My topic today is very specific and is most applicable to doctors who are imminently selling their practice, but it’s come up no less than 5 times in the last month and is (in my opinion) pretty interesting. At the very least, by reading through you’ll learn about a trendy new investment vehicle: Opportunity Zones.
What is an Opportunity Zone?
In 2017, Opportunity Zones were created as part of the Tax Cuts and Jobs Act to spur economic growth in distressed areas. In short, they are federally designated real estate “zones”. Essentially, for investors willing to pump money into these communities under very specific conditions, significant tax breaks might be available (it’s worth noting that I’m borrowing the “mights” and mays” directly from the IRS website).
On a practical note, Opportunity Zones most likely need to be invested in through a fund, not individually due to the very specific ways in which they need to be managed, and for the flexibility of an early exit (if available).
Tell me more about the tax benefits.
Opportunity Zones are most attractive for investors who have long term capital gains tax they would like to avoid (for example an OD selling their practice for a high multiple). In exchange for putting your money into poor economic areas, you get to defer and reduce the capital gains tax owed. An example:
A doctor has a $100,000 long term capital gain from selling his or her practice and elects to invest in an opportunity zone within 180 days of the sale. Taxes owed on the $100,000 is $20,000. Instead of paying the $20,000 the following April, it is deferred based on how long the doctor remains invested in the Opportunity Zone.
At the end of 5 years, they’ve earned a 10% discount on the gains, so instead of owing $20,000, they would owe ~$18,000. At the end of 7 years, that discount is increased to 15%, so they would then owe ~$17,000. Assuming the doctor stayed in Opportunity Zone the full 10 years required for the investment to qualify as an Opportunity Zone, they would owe the IRS the $17,000 in the 10th year.
Furthermore, if the initial $100,000 investment is held and valued at $250,000 at the end of 10 years, their basis in the project is scheduled to be stepped up to $250,000 (so if you sold at the end of year 10, there would be no capital gains). The icing on the cake is that any income earned through the investment "may be" tax free.
What’s the catch?
As an Advisor, there’s a few things that concern me about Opportunity Zones. First, they’re very new. No projects have been through the 10-year term (which regardless of what happens in the next election, will be on the watch of a new administration) and set IRS precedence for the above tax deferrals and adjustments.
Another issue is the underlying project. Think of it: you’re being asked in investment money somewhere that nobody else wants to, so much so that the government is offering significant tax benefits. Just because some funds are coming in to finance a project doesn’t mean that it will revitalize the area. At the end of the 10 years, it could just be a bad investment in a bad location, and that $100,000 investment could worth less than your initial investment, undoing any tax or deferral benefit.
Most concerning is that there’s no guarantee anyone will want to purchase your share in the opportunity zone at the end of 5, 7, or 10 years, and it's very hard to pay for food or healthcare with shares of a specialized real estate fund, not to mention you owe the gains you deferred whether you are able to exit the fund or not. Even though the stock market goes up and down, there’s at least flexibility to choose your investment, and a market where it’s historically been easy to buy and sell investments as you need to.
Ultimately, Opportunity Zones can make sense for the doctor who has more capital than they need to meet their long-term goals, but unfortunately that’s not the case for most of us. We need the money we’ve worked so hard for to get through retirement. Life can change frequently and dramatically, making flexibility an important factor in financial decisions- make sure you have flexibility in your financial life before deferring gains into strategies like Opportunity Zones.
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