- At the end of last year, $6.1 trillion in capital gains was sitting in mutual funds, stocks and corporations that investors had not cashed in, according to the Economic Innovation Group.
- The idea is to funnel such unrealized capital gains to economically struggling areas by offering a tax break to investors who reinvest their gains in so-called opportunity zone funds.
- Recent federal guidance for setting up these funds is likely to spur more funds being created as investors look for ways to get in on the program.
A new type of investment fund could end up benefiting two groups that typically are not well-acquainted: people with large investment profits and low-income communities.
And with federal guidance recently issued for setting up these so-called opportunity zone funds, the trickle of them coming into existence around the country is poised to become a steady stream.
For investors with existing assets that have generated profits — capital gains — reinvesting those gains into these new funds could deliver a sizable tax break. And for the struggling areas — dubbed opportunity zones — the funds could deliver an infusion of investor money that typically would bypass them.
"I really think this has tremendous potential to have a lasting impact in some of our country's most distressed communities," said Lisa Starczewski, co-chair of both the Opportunity Zones team and tax section for the national law firm Buchanan, Ingersoll & Rooney.
"There's noble intent, which is to invest in these zones by getting the trillions of dollars in unrealized capital gains into these areas," Starczewski said. An unrealized gain is basically a profit on paper — i.e., you haven't yet sold the asset.
Created by the massive tax overhaul that took effect this year, these opportunity zone funds (technically called Qualified Opportunity Funds by the IRS) have been coming on line slowly as many interested investors awaited guidance. The first indication came Oct. 19 in the form of an IRS rule proposal that will serve as a basis for decisions until it is finalized. Additional information is expected by January.
In theory, anyone — an individual, a group of people or a business entity — can create a fund of any size by setting up a qualifying entity and filing the proper paperwork at tax time.
"The goal was to make these funds accessible enough so that it wouldn't be only large institutional players that can participate," said John Lettieri, president and CEO of the Economic Innovation Group in Washington, the think tank that hatched the idea for opportunity zone funds and helped get them included in the tax legislation.
The group estimates that at the end last year, $6.1 trillion of unrealized gains was sitting in stocks and mutual funds alone. On top of that are untold unrealized gains in other assets, such as a business or real estate.
"The premise is that even with how well investors have done, you have a lack of equity in some areas," Lettieri said. "This doesn't require a big change in behavior to have a large-scale economic impact."
More than 8,700 spots across the country have been certified as opportunity zones and are candidates for these funds' money. The zones, which collectively are home to 35 million residents, are spread across rural and urban areas in all corners of the country and face varying degrees of economic challenges.
The bulk of these funds' money (90 percent) must be invested in projects located in an opportunity zone. Those projects could involve investing in new development or a property upgrade, funding a start-up business or putting money toward any other qualifying local initiative.
Other requirements include that any business invested in by the fund must derive at least 50 percent of its gross income within the zone. That could pose a challenge for start-ups to qualify for opportunity zone investments if their customer base would largely be located beyond the zone's borders — i.e., a company that sells a product or service online.
This doesn't require a big change in behavior to have a large-scale economic impact.John Lettieripresident and CEO of of the Economic Innovation Group
Additionally, the only way for investors to get preferential tax treatment is for the money they put into the fund to come from capital gains generated from another asset. As long as the gain is reinvested in the fund within 180 days of the sale of the other asset, the money is eligible for the tax break.
Specifically, investors could defer paying taxes on that gain until as late as the end of 2026. Separately, if they remain invested in the fund for at least five years, they can exclude 10 percent of the gain from taxation. If they stay in for seven years, another 5 percent is excluded. And if they remain invested for at least 10 years, any gains generated by their investment in the fund would be tax-free.
For illustration: If you had a $100,000 gain from selling an asset and reinvested it in an opportunity zone fund, after seven years the taxable amount of the gain would be $85,000 ($100,000 less the 15 percent reduction of $15,000).
And say that initial $100,000 grew to $200,000 over 10 years of being invested in the fund. You could take that $100,000 gain ($200,000 less the initial investment of $100,000) entirely tax-free.
