to invest, we are able to take advantage of all the opportunities. I'm sure that hedge funds, private equity firms, and venture capital firms will be launching Opportunity Funds in the near future.
Readers, are you aware of any other Opportunity Funds available to retail investors? What are some other positives and negatives of the Investing In Opportunity Act you can think of?
Thanks Fundrise for being a long-term affiliate partner and Financial Samurai sponsor. From their Internet Public Offering to their eREITs, I'm always impressed with their innovation in the space.Â
Bummer, you have to be accredited.
Is there a single location or laundry list of things like Trust-Death Tax, HSA, 529, O Fund, 401k, Roth, Traditional, etc that tells us about areas where we can invest to defer or sometimes legally not have to pay taxes?
Will be a nice to have and keep. Also Sam do you consult one on one with folks like us on a 1 hour call of sorts, obviously for a fee?
I dont understand this statement (in quote below), are you saying you can take profits from an IPO stock and not pay capital gains on it? I thought this was about not paying capital gains AFTER investing in the OZ after a 10 yr holding period? Can you clarify?
“Instead of paying a hefty capital gains tax, you can invest the proceeds in an Opportunity Fund focused on real estate redevelopment in what you think will be the next Silicon Valley”
You can defer capital gains tax from your IPO proceeds and get to pay incrementally less tax as time goes on if you invest the proceeds in an O-fund. After year 10, if you sell or when the fund liquidates since 10 years+ will probably be its plan, you pay zero capital gains tax.
The O-fund investment should come from a profit that is exposed to capital gains tax.
Someone who invests fresh capital would not be able to take advantage of the tax deferral under the federal rule. Has to be a qualifying capital gain to take advantage of the tax benefits.
Saw something about this a month or so ago. It is very interesting, but I have 2 cons:
1) I don’t have enough capital gains sitting around as an individual to make it worthwhile. I can imagine big time investors are a different story
2) It seems like a lot of work to get 0% capital gains when I can just manipulate my income to get into the 15% marginal tax bracket one year and then realize all my long term gains at 0% that year. Compare that to investing 10 years in a bad neighborhood…
So the last 5 years I doubled (100%) my net worth with Investments vs when I look at my house for the same time-frame it only had a 63% increase. Now mind you my neighborhood is really good because at it’s lowest (i.e the market during the 2009 recession) my house had a 4% dip only before I bought it.
So the math really does not add up. Yes I do agree one should buy/mortgage real estate and have other means from a financial independence standpoint but looking for the biggest bang for the buck is what i’m trying to figure out. Thanks Sam.
BTW, most of your history is close to mine, infact very identical in every way. Yet I would say you have done amazingly well and please do keep sharing your wisdom with us all. You are the best in my books along with Money Mustache, not being bias.
Montrose, Colorado!
Totally crushed them in high school basketball, haha! They are in need of economic investment, beautiful part of Colorado.
Sam,
Timing on this is topic is perfect! Bought property in 2015 that lies within the OZ as a future redevelopment project. Trying to take advantage of benefits of OZ when you already own is challenging. The time required to complete the project is also a bit tight for bay area development at the moment.
I think this is a great concept to try and incentivize “locked equity” to be used in the US. (Well done gov’t!) Perhaps more thought needed to go into the map of these zones. There are OZ zones in Ca that will never be considered, and then some cities that should have expanded on their OZ. This reminds me somewhat of the tax incentives that were offered by the Federal Govt after Hurricane Katrina, to promote redevelopment in New Orleans.
Enjoy your blog work. Good research on this one!
Nick
Hi Sam,
I think one of the charts Fundrise provided is inaccurate. If You put 100,000 into a regular stock portfolio averaging 7% for 10 years you would end up with $196,715. Take the 23.8 percent taxes off your still left with $73,696.83. I’m not sure how that translates into a 32% ROI.
I’m also wondering if their projections includes dividends. If not the numbers are even more eschewed.
Thanks, Bill
Hi Bill,
Here’s their explanation.
Looks like the confusion might be on the initial taxes paid to roll over 100k of capital gains into a new stock portfolio. Below is the full explanation text for your convenience:
——————-
* The calculations show an investor’s potential after-tax returns under different scenarios, assuming an investment of capital gains prior to December 31, 2019, a 10 year holding, annual investment appreciation of of 7% and a long-term capital gains tax rate of 23.8% (federal capital gains tax of 20% and net investment income tax of 3.8%), only taking into account tax at a federal level (not state). Note, however, that the performance assumptions shown are for illustrative purposes only, and are not intended to reflect the actual experience of any individual investor.
