Time is running out to get the biggest tax break from opportunity zones, but there's one snag for financial advisers: They don't see a lot of compelling investment options for clients.
"The deals haven't worked out to be that great," said Leon LaBrecque, an adviser at Sequoia Financial Group. "I was really excited with [opportunity zones] when they came out. But I haven't seen a good enough deal come across my desk yet that made me get excited."
The 2017 tax law created tax incentives to invest in so-called opportunity zones. The law, which reduces and shields tax on a capital gain, is meant to promote investment in more than 8,700 economically distressed communities across the U.S.
However, to get the full tax benefit, wealthy clients must invest by the end of 2019 — less than four months away. That deadline could lead advisers and clients to rush into a poor investment deal.
The law allows investors who recognize a capital gain — from a stock sale, for example — to roll that gain into an opportunity zone fund and defer paying capital-gains tax for several years. Investors get a 10% step-up in tax basis — essentially a 10% reduction in tax — if they hold the investment for five years, and 15% if they hold it for seven years.
The sticking point is that the deferred tax comes due by Dec. 31, 2026 — which is seven years from the end of 2019. So, clients that invest in an opportunity fund in 2020 and beyond will not be able to get the maximum 15% tax reduction.
In addition, an investor only has 180 days from the sale of the original security to invest in an opportunity fund and access the tax break.
"You have these two deadlines that could entice someone to invest in a product that might not be the best one for them because of that deadline," said Tim Steffen, director of advanced planning in Robert W. Baird & Co.'s private wealth management group. "It'd be trying to maximize a tax benefit at the risk of making a poor investment."
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There are three types of opportunity fund investments: real estate development; redevelopment (i.e., refurbishment) of existing buildings; and start-up businesses, such as opening a restaurant, dry cleaner or movie theater. The funds are structured as limited partnerships or nontraded real estate investment trusts.
Opportunity funds are only available to qualified purchasers — those with a net worth of at least $5 million, which can't include a personal residence, said Mr. Steffen.
Perhaps one of the biggest tax benefits of opportunity zones is that any appreciation in the opportunity fund is tax-free as long as it's held for at least 10 years. Altogether, the federal tax incentives for opportunity zones could improve an investor's return by up to 50%, according to accounting firm Novogradac. (There could be an additional boost depending on state tax rules.)
However, these investment benefits will start to decline after this year, according to Kevin Wilson, a partner at Novogradac.
'A little scary'
But there aren't many choice funds available for investment, said advisers, who urged wariness of lackluster deals and the fraudsters who will likely emerge to try to benefit from the tax hype.
"It could be a little scary," Jason Kolinsky, partner at Kolinsky Wealth Management, said of investing in opportunity funds. "There will be people popping up all over the country. You have to be really careful about who you get in bed with."
That's especially true since many of the funds are opaque private placements, he said.
"There will be a lot more buyers than sellers," Mr. Kolinsky added, referencing the short timeframe for investment. "It's common sense that there will be a lot of deals that suck that people want to get involved with."
Mr. LaBrecque passed on some small private real estate deals in Detroit focused on building early childhood development centers. The deals would have had an estimated internal rate of return of roughly 4.8% to 5.2% at best, he said, and were risky because they were predicated on having a single tenant and payor. He declined to name the specific funds.
For the deal to make sense given the risk profile of the funds, projected returns would have to be around 8% to 10% for real estate and 12% to 16% for a private placement, Mr. LaBrecque said.
"It didn't have enough meat on it," he said. "Saving the capital gain wasn't worth it."
There are more than 230 opportunity funds currently available with more than $62 billion in investment capacity, according to Novogradac.
Only a sliver of those have made their way onto brokerage platforms. Mr. Kolinsky's broker-dealer, American Portfolios Financial Services Inc., recently made four opportunity funds available for advisers: Peachtree Hotel Opportunity Zone Tax Advantage Fund, Griffin Capital Qualified Opportunity Zone Fund, Cantor Silverstein Opportunity Zone Trust Inc. and Inland Saint Paul Opportunity Zone.
Mr. Kolinsky has used an opportunity fund with one client who had a $1 million long-term capital gain from a mutual fund. He rolled $300,000 of the gain into an opportunity fund, a private placement seeking $100 million of investment capital and aiming for a roughly 8% to 10% annual return. He declined to name the specific fund.
Mr. Kolinsky had a prior relationship with the fund manager, a real estate developer, which had projects in development that were coincidentally located in areas subsequently designated as opportunity zones.
Baird currently offers one fund — The CIM Opportunity Zone Fund — and expects to add another in the fourth quarter. The private-equity fund targets an annual return of roughly 9%, said Dayna Kleinman, Baird's senior product manager of alternative investments. The fund is seeking $5 billion of investment.
CIM had been involved in real estate deals in opportunity communities prior to the 2017 tax law — roughly 65 of its 125 portfolio properties fell in the opportunity zone map, Ms. Kleinman said.
"There are 8,700-plus opportunity zones that were identified. It's safe to say not all zones are created equal," she said. "Not all funds will be created equal either."