The DI Wire publisher, Damon Elder, and Michael Fitzpatrick, a partner at Baker Tilly, discuss opportunity zone investments in the latest video from ADISA’s Focus on Alternatives, an educational series that covers key topics in alternative investing.
The opportunity zone program was created to spur investments in low-income and distressed communities across the nation by offering potentially significant tax benefits to investors, particularly those who hold their investments long term. Fitzpatrick explains why he is bullish on the opportunity zone program, their associated tax benefits, the approximate equity that has flowed into these communities since the program was first introduced in 2017, and how he believes the program will evolve in the future.
Damon Elder 00:06
Welcome to another edition of Focus on Alternatives, sponsored by ADISA. I’m Damon Elder, the publisher of The DI Wire.com. Today I’m joined by Michael Fitzpatrick a partner with Baker Tilly. We’re going to be discussing opportunity zones, giving an update on this relatively new investment opportunity that was introduced in 2017 in the Trump tax package. So, Michael thanks for joining us today why don’t you why don’t we start out with just a brief overview of the opportunity zones the benefits the protocols et cetera.
Michael Fitzpatrick 00:35
Sure yeah, the intent on opportunity zones was to stimulate the investment of capital, and low-income communities that are under invested. And this is done through a tax incentive for investors who invest realized capital gains, whether they’re real estate related, or stock related or virtually from any source into an opportunity zone fund and hold that investment for a period of time and there are certain benefits that accrue to them. So, the first benefit is if they hold the investment for a period of 5-years they get a deferral on their original capital gain until 2026. And when that gain is paid, they get a 10% discount on the gain when they pay it. So, if they have $1,000,000 gain make $1,000,000 investment, they report the gain in 2026 at $900,000.
Damon Elder 01:20
And that gain doesn’t include whatever they may have made in the opportunity zone.
Michael Fitzpatrick 01:23
No, right as long as they’re continuing to hold the opportunities on those gains are unrealized but when they sell that opportunity zone investment if they’ve held it for 10 years or longer, there is no taxation, and what’s really critical and misunderstood or not known Is there’s no recapture of depreciation if it’s a real estate investment where they received real estate deductions or tax depreciation deductions.
Damon Elder 01:46
So that’s pretty powerful incentive, again if you’ve been holding apple stock for a number of years sell it and reinvest in an opportunity zone really get some tremendous tax benefits.
Michael Fitzpatrick 01:56
Yeah, you get a 10% discount on the apple stock gain, and then on the real estate gain that you would invest in after you held it for 10 years there’s no taxable event at all. And that can often be equivalent to about 30 to 35% of the capital invested.
Damon Elder 02:11
Wow, very significant OK. We’re four years in at least since opportunity zones were introduced. I know it was a very slow rollout because we were waiting for regulations from the IRS and others, so I think really we started to see projects really start to get going at least equity inflows in around 2019 or so. How has it been going I mean a couple of years of actual work really four years since the introduction how has it been working what type of equity inflows have, we been seeing you know what real world impact have we witnessed?
Michael Fitzpatrick 02:40
Yeah, I know that our firm expected a significant rush into this space. I can tell you that certainly we have line of sight to the capital gains our clients report. And you know and that’s only a small part of the country. And because these tax benefits are so lucrative, we did expect to see greater amount of capital. I’ve seen a couple of different varying reports. I’ve seen 17 ½ million as of January 3rd June 30th of this year but that would just be the equity investment in the QOF.
Damon Elder 03:10
Is that millions or billions?
Michael Fitzpatrick 03:11
Billions… excuse me, yes 17 ½ billion. But they would just be the equity portion so those are probably leveraged, so maybe conservatively if they’re 50% leverage that’s 35 billion of investment, but I’ve also seen numbers as high as 75 billion which would surprise me.
Damon Elder 03:24
We’re seeing growth maybe not as rapidly as we expected but, but we are seeing growth, right?
Michael Fitzpatrick 03:31
Yeah, we are… and you know there is one provision that’s gonna fall off or sunset on December 31st this year is that 10% basis adjustment or discount that I mentioned. Investments made in the QOF after December 31st of this year they can’t be held for five years by December 31st of 26. So, they won’t qualify for that 10% basis adjustment but again if you dig into the math, I’m a little bit of a excel spreadsheet geek and math guy, it’s not material to the tax benefit the real benefit Is the 10 year old that is significant.
