In 1789, Benjamin Franklin penned the now famous words, “In this world nothing can be said to be certain, except death and taxes.” Indeed, most of us would have a difficult time arguing to the contrary. However, a recent change in U.S. Federal tax law as part of the Trump administration’s 2017 tax reform may call the latter part of Mr. Franklin’s statement into question, at least for some investors.
As part of the tax law changes that went into effect with the passage of the Tax Cuts and Jobs Act of 2017, a new classification of investments was created which may allow investors to defer or even eliminate some capital gains taxes if certain conditions are met. This new type of investment is called an “Opportunity Fund,” and it may be an attractive way for investors to create positive impacts with their capital while decreasing the burden of taxes.
An Opportunity Fund is a private sector investment vehicle that invests at least 90% of its capital in newly created “Opportunity Zones.” These zones are low-income census tracts that are nominated for such status by state governors and then certified by the U.S. Department of the Treasury.
The creation of Opportunity Funds and granting of favorable tax treatment on the funds encourages long-term capital investment into economically disadvantaged communities that have historically been starved of such investment. Opportunity Fund investments may include affordable housing, infrastructure, and small business investments, among others.
Currently there are over 8,700 certified Opportunity Zones in the U.S., with zones in every state and territory. This number is expected to continue growing, along with the number of Opportunity Funds that will provide the mechanism for investment in these communities.
So how do Opportunity Fund investments work, and what tax advantages can Opportunity Fund investors enjoy? The best way to understand how Opportunity Funds work is to walk through an example. Let’s start by assuming that you have a taxable investment that you’ve held for a period of time and which has increased in value. You paid $100 for the investment, and now it is worth $200.
You would like to sell this investment and redeploy your capital elsewhere, but you are hesitant to do so because the sale of the asset would result in a taxable capital gain that would effectively lower your return on the investment by your capital gains tax rate (we will assume you are subject to the maximum capital gains tax rate of 23.6%).
This is where Opportunity Funds enter the picture. Let’s assume that you go ahead and sell the asset and realize a $100 capital gain. This would normally result in a tax burden of $23.60. However, instead of reinvesting your $200 of proceeds into a stock or bond, you invest $200 in an Opportunity Fund.
When you file your taxes for the year in which these transactions took place, you will NOT pay any capital gains tax on the $100 gain that you realized. Instead that tax is deferred until some future date, and it may even be decreased if certain conditions are met (our example will illustrate this).
As it turns out, you are a patient, long-term investor, and you decide to leave your capital invested in the Opportunity Fund for five years. If we assume you earn an annual return of 5% on your investment, your initial $200 investment will have grown to $255. But something interesting happens after your money has been invested in an Opportunity Fund for five years.
Your initial cost basis from your original investment ($100, remember?) gets “stepped up” by 10%. This means that your cost basis on your original investment is now $110 instead of $100, effectively reducing your tax burden by 10%. If you were to go ahead and sell your Opportunity Fund investment at that point, you would then owe capital gains tax on your entire gain, less the adjustment for the cost basis step-up.
So you would be realizing a taxable gain of $145 ($255 current value minus $110 adjusted cost basis), while your actual gain would be $155 ($255 current value minus $100 original investment). At your 23.6% capital gains tax rate, this works out to an effective rate of 22.1%.
By investing in an Opportunity Fund and holding it for five years, you have reduced your effective tax rate by 1.5%. Maybe nothing to write home about, but a nice perk nonetheless.
However, there’s more.
Let’s say that you don’t need the money that you’ve invested in the Opportunity Fund anytime soon and leave it invested for seven years rather than five. At seven years, your initial cost basis on your original investment gets stepped up by another 5% (from $110 to $115 in our example). If you were to sell your Opportunity Fund investment at that point, you would realize a gain of $181, but only $166 would be taxable.
This results in an effective tax rate of 21.6%, meaning you’ve now lowered your capital gains tax rate by 2.0%. This is getting interesting.
Now, we’re going to assume that you’re an especially patient investor with a long time horizon, so you leave your money invested in the Opportunity Fund for a full 10 years. At that point, your investment will have grown to $326. Your cost basis on your original investment has already been stepped-up to $115, so your tax burden has been reduced by 15%.
But something really special happens after you have held an Opportunity Fund investment for 10 years. At that point, any gain that you have enjoyed on your Opportunity Fund investment becomes completely tax free. Even though your investment has grown from $200 to $326, you do not owe any tax whatsoever on this gain.
So in total, you have generated a capital gain of $226 ($326 current value minus $100 initial investment), but only $85 of this gain is taxable ($200 minus $115 adjusted cost basis). This means that the effective tax rate on your $226 gain is a measly 8.9%!
By investing your proceeds from your initial investment in an Opportunity Fund and leaving that capital invested for 10 years, you have succeeded in reducing your capital gains tax rate by 14.7%, all while providing capital to communities where it is most needed.
Now that is worth writing home about.
The potential tax savings that Opportunity Funds may offer are eye-catching. Add in the fact that such investments can make a real difference in lower income communities and you have a potentially game-changing investment strategy. However, it is important to note that this is a very new area of investment, and the number and quality of Opportunity Fund investments is still quite low.
While the tax advantages are attractive, Opportunity Fund investments need to generate competitive risk-adjusted returns in order to compete with other investment options. The beneficial tax treatment of Opportunity Funds doesn’t count for much if the investments lose money.
But I expect that Opportunity Fund investing will be an area of substantial growth in the coming years as more investors and investment managers learn about the potential benefits that Opportunity Funds may present. I encourage readers to monitor this area of the market, as they just might be able to prove Benjamin Franklin wrong while also making a positive impact with their money.