For all developers / value-add investors on the forum, have you looked at any opportunity zone deals? Given pension funds are not taxed on gains, high net worth LPs seem to be slated for the greatest benefit to these types of deals. Has anyone studied the relative “hit” to LIRR/EM an LP could take in exchange for the perceived tax shelter benefits that investing in an opportunity zone could offer? I’m curious if an LP that might typically want a 17% LIRR could live with lower returns due to the tax shelter. This could make deals that previously required 18-20% project level IRR, very doable at a 15-16% if said LP is good with lower returns; more importantly the sponsor promote could very well remain intact and unchanged from the “typical” return threshold.
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Yes. Depending on the deal profile, the state's tax laws, and the hold period, I have found that OZ deals can increase LIRR by 4.0%-10.0% (or more) over a 10-Year period when factoring in the benefits of the program. A state like California, where we invest out of, has a combined capital gains rate of 37.1% (20% Federal + 3.8% Obamacare Tax + 13.3% California). This provides a significant increase in net proceeds when factoring in the after-tax capital gains that will now be exempt from taxes.
Further, when the initial capital gain is not taxed until 2026, the re-investment has a 7+ year window to compound versus facing a 37.1% Cap Gains rate first and then investing into a new deal (in a non-opportunity zone scenario).
This program has significant benefits depending on what state an investor lives in and their time horizon.
Because a 1031 Exchange only defers a capital gain. The Opportunity Zone Program defers a capital gain (albeit it only until 2026) AND fully exempts you from a capital gain on your Opportunity Zone reinvestment.
The only scenario I would say the 1031 Exchange makes more sense is if you are willing to hold an investment until you pass away, at which point the basis steps up to market value as you transfer the asset to your descendant. (Someone with more tax experience feel free to chime in if I'm missing something here)
So, lets run an example that assumes the following:
1. Sale of Original Investment
On July 1st, 2018, Investor sells Apple stock and realizes gain of $250,000
2. Investment Deferred Gain in Qualified OZ Fund within 180 Days On October 1st, 2018, Investor reinvests all of the gain in the OZ Investment.
3. 5-Year Holding Window
After holding in OZ Investment for 5-Years, on October 1, 2023, Investor is entitled to a basis adjustment equal to 10% of the deferred gain ($25,000)
4. 7-Year Holding Window
After holding in OZ Investment for 7-Years, on October 1, 2025, Investor is entitled to an additional basis adjustment equal to 5% of the deferred gain ($12,500) of total basis adjustment of 15% ($37,500)
5. Recognition Event on 12/31/26
On December 31, 2026, if investor has not yet sold the investment, investor recognizes capital gain of $212,500 ($250,000 minus $37,500).
6. Holding Period of 10 Years or More Upon a sale of the OZ Investment, on or after October 1, 2028, the basis in the investors investment will be equal to the fair market value of the investment on the date the investment is sold. Thus, if investor sells the investment for $5,000,000, the basis in the investment will increase to $5,000,000, allowing the investor to exclude the entire $4,750,000 gain in addition to deferring the taxes on the initial gain for ~8 Years (if invested today).