By: Mike Huisman, Head of Alternative Product Solutions at Envision Financial Systems Inc.
It often is said that nothing quite focuses the mind like a deadline, and a big one is coming up at the end of the year for the nascent opportunity zone (OZ) investment market, which one economic policy think tank says theoretically has the potential to reach $6 trillion.
Created by the Tax Cuts and Jobs Act of 2017 to promote long-term investment into low-income rural and urban communities, OZs are geographies where qualifying investments in property or businesses benefit from deferral of realized capital gains through the end of 2026.
Investors with unrealized capital gains in any existing investment (whether stocks, bonds, real estate or other) can liquidate that holding and roll the proceeds into an OZ investment without paying the capital gains for as long as they remain invested in the OZ, up to seven years. On top of that, investors enjoy a 10 percent reduction in their capital gains liability after five years or a 15 percent reduction after seven.
As such, in order to maximize the tax benefit and take full advantage of the 15% reduction, investors have every incentive to deploy capital to OZs before Dec. 31, 2019, a full seven tax years ahead of the end of the deferral period.
The Gold Rush is On
Unsurprisingly, as the clock ticks down there has been a great deal of activity in the OZ sector, with organizations of all stripes scrambling to launch qualified OZs and raise capital. Newmark Knight Frank, a leading commercial real estate research firm estimates that $20 billion is being raised to beat the deadline.
Fund sponsors range from established, multibillion-dollar institutional real estate investment firms to much smaller start-ups with local expertise and plenty of boots on the ground.
But while the pitch decks and private placement memoranda may be ready and the trickle of capital may soon turn into a flood, it’s an open question whether every sponsor has fully thought through and prepared for the unique operational and recordkeeping demands OZ funds will place on their infrastructures.
As with other alternative investment categories, OZ funds differ from traditional investments not only as a category but as individual vehicles. It’s not enough to gear up for them in general.
Many sponsors and service providers have already learned the hard way that trying to tweak business processes and software made for cookie-cutter products leads to massive headaches and messes of data.
And compared to what’s come before, OZ funds are likely to be among the most thorny products many sponsors and service providers have yet handled at large scale.
A Different Kind of Animal Altogether
OZ investment vehicles have in common with other alternatives a slew of operational complexities that defy traditional one-size-fits-all approaches. What sets them apart is higher stakes (and therefore higher reputational risk) as a result of higher dollar amounts and regulatory nuances:
• The checks tend to be big. Because they are private direct investments and there is significant complexity and planning involved, many investments in OZs will be well into seven figures—individuals who sold large businesses or locked in a windfall by selling a stock, real estate or even a cryptocurrency holding.
• The margin for error is small. Because much of the appeal of OZ investments is linked to their tax benefits, the consequences of recordkeeping mistakes—mishandled capital calls, botched beneficiary designations and transfers and premature distributions—that might jeopardize their privileged tax status are significant to investors and therefore the reputations of the firms that serve them.
Then, on top of the general operational complexity that comes with many private direct investments, including capital calls and distributions (and the high-volume investor communications that come along with them), there’s a spaghetti soup of regulatory issues to contend with.
For example, consider that OZ investor accounts are federally regulated. Most, but not all, states have conformed their state-level capital gains tax laws to the federal code.
Further, states (and even local governments) are running to provide tax incentives for investors to place their cash in an OZ in their jurisdictions. So not only taxes vary—incentives do, too—subject to an array of policies that differ state by state and municipality by municipality.
That means New York incentives may differ from those in Texas, which may differ from those available in West Virginia. Here are a couple examples:
• A South Carolina bill to create a 25% tax credit for OZ investment with a cap of $50,000;
• An Ohio bill to create a 1% non-refundable credit for investments in Ohio qualified OZs…but the OZ must hold only Ohio OZs.
“You cannot be serious”
All of these nuances and complexities must be tracked assiduously. And because OZ funds are a new phenomenon, sponsors should expect that auditors, lawyers and regulators will be watching every move.
Still, despite the high stakes, we have been astonished to see that many OZ fund sponsors—particularly the new, smaller entities that are starting up to capture the growth—are planning to handle investor recordkeeping manually in-house, most often with spreadsheets.
Spreadsheets? In the words of tennis legend John McEnroe, “You cannot be serious!”
Now don’t get us wrong. Spreadsheets are powerful tools for building financial models of companies and investment properties or for maintaining a balance sheet. But we would submit that they fall short when it comes to the demands of creating and maintaining accurate investor records.
And remember, OZ accounts are likely to be in place for up to seven years. That’s a long time to be disserving investors because the recordkeeping approach isn’t up to the task.
The compliance and tax-treatment tracking and cross checks that can be embedded in an Excel file are crude at best. The possibility of operator input error is high. (Actually, given the results of academic research about spreadsheet accuracy, we can say with confidence that operator error is unavoidable. Humans are prone to overconfidence not only about their spreadsheets’ accuracy but also about their own ability to discover and correct any errors that may be lurking.)
Large OZ fund sponsors, particularly those already managing real estate and other private direct investment funds appear to agree and in most cases are setting OZ funds up to run on their existing, sophisticated recordkeeping platforms with custom modifications.
Small- and mid-sized fund sponsors, who face the additional challenge of fewer resources to deploy at high-volume redemption periods, would do well to follow suit and implement a dedicated recordkeeping functionality that eliminates the business risk inherent in “spreadsheet operations.”
If they lack the resources to create such functionality, and many do, they should look for a partner or a team of partners to help them.
After all, the stakes are high and the margin for error is low.
The views and opinions expressed in the preceding article are those of the author and do not necessarily reflect the views of The DI Wire.