Introduction: Welcome to the Bryn Mawr Trust wealth management podcast, providing commentary on what’s moving the financial markets, financial planning, and other timely business and monetary topics. Please welcome your host, Jennifer Fox, president of BMT wealth management.
Jen Fox: Hello. We’re here to discuss the tax opportunity available by investing in qualified opportunity zone funds in some of the recently issued regulations that were released in may of 2019 recently we hosted a highly attended seminar on the topic. The feedback we received was so positive that we decided to do a podcast version to provide background and some more recent updates. This tax opportunity, it was first introduced as part of the tax cut and jobs act in December, 2017 now has a ticking clock, uh, as the ability to realize the full benefit will require action by the end of December, 2019. So a quickly ticking tock. Joining me today is Jennifer Marshall, senior vice president and director of tax services at BMT. Jennifer is an enrolled agent, which means she’s a federally authorized tax practitioner who has technical expertise in the field of taxation and who is empowered by the us department of the treasury. To represent taxpayers before all levels of the internal revenue service. Welcome Jennifer.
Jen Marshall: Thank you, Jen.
Jen Fox: Jennifer, why don’t we kick it off by talking about what is a qualified opportunity zone fund and what are some of the benefits, kind of the rationale for it. What happens when you’re in the fund? So if you could start kind of even at the beginning of what is the qualified opportunities zone fund.
Jen Marshall: Absolutely, Jen. It’s so the fun came about, it was introduced as part of the new tax cuts and jobs act that was introduced and enacted in 2018 and it, the intention of having a qualified opportunities zone fund was to provide a tax incentive for the sale of investments. So let’s just say stock, it allows you to defer the tax that you would pay on that gain if you’re willing to then take the gain from that investment and make an investment into a qualified opportunity zone fund. And I’m sure you’re thinking, well, okay, but why would they want us to do that? So these what these qualified opportunities own funds are, um, are really areas that are considered low income communities. They’re really areas that are in need of revitalization. They’re areas of opportunities, um, within many distressed areas. So that’s basically what it is in a nutshell is it’s an Intax incentive that allows taxpayers to defer gain that they would have to recognize as income if they’re willing to take that and invest it in an an a qualified opportunities zone fund. Um, in exchange for that.
Jen Fox: That sounds like a pretty fair trade of being able to defer the taxes in exchange for helping out areas that by definition have a lot of opportunity. What does it mean to be in the opportunity fund though? Does a work like a gift or is it an investment?
Jen Marshall: It really isn’t an, it’s an investment vehicle. Um, they can be set up as either a corporation or a partnership. And of course there’s multiple criteria that it has to mean in order to qualify. Uh, the bulk of that being that what is held within the fund has to be at least 90%, um, invested in qualified opportunities, zone real estate. And it can also be invested, um, not just in real estate within that zone. Um, but it could also be a qualified or what they refer to as a qualified opportunity zone business. And that would be any business where substantially, and I think that is 70%, so 70% of the tangible property, um, in that business is owned or leased within that qualified opportunity zone.
Jen Fox: So really having that tremendous business impact to that zone directly.
Jen Marshall: Absolutely. And you know, at the same time of course, along with providing a tax incentive, there are also other restrictions that they wrote into providing that benefit. For example, it does specifically exclude investments in a lot of entertainment type of businesses. Some of the examples are things like golf courses, country clubs, um, hot tub facilities, tanning facilities, race track, gambling, all of those sort of entertainment type venues. Um, they have specifically excluded from this provision.
Jen Fox: Got it. So really trying to have that positive impact in the community from a business perspective. Um, let me ask you a different question, Jennifer. So what type of tax payers are eligible to participate? Is this anybody or are there restrictions?
Jen Marshall: It’s obviously pretty a pretty broad group. It’s any entity that would be recognizing, um, or would have to pay tax on that game that they’re allowing to be deferred. So individuals, corporations, partnerships, it would include trusts and estates. Um, it also includes regulated investment companies and real estate investment trusts as well. So I mean, basically any taxable entity, um, that would have to recognize tax on that gain.
Jen Fox: So those are folks who are eligible to participate from both sides. The deferral of the gain as well as participating in the actual opportunity fund investment.
Jen Marshall: Yes. I mean they’re, they’re closely related because you can’t do one without the other.
Jen Fox: Gotcha. So it sounds like there’s definitely some finer points of the rules on the qualified opportunities zone property and the type of business. But let’s talk a little bit about the deferral of the gain. How does that work? Because it sounds like deferring it, getting a tax credit is fantastic, but kind of, what’s the timeframe? What’s the parameters around that?