Damon Elder 04:04
And that doesn’t matter there are time frames on that I mean that goes to 2046 or something?
Michael Fitzpatrick 04:09
2046 I believe is the right answer right, so you know plenty of time where there’s not going to be a rush to sell these assets after they’ve been held for 10 years. Plenty of time to liquidate in an orderly way or hold it even longer.
Damon Elder 04:20
So, the end of this year you’re going to lose part of that incentive, but a relatively insignificant amount the long-term hold.
Michael Fitzpatrick 04:26
Damon Elder 04:27
OK, let’s talk a little bit more about that though with the potential tax increases, obviously capital gains they’re they’re targeting they’re even looking at it getting rid of step up in basis. What are all the tax implications and how are they going to impact I mean maybe they’ll be beneficial for qualified opportunity zones I don’t know
Michael Fitzpatrick 04:42
Damon Elder 04:43
What are you seeing?
Michael Fitzpatrick 04:44
Absolutely, I think some of these things can actually stimulate interest in OZ’s and increase in the tax rate would be one of them. So, you know on first blush you might say well wait a minute if I can pay my tax gain now at 20% and not defer it until 2026 when the rate might be higher is then a good thing.
Damon Elder 05:02
Michael Fitzpatrick 05:03
Well, the fact is is that what people forget is Step 2, step 2 is you’ll hold the OZ investment in additional 5-years to the that 10-year holding period and the from the capital gain and the depreciation recapture at that point in time you have to assume it’s going to be the same higher rate.
Damon Elder 05:19
Michael Fitzpatrick 05:20
Is a significant significantly outweighs, sort of that you know if the music stopped after five years and all you did was pay a higher tax yeah, it’s a bad decision. But you’ve got to play the long game and hold it for 10 years to get the full benefit and then it becomes a hedge against rising tax rates
Damon Elder 05:35
Right, the the the the hedge is is a great incentive
Michael Fitzpatrick 05:40
And then as it relates to the step up in basis, and you know reducing the estate tax exclusion. The step up in basis in OZ’s is Independent from what they’re talking about with the step up in basis on that and so this OZ’s actually become an incredibly powerful estate planning tool. That would happen is is so take for instance you know mom and dad sell an apartment complex right and they’ve got a large they’ve got low tax basis large capital gain they’re really thinking about the next generation. Instead of keeping that in their state where it’s potentially gonna be subject to a state taxes or maybe no step up in basis. They take the gain, and they invest it into qualified opportunity fund, and then that becomes left and that goes into a grantor trust. There it’s now an irrevocable trust for their heirs the step up in basis benefit travels over to the grantor trust with it. So, the heirs would then receive that asset as long as the trust held it for 10-years from the date of inception to the data disposition the errors would get the step up in basis and it reduces the estate tax in the parents account.
Damon Elder 06:48
So even if there are, and again step up and basis is still in the current reconciliation discussion it’s still that really probably would be an incentive for from an estate planners perspective really for qualified opportunity zones and funds.
Michael Fitzpatrick 06:59
Yeah, you can really get the best of both worlds, because you can you can take taxable assets out of the estate get them out of the estate tax regime and then you can still retain a step up in basis where normally that wouldn’t be possible but for an OZ investment. And then probably the tripleheader on that is if mom and dad are still living in 2026 when the deferred taxes due, they can pay that tax from their taxable estate and further reduce their taxable assets.
Damon Elder 07:25
OK, so this program was intended to be temporary I think the sunset date in 2026. But it seems and when certainly when it passed it had bipartisan support as you said President Biden seems to be in favor maybe some tweaks around the edges, but it still seems to have bipartisan support so looking ahead in 2026 isn’t that far off
Michael Fitzpatrick 07:46
Damon Elder 07:47
Do we anticipate an extension of this program perhaps making It permanent you know what are you seeing what are you hearing?
Michael Fitzpatrick 07:51
Yeah, great question so I mentioned a minute ago that we’re a large consultant and the tax credit area. That program has been living on annual extensions for a long time sometimes three years sometimes 5-year extensions which is what it’s on right now. I think that just like what new markets has gone through OZ will go through an evolution right, so the types of projects that are being financed today with new markets you know or the ones that were being financed originally you probably couldn’t get done today didn’t have enough community impact.