(Click on chart to enlarge.)
So, when all is said and done in this illustration, you could end up paying taxes on just $85,000 of gains instead of the full $200,000 that you would without the tax break.
The recent federal guidance also clarified that if short-term gains are reinvested into a fund, they will remain characterized as such and not be considered long-term gains after being deferred or reduced.
Short-term gains, which are gains generated from assets held for one year or less, are taxed as ordinary income subject to tax rates up to 37 percent, depending on a person's overall income.
The tax rate on long-term gains — those on assets held for more than one year — ranges from zero to 20 percent, depending on your income. Also, taxpayers with adjusted gross income of $200,000 or more ($250,000 for married couples filing a joint return) pay an extra 3.8 percent on those gains, for a total of 23 percent.
While the new opportunity zone funds seem poised to attract investors looking to both minimize their taxes and do it in a way that benefits struggling communities, there are skeptics.
"Some of these zones are in gentrifying areas that would have attracted investments anyway," said Steve Rosenthal, a senior fellow at the Urban Brookings Tax Policy Center. "You'll probably see projects that were already going to happen being restructured to use these funds."
He also questions whether the government will be able to accurately gauge whether the investments are making a difference in the opportunity zones.
"I think the program is well-intentioned and not intended as a giveaway to rich guys or anything like that," Rosenthal said. "But it will be hard to measure whether it's working or not."
Past federal tax incentives to spur investment in distressed areas have produced mixed results for the communities they were intended to benefit. However, Economic Innovation Group's Lettieri pointed out that opportunity zone investments are designed differently: The tax benefit is not capped as it has been in past efforts, the initiative is more widespread and investors only get the full tax benefit if they're in for the long haul.
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"Investors will have to commit through a long period and then have gains to reach the end of the tax rainbow," Lettieri said.
Of course, there's no guarantee that investors will come out ahead, which means it will be important to evaluate the specific projects that the fund's assets would go toward, and weigh the potential risks with the hoped-for benefits.
Already, a variety of investors — from real estate developers to venture capitalists and financial institutions — are in various stages of creating these funds and raising money for them.
PNC Bank, for instance, has a fund that already is investing in qualified projects spanning manufacturing, housing and business incubators in different opportunity zones, according to a bank spokesperson. However, it is composed of gains owned by the bank and not open to the public. Goldman Sachs also has been raising money for such funds, according to published reports.
Industry watchers expect that more financial institutions will create funds and potentially make them available to the public. Financial advisors with interested clients also are paying attention to the development of these new funds.
"The reality is this is one of the best tax things that has passed in the last decade, if not our lifetime," said certified financial planner Matt Chancey, an investment advisor in Orlando, Florida. He has client money ready to invest when the right opportunity presents itself.
"We've got a substantial amount of money on the sidelines, and we're just waiting for more guidance because we haven't eclipsed the 180-day [reinvestment] window," Chancey said. "It feels prudent to wait until Treasury tightens up the regulations and more projects come on line."
Meanwhile, Lettieri predicts that a year from now, tens of billions of dollars will be invested in these funds. While that's just a fraction of the trillions in unrealized gains out there, it's enough to start making a difference in communities, he said.
It feels prudent to wait until Treasury tightens up the regulations and more projects come on line.Matt ChanceyInvestment advisor
Additionally, much of the success of the nationwide initiative will depend on the degree to which officials and investors embrace it at the local level.
"It's a national initiative, but it's really a local effort, and there are slightly different approaches everywhere," Lettieri said.
At this point, it's uncertain how soon the opportunity zones could expect to see large amounts of money moving into local projects. Already, the IRS guidance gives funds 31 months to put their money to work. That means investors could theoretically park their capital gains income in a fund and not have it actively invested in an opportunity zone for another couple of years. Either way, the money would qualify for the tax deferral and capital gains tax break.
For now, investors generally should approach these funds — whether through their own creation or someone else's — the same way they would any investment option.
"We're very early in the regulatory process and a lot of answers aren't available yet," Lettieri said. "But investors should do what they should be doing with any potential investment, and that is to screen carefully, look to trusted intermediaries and be judicious."