Financial advisers have a new way to deliver impact investing to wealthy clients — one that comes with substantial tax benefits — courtesy of a fledgling federal tax law.
The law created a way to invest in "
qualified opportunity zones," which are low-income communities around the country earmarked by state governors and the Treasury Department for investment in order to spur economic development and job creation.
Importantly for advisers' clients, investment in these opportunity zones can yield big tax breaks on capital gains. Those potential breaks include the deferral, reduction and outright elimination of capital-gains tax, which is generated when an investor sells an asset, such as a stock, that's appreciated in value.
"I think there will be some legs on it," Leon LaBrecque, managing partner at LJPR Financial Advisors, said of the opportunity-zone provision. "I think there's an impact investment angle and I think there's a tax angle."
The
Internal Revenue Service released a list of thousands of qualifying opportunity zones on July 9. Investors will be able to invest in these regions via a qualified opportunity fund, a vehicle set up as a partnership or corporation that invests in things like real estate in that community.
Here's an explainer of how the tax break works.
Investors use capital gains to buy into an opportunity fund. Tax payment on those gains can be deferred until 2027. Further, if clients hold their opportunity-zone investment for five years, the tax bill on the deferred tax falls by 10%; after seven years, it's a 15% reduction. If clients hold it for at least 10 years, they also pay zero tax on any gain from the opportunity-zone investment.
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So, let's say a client, Deborah, pays the top capital-gains rate of 23.8% (the 20% capital-gains tax rate plus the 3.8% net investment income tax). She generates a $300,000 capital gain from the sale of appreciated Google stock. Rather than pay $71,400 in tax on that gain, Deborah and her adviser defer the tax by investing in an opportunity fund.
After five years of holding the fund, Deborah would get a 10% reduction in tax, or $7,140. After seven years, her tax savings would be $10,710.
In addition, let's say Deborah holds the investment for 10 years, and her original $300,000 has grown to $1 million. She would not have to pay any tax on the resulting $700,000 gain when she sells her investment in the opportunity fund.
Derek Uldricks, president of Virtua Capital Management, calls the latter the "big enchilada" from a tax-break perspective.
"It's a really powerful investment tool for people who are in highly appreciated stock or have a business they have sold or are coming out of a real-estate deal and have a lot of gains they want to defer," Mr. Uldricks said.
Virtua is a private-equity firm among the first companies to launch a fund investing in opportunity zones. The $200 million fund is investing primarily in real-estate development across the Southwest and Southeast, and more funds are in the works.
Opportunity-zone investments will make sense mainly for ultrahigh-net-worth clients, at least initially, according to tax experts. They expect the bulk of investment opportunities will come via funds requiring accredited-investor status attained by the wealthy; plus, the largest tax advantage will come from wealthy investors paying the highest capital-gains tax rates.
"I think investors will be very interested," said Steven Rosenthal, a senior fellow at the Urban-Brookings Tax Policy Center.
Mr. Rosenthal said opportunity funds have a "fair amount of latitude" in terms of what they invest in, and there are so many designated zones that they cover "very commercially viable parts of the country."
The tax provision also offers more latitude with capital-gains deferrals than other areas of the tax code, he said. Take 1031 exchanges, for instance, which allow real-estate owners to defer gains by rolling them into a similar investment. With opportunity zones, only the gains from an asset sale need be invested; with 1031 exchanges, investors must roll over all of the original investment in order to get tax deferral.