Today the program is really hitting on all cylinders with community outcomes. I think it wise will go through a similar type of evolution. Where they’ll tweak it around the edges, they’ll kind of get rid of some of the unintended consequences they’ll create a little bit more reporting and accountability for it. I don’t think they’ll get into like mandating minimum types of outcomes or certain types of outcomes like the new market program does. I think they’ll still let it be a little bit or you know let the you know the the invisible hand of the economy kind of guide it.
Damon Elder 08:49
Michael Fitzpatrick 08:50
But I think they will tweak it around the edges and make some improvements and keep it going.
Damon Elder 08:53
Ok, great you know another thing we’ve been hearing is that given the slow nature of the regulatory rollout by the IRS, and you know the impact of COVID particularly in 2020 where there was certainly a bit of a hiccup cash flow and dollar flows into some of these programs. One of the things we’ve been hearing is that they may extend that 10-year deadline from 2026 to 2028 is that true is that something you’re hearing or expecting?
Michael Fitzpatrick 09:17
Well so when they actually certified the census tracts for OZ status, they were certified from 2018 to 2028. The magic of 2026 is when the deferred tax benefit expires and of course 2021 the inability to hold it longer than five years. But you know theoretically you could make an oz investment in 2027 you just don’t get a tax deferral on your original gain, and you don’t get a discount. But you do get that longer term benefit which kind of gets into you know investors have been too short term focused and advisers for that matter have been too short term focused on that initial discount on the original gain it’s immaterial.
Damon Elder 09:56
Well, you know I actually in preparation for this interview Michael, I was looking at something I think you actually had a hand in at Baker Tilly about the kind of equivalent return you would need from an investment versus the tax benefits that you would receive along with potential other investment benefits from a qualified opportunity zone investment, why don’t you discuss a little bit.
Michael Fitzpatrick 10:17
Sure yeah, we published a short paper and created a very simple excel model that can be downloaded from our website. And what it does is, it’s not like I would call it be all end all decision making tool, but it will give someone a flavor for. If I have an option if I if I have a realized capital gain event, and I’m going to make a reinvestment decision right, I sold something not going to put the money under the mattress so I’m going to reinvest it. If I invest in an opportunity zone and I assume maybe a 10% rate of return what are my after-tax cash flows for holding it for 10 years? And what are my tax consequences for paying the deferred tax in 2026 at the current rate or even at any rate I choose. So, we made it a variable for the investor to look at.
Contrasting that with then it solves for the the the excel model solves for what rate of return would I need in a non-OZ environment to end up with the same after-tax cash flow after 10 years. And what you’ll find is and this kind of proves out the hedging point that we made earlier, what you’ll find is is that a 10% OZ return equates to almost a I believe it’s about a 15% non-OZ return. So you almost a 50% higher rate of return in order to get the same after tax cash flow after 10 years, and if you assume that the captain rate goes up you need something higher like 16 or 17% so it really just proves out the fact that it is a hedge.
Damon Elder 11:47
Really, the benefits from an investment perspective really still massively significant.
Michael Fitzpatrick 11:51
And if you’re looking at two different some people say well 10 – 15% the fact the matter is it’s a 50% higher return when you go from 10 to 15.
Damon Elder 11:58
Yeah, you’re not talking 5% you’re talking total return.
Michael Fitzpatrick 12:01
So really what you’re looking at is is there’s you’re looking at different risk profiles of these two assets right. I mean the asset that’s going to project or return 10% is clearly going to have a lower risk profile than the one that’s projecting 15.
Damon Elder 12:13
So, I think it’s probably safe to say that you’re bullish on opportunity zone investing and funds and the entire program moving forward?
Michael Fitzpatrick 12:20
Yeah, absolutely. I think there’s a lot of education to be done and I’m grateful for the opportunity to to talk to you today to get the word out.
Damon Elder 12:28
Well, we appreciate your insights for sure, and the wisdom. Because I think they’re still still largely misunderstood and certainly not properly understood program, so I think we’re going to start seeing a lot more inflows as people do kind of really get educated on this and potentially you know if we do see some tax changes it’ll make it even more attractive. So, time will tell.
Well again Michael thank you for joining us today very helpful and very insightful. And thank you for watching.
For more information on all things alternative investment be sure to visit www.adisa.org thanks again
For more ADISA news, please visit their directory page.