This trendy tax play is making its way to financial advisors

Personal Finance

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A hot tax-advantaged opportunity is making the rounds among financial advisors.

Just make sure you don’t overlook the risks.

The Tax Cuts and Jobs Act, which went into effect in 2018, established so-called qualified opportunity zones — economically disadvantaged areas across the country.

Funds specializing in qualified opportunity zones allow people to invest in these communities and receive a raft of tax advantages if they hold the investment for a minimum of five years.

Investors have put $6.72 billion into these funds as of Jan. 9, according to data from Novogradac. The accounting firm, which specializes in real estate, surveyed 292 funds.

Word of these investments is also trickling down to financial advisors and their clients.

For instance, registered investment advisors who custody assets with TD Ameritrade can access some of these funds on the firm’s platform, said Alyson Nikulicz, a spokeswoman for TD Ameritrade.

Advisors, however, should be mindful of the complexities of these investments before they recommend them — particularly the tax consequences that may surprise clients.

“The advertising is all the bells and none of the drawbacks,” said Dan Herron, CPA and principal of principal of Elemental Wealth Advisors in San Luis Obispo, California.

“Are you telling me that when you sell this to a client, you’re opening their tax return and seeing how it affects them overall? I doubt it,” he said.

How it works

A sign displayed on Bruckner Building reads ‘Commercial Space Available’ in the Port Morris neighborhood of the Bronx borough of New York. For a limited time, investors who develop real estate or fund businesses in opportunity zones are able to defer capital gains on profits earned elsewhere and completely eliminate them on new investments in 8,700 low-income census tracts.

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To qualify for the tax break, you must roll in a significant amount of capital gains. This could be by selling a business, for example.

Money from other sources would be deemed “non-qualified,” and thus not eligible for the benefit.

Once you’ve sold your property, you have 180 days to reinvest the gains into a qualified fund, which invests in opportunity zone properties.

You can defer taxes on the orginal capital gains you invested until you sell your holding or until Dec. 31, 2026, whichever is earlier.

Keep your holding for more than five years, and you can exclude 10% of your originally deferred gains.

Investors getting into the funds now have missed the boat on a 15% exclusion. That tax break was available to those who rolled their gains into an investment by Dec. 31, 2019.

If the fund fares well and you hold it for at least 10 years, you won’t owe taxes on its appreciation once you sell it.

Tax landmines

Accountants warn that the hype around the advantages of these funds may distract advisors from tax-planning risks.

“Small investors need to be aware of inclusion events,” said Tim Steffen, CPA and advisor education senior consultant at PIMCO. “This is offering unique complexities you wouldn’t think of when you look at a mutual fund or an exchange traded fund.”

For starters, while you may get a permanent exclusion on 10% of your original gains (or 15% if you got in before the end of 2019), you’ll eventually have to pay taxes on the remaining 90% (or 85%) of the deferred gain.

You could be paying those taxes on Dec.31, 2026.

Surprise inclusion

An ‘Available’ sign is displayed outside a former Walmart Inc. store in Boulder, Colorado, U.S., on Saturday, Jan. 12, 2019. For a limited time, investors who develop real estate or fund businesses in opportunity zones are able to defer capital gains on profits earned elsewhere and completely eliminate them on new investments in 8,700 low-income census tracts. The goal is to reinvigorate these areas.

Bloomberg | Getty Images

In December, the IRS and Treasury published final regulations that detail the tax implications investors face with qualified opportunity zone funds.

For instance, an investor who gifts his interest in one of these funds while still deferring capital gains will need to include that gain on his tax return.

Further, in a divorce, if the investor transfers the holding to an ex, then he’s recognizing the deferred gain on his tax return.

There’s also the risk that a client could wind up deferring capital gains well into a time when taxes are higher.

“Depending on what happens with elections this year, it’s conceivable you could end up with much higher capital gains rates in three or four years than you do today,” said Jeffrey Levine, CPA and CEO of BluePrint Wealth Alliance in Garden City, New York.

Major risks

Thomas Barwick

Aside from the surprise tax consequences, advisors should be mindful of the liquidity risk clients may face.

“These are meant to be long-term investments; this isn’t money you’ll need to use in a few years,” said Steffen.

Further, the expenses can be high.

Management fees for opportunity zone funds could range between 1% to 2% per year, plus 20% of gains if the performance exceeds a stated hurdle rate, according to Jon Halpern, founder of Halpern Real Estate Ventures, a New York real estate investment firm.

Broker-dealers may offer investors access to a fund as a private placement under Regulation D, meaning the firm may only make it available to accredited investors.

Those people must have a net worth of at least $1 million, excluding their residence, and income exceeding $200,000 in each of the last two years. This threshold goes up to $300,000 for a married couple.

Perform due diligence

Luis Alvarez

Advisors should kick the tires extensively on any opportunity zone fund that comes their way.

Read the prospectus or the private placement memorandum: Glossy marketing literature may play up the tax benefits of these offerings. But the prospectus has the details on liquidity lock-ups, fees and unexpected risks that come with investing in real estate.

Learn about the provider: How long has the provider been around, and what’s their experience in dealing with distressed communities? “This entire means of investing is always predicated on the underlying real estate itself and the sponsors’ track record and experience,” said Michael Burwick, an attorney with The Wagner Law Group in Boston.

Assemble your experts: It takes a team to root out whether this is appropriate. Rope in the client’s CPA and estate planning attorney to make sure you cover your bases.

Make sure the client understands it. Forget the razzle-dazzle of the tax play. Does the client grasp the risk of getting into these investments? “There’s an easy way to avoid paying taxes,” said Levine. “It’s called ‘losing your money.'”

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