The calculations for the standard stock portfolio are based on rolling over capital gains equal to $100,000, at an initial tax of 23.8% (using the same assumptions described above), into a standard stock portfolio, the remaining $76,200 of which then appreciates at a compounding return of 7%. At the end of each holding period, the investment in the standard stock portfolio is assumed to be sold and long-term capital gains at a tax rate of 23.8% paid on the capital gains from the investment in the standard stock portfolio.
Sam, I got a couple of questions then.
First why would Fundrise assume a 7 percent return on a stock portfolio when we have a 100 years of data telling us the average is 10 percent? Should I start shaving 30 percent of historical returns off all my investments? That aside, even if I start with the $76,200 number and compound that number by 10 percent, pay my capital gains tax I’m still left with $168,739. Thats double what Fundrise says you’ll return.
Second, I pulled this quote from your post. Unlike the stock market, real estate doesn’t just go * POOF * during a downturn. This is misleading. Yes you still own the physical real estate same as you would the existing amount of stock shares. However the value of each asset is what really matters. As we’ve all seen real estate values can plummet just like the market.
Third, are the Fundrise advertised returns net of fees? Fees can have a HUGE impact on future returns and since there was nothing listed in the post I’m assuming to get this information a person would have to read and more importantly understand the fine print.
In conclusion, what Fundrise is asking us to do is lock our money up for 10 years, maybe beating, maybe not what a boring index fund does with a company that doesn’t have a track record through a major recession investing in depressed areas of the country that historically have done poorly. Sign me up!!
Bill, I’m not sure why you’re so upset. If you are not willing to lock up an investment for 10 years to get tax-free profits, then definitely don’t do it. Nobody’s forcing you.
Investment duration Is what the government wants to help these opportunities zones rebuild and thrive. Flighty capital creates uncertainty and instability. But if capital plans to be there for a long time, it’s easier to make long-term investments such as buying a house, hiring people, and so forth.
It’s definitely worth bringing up your concerns with the government. They’re still working out some of the final details. You can perhaps make a difference to help create the laws to better suit your financial needs. Or, you can just invest in something else more suitable.
I’m certain there will be many opportunities funds that will be created over the next two years. And just like everything, some will perform better than others. But real estate is the easiest class to get started with.
A lot of people were talking about this new investment at the Aspen conference where Charlie Rose used to host. A couple friends and highly successful entrepreneurs plan on investing some of their private investment with falls in opportunity funds. Everybody’s doing their due diligence now.
Your last observation about hedge funds, private equity, or institutional money was the very question I asked myself while reading your post. I would have to imagine the O-Zone benefits would make a compelling pitch during a sales meeting to some pension funds with long-term investment needs. The cash flows could service their ongoing cash distribution needs for monthly pension payments while also providing potential appreciation value with tax benefits. It will certainly be looked at by the institutional money.
I don’t have any money to take advantage of this right now but in a few years I will be eager to look more into it. Very helpful information I hadn’t heard anything about. Good sleuthing, Sam!
Thanks for the post. I never heard of Opportunity Zones until recently. We are trying to figure out what to do with our rental properties that have tons of equity and little cost-basis. We’ll be taxed like crazy if we sell with our income.
The reduction in taxes after a decade could be the best return since we don’t need the cash now. Wasn’t sure how the math would work out verses investing the money for 10 years, so your post helps a lot with that exercise.
Nice to know more about this option and that the resulting OZ investment could potentially benefit others in the community as well. Again, thx.
Will just put it out there, you don’t have to buy into a fund to take advantage of this tax credit. That is the most hands free way to do it but you can stand up your own LLC that’s stated purpose is to invest in OZs then make OZ investments or property purchases. The catch with realty investments is the requirement that the developer put 100% of the property cost (Treasury’s current definition of “substantial”) into property improvements. a 100K property will require and additional 100K in re-development investment. In my area the OZ properties owned by commercial holdings have already started to ratchet up the price of the base property for sale to these new OZ investment funds (supply and demand in action). There is also (as of a month ago) no input from Treasury on what a fund can withhold to pay itself for the management and structural costs so this is something to watch when buying into someone else’s fund. I am assuming that Fundrise is looking at that 10% of outside OZ allowance as their possible take but know before you invest that the funds currently have no set compliance guidelines for these costs. Further and most importantly in my mind, the investment doesn’t have to be property. You can make equity investments into firms located in an OZ but the case for that holds even more questions that Treasury has yet to weigh in on. Regardless this is an opportunity for many to consider.
Fascinating! This is the first I’ve heard of opportunity zones. The oz focused fund sounds like a convenient way to get investment exposure too. Thanks for highlighting this!
