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Tax Benefits Of The Opportunity Zone Program For High-Net-Worth Individuals

Wednesday, 03 October 2018
Tax Benefits Of The Opportunity Zone Program For High-Net-Worth Individuals

As the Roman stoic thinker, Seneca once wrote, “Luck is what happens when preparation meets opportunity.” I cannot think of a more apt description for the current state of tax planning when it comes to ultra-high net worth individuals and families.

While the 2017 Tax Cuts and Jobs Act (“TCJA”) created confusion from the backrooms of strip mall fast service accounting operations to the boardrooms of family offices and private equity firms, it has also laid the groundwork for one of the most unique and potentially community-changing tax deferment and avoidance opportunities.

The Opportunity Zone Program - a provision of the TCJA - allows each state to establish what are called “Qualified Opportunity Zones” (QOZ) in lower-income communities and disadvantaged “zones” within parameters set by federal government.

In order to propel investment in these geographies and attract job-creating businesses, the tax law incentivizes investment in businesses and real estate in these opportunity zones through a ten-year deferment, potential partial forgiveness and complete avoidance of capital gains taxes. With trillions of dollars realized in capital gains annually in the United States, this program can have profound structural and social impacts if applied correctly.

The benefits of this provision for ultra-high net worth (UHNW) families and investors are two-fold. First is the potential financial value in deferring taxable gains into potentially lucrative investment opportunities. To some degree, this alone should compel investors to get involved in the program. However, due to the unique nature of the opportunity zones, these investments should also fall under the banner of impact and socially responsible investments.


Here is an opportunity in the real estate space that has the potential to be a once-in-a-generation chance to access these demarcated areas while postponing and possibly eliminating tax liabilities. A lot of money is going to be pouring into these areas, so, in general, the prospects for future appreciation in these geographically restricted opportunity zones — and the surrounding neighborhoods — are high simply from a supply-demand dynamic that should evolve and take a life of its own.

I believe to truly maximize returns on QOZ investments might take some creativity in addition to an intimate familiarity with existing partnership tax laws. Experience has taught me to look outside the box at both the potential positives and negatives when new opportunities like the Opportunity Zone Program — which has many unknowns — arise. There are many specifics that investors need to be aware of before seeking to defer their capital gains through these new investment vehicles.

However, while the actual statute is somewhat clear, as you’ll see, there still needs to be considerable guidance and clarifications from the Treasury on how some long-standing rules carried over from traditional investing and partnerships are applied.

First, to be able to invest through this program, firms need to set up Qualified Opportunity Funds with specific guidelines. It is only through these funds that investments into opportunity zones can be made. This creates multiple complexities beyond the need for firms to set up the structures of these unique funds so as to maximize all the available benefits and even additional benefits not originally contemplated by the drafters of this specific legislation.

Partnership tax rules are very complex and there are potential inconsistencies between, say, the tax consequences of the partners vis-à-vis the tax consequences of the underlying partnership. In some instances, because of the intricate interplay between the TCJA and partnership tax rules, the TCJA provisions could create certain tax inefficiencies that would not otherwise exist with partnership-based investments. Unfortunately, we have to wait and see how current rules will be applied. And that is where the risk but also the potential benefits may come into play.

As I see it, anyone who has done their homework and has a knowledge of partnership tax rules may be able to find more benefits through the program than initially thought, with the caveat that further guidance may change this landscape. For instance, some quick financial analysis and modeling of projected real estate IRRs over different time periods might make an investor rethink waiting for the ten allotted years to maximize the tax deferment and potential avoidance benefit.

If you model out certain real estate investments - comparing a five-year investment versus a ten-year one — there may be situations where the IRR is greater in the shorter period, despite the potential loss of tax benefits. However, we do not know whether a sale within the ten-year holding period is violated if the partnership flips the underlying investment within the ten-year period or whether the holding period applies at the partner level – i.e., the partner selling the interest in the Qualified Opportunity Fund.

That said, depending on the success of the underlying investment after ten years (i.e., your exit assumptions), the after-tax enhancements to real estate investment IRRs within one of these zones could be as high as 400 to 600 basis points (and even higher) on an annualized basis. This can be further impacted with the use of leverage and the use of free cash flows from any investment within the ten-year holding period. Whether we are allowed to distribute free cash flows from rental income to the partners or possibly refinance/recap the partnership after development and distribute out part of the equity to investors are questions that are yet to be determined.

Moreover, amidst all this opportunity, there may be other hidden gems. If we take a thirty-thousand-foot view of this program and its larger macro impacts, we would expect that highly concentrated positions and/or undesirable assets with embedded capital gains will be sold in 2018 and 2019, knowing that the capital gains can be indefinitely suspended, and the proceeds diversified into investments that have structural underpinning for further appreciation.

Even more pronounced are all those hedge fund managers that will be stuck with short term gains reported on their K-1s because of the TCJA’c new carried interest rules. An investment in a Qualified Opportunity Fund may be just what the doctor ordered. While Trump’s landslide tax legislation took from one hand, it may give back much more to the other.

With so many new and existing sources of capital gains, this program has the potential to cascade and morph into something much bigger than what markets are currently discounting across many more verticals than one would imagine. This should lead to lots of real estate development within these zones and for savvy investors, the surrounding areas — those not deemed QOZ — could hold more attractive spill-over investment opportunities.

Intended or not, the new statute could create a real estate nirvana in these under-utilized and underdeveloped areas leading more individuals, families and firms — hedge funds/private equity funds included — into these geographies. Think about it – hedge fund managers sponsoring Qualified Opportunity Funds can defer their carried interests to realize even more carried interests. Talk about luck.

Thus far in my home state of Massachusetts, Governor Baker has designated 146 opportunity zones across the Commonwealth. These range from neglected neighborhoods in Cambridge to long-ignored sections of Boston to large swaths of Lynn, Lowell, Haverhill, Chicopee and others. This represents a tremendous potential change for these areas, and even the contiguous areas. As we learn more and more about the provisions of the law, our stance and plan of attack will become clearer.

While we continue to receive more guidance, we are furthering our preparations to invest in the QOZs. For now, our advice is to make sure that ultra-high net worth investors are aware of this unique opportunity, the risks, and the myriad ways to benefit from this once-in-a-lifetime program.

If you are prepared for when this opportunity strikes, you will create your own luck — as well as potentially lucrative returns.

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