Man, I’m dating myself. This reminds me of Jack Kemp’s Enterprise Zones. I sure hope the Opportunity Fund idea works. We’re a rich country, but there are no shortage of depressed cities and towns. It also reminds me of the classic chicken or egg argument. What’s going to spur the revitalization? An infusion of capital? Or a shift in culture? Or can they both work in unison? Great post, my friend. I got Fundrise on my radar. Cheers.
funny timing. My broker just called me today about an opportunity fund that skybridge is launching. Not sure if this is just another flavor of the month but certainly worth exploring more. Can probably get mid to high singles just with proper management of the real estate, throw in the tax benefits and you could be looking @ low to mid teens. We’ll see…
I had come across this concept recently as well. Definitely intriguing with the tax benefits but still a bit too risky for my blood.
If you get lucky you can make a killing with the tax advantages as a bonus. But I guess the reason why the government is conceding taxes is they are trying to develop areas that would not have been developed without them (which in my mind means has more risk associated with it).
will keep my eye on it for future stuff, but probably from the sidelines.
Interesting concept. This can be a great opportunity or an illiquid nightmare. Some weed and seed communities remain weeds, no matter how much money is poured into it. Part of the equation includes if the government has accurately identified an area where demand to occupy it will exist if improved.
This is initially compelling to me as a way to minimize the impact of capital gains on my recent business sale this past week as I’m VERY reluctant to get this money involved with the stock market at the moment, so could this be an option? At first glance, yes. But the more I think of it, if these zones couldn’t hack it in the most recent prospering environments, and we are starting to wonder if this is the end of the cycle, then you are left with capital tied up in a downturn in a “bad area”. I suppose it puts a lot of emphasis on the area and whether you think it can be improved.
Really great point about not being able to prosper in one of the biggest recoveries.
There really are some structural issues to be aware of, namely demographics that could take a generation to play out.
Hence, an investor and Opportunity Fund manager needs to thoroughly research the Opportunity Zone(s) they plan to invest in first. Look at the demographics, what is broken, the government etc, and weigh that against the success of the investment/business and tax benefit.
There will probably be “hot” Opportunity Zones as well, where money starts piling in with more supply than demand, thereby driving up prices of real estate at least.
I’m excited to cover this space over the next several years. I’m sure a prominent Venture Capital firm will great an Opportunity Fund, raise $1B+ and the FOMO of the entire community will start creating their own.
I think the big one for me is as a small investor, even accredited, I suspect it will be tough to get in on a good deal at a reasonable price. I suspect a rush of larger investors which might mean unreasonably high prices at least in the near term. Also I suspect a lot of opaqueness on the part of the investments at least at the start. I guess what I’m saying is I like the idea but like a new car I never buy or invest in a new type of offering until the bugs have all been worked out.
This is very interesting, but I’m always leery about investing in a brand new product. Also, 10 years doesn’t seem long enough. Why don’t other company offer similar products? Although, this sounds perfect for our situation. I’d love to defer tax for about 10 years. We’d be in a lower income tax bracket by then.
OZ Camden NJ should be one of the most desirable suburbs of Philadelphia but much of it more closely resembles the scenery of a war torn country. A ferry could get you to Philadelphia in about 5 minutes and there are 2 bridges and light rail servicing the area. It has 2 prominent medical centers, a branch of Rutgers University, and major corporate headquarters and offices such as Campbell’s, Subaru, NJ American Water, L3, and Holtec (all provided various tax abatement and special programs. My grandmother moved out about 10 years ago and sold her 3BR 1BA row home for $18000 and it was one of the nicest houses in the city. The decades of decline that started in the 1970’s will be hard to climb out of. There are not enough jobs for residents at the companies listed above, so you have this gentrification of work. People drive in at 9AM and leave at 5PM. Until there is investment in work opportunities for locals, it will be hard to build the community back to it’s former glory and full potential. And since you always ask….what will I be doing about this? Probably nothing at the moment. I am hopeful that making the tax benefits typically reserved for major corporations available to us “regular folk” that change for Camden may be possible because there is strength in numbers.
Thanks for sharing this Sam. This sounds like it could potentially be a great way to do some tax efficient investing. When I went to Fundrise’s website I was unable to find any details on their fee schedule.
I’m just interested in figuring out how they make money when people invest with them.
Great post highlighting some interesting opportunities.
Near where I live Maryland has been doing this for businesses. Maryland is notoriously high tax and business unfriendly, but they have a “Bio Tax Credit” program that gives tax incentives to early stage bio-tech companies along the I-270 corridor. It’s worked. Some of the biggest and best breakthroughs in the bio-tech arena have come from companies in this area. Too bad they don’t wake up and see that it would be better just to lower taxes across the board to spur similar growth in all areas.