Jen Marshall: Of course. So along with any sort of tax incentive comes the laundry list of rules that you need need to follow in order to engage in that. So, uh, to begin with, it is an election that you make when you file the tax return for whatever entity is making that election. Um, and there are some additional requirements. So when you sell this property that is generated, this game that you wish to defer, uh, it cannot be, it has to be sold to an unrelated party. So we can’t sell it to our brother. And uh, in addition to that, then, uh, the tax that is deferred has a, as we, you know, I mentioned earlier, there’s a ticking clock on that. Um, so there is an end period, you know, where you have to um, realize the benefit before then. Um, so the triggering event there, I mean, you do eventually have to pay the tax, so you would have to pay the tax on either when you sell the fund itself, the, the zone fund that you invested in or the end of the credit period, which is 1231 of 2026.
Jen Fox: Got it. And that’s gonna be effective for any property sold before December 31st, 2019. So anything after that doesn’t qualify. But anything that is sold between now and December could be eligible for qualified opportunity zone credit.
Jen Marshall: That’s a really good question, Jen. So I’m going to say yes and no. So, um, yes to the part that in order to realize the full potential of the tax incentive, you have to make that election. You have to sell the property that is generating the gain before the end of 2019 and if you do that, w what not only will you be able to defer the game, but depending on how long you hold it, you will also get a step up in basis, which allows you to decrease the amount of the gain that you’re going to pay tax on. So the maximum benefit that we’re going to realize here is to have that investment locked in by the end of 2019 and that gives you a 15% reduction in the amount of gain. But there is opportunity beyond that as well. Um, because it does allow for a shorter holding period of five years in the fund that then allows you to reduce your game by 10% and uh, there’s actually some additional benefits in that you can realize from holding the fund itself. And of course, you know you’ve taken that money and you’ve invested in that fund and then the fund itself is hopefully appreciating as well. So there are some additional tax benefits to the appreciation on the fund as well.
Jen Fox: Why don’t we walk through an example of that? Say you sold stock and you have $1 million gain on that stock, how would that work if you were to elect the qualified opportunities zone credit for your 2019 tax return and then how would it work as you move forward?
Jen Marshall: Sure. So you now have made this sale before the end of 2019 and you have generated a million dollar gain. You’re going to within 180 days of generating that turn around and invest that into a qualified opportunities zone fund. If you hold the fund for a minimum of five years, you are able then to reduce your taxable gain by 10% in other words, 100,000 so now not only have you deferred tax, but now you’re only going to be taxed on 900,000 instead of a million. So let’s say you sold after five years, you’re only paying tax on the 900,000 and then your basis in the fund itself that you invested in is now 100,000 so whatever amount you were able to reduce your gain, that becomes the basis in the fund itself when you sell the fund.
Jen Fox: So if I sell property I’m with for that million dollar gain, are you saying that I’m not paying that tax in April of 2020 with my tax return that I’m deferring it until whether it’s the five-year or seven-year period or whenever I get exit the fund?
Jen Marshall: That’s correct. So the minimum in order to realize any benefit is the five years. That’s there’s no restriction that’s stopping you from selling it. After you’ve held it for one year and decided that you’re unhappy with the performance or there’s some other risk areas, um, that you’ve determined no longer meet your tolerance, then you still have that ability to sell that fund. And then at that point, it, it’s a triggering event. So then you’re required to pay the tax on the million dollar gain. And there, there is ultimately no benefit except for the deferral, um, on the game. So in addition, so let’s say you go ahead and you hold it for the whole five years, you’re deferring paying that tax until that sale five years later. So let’s say you sold it in October of 2023, those funds wouldn’t be due until the following year of filing and 2024. And again, you then you would only pay tax on 900,000 instead of the million.
Jen Fox: So that’s two benefits right out of the gate in the sense that you’re deferring the payment of the tax. Um, the second benefit being that you get a potential overall reduction in the text depending on your holding period. And then I think the third benefit, uh, as you start to really extrapolate is really looking at the benefit and the potential return from the opportunities zone fund itself.
Jen Marshall: Absolutely. And you know, so not as you’ve mentioned, not only are you having the advantage of, of deferring tax and anyone in the tax world will, will always tell you how it is always better to pay later. Um, so in addition to that, an even bigger tax incentive that they’re offering is that if you’re willing to hold on to that qualified opportunities zone fund for a minimum of 10 years, you can and, and that fund has appreciated. So, you know, your original investment of $1 million is now worth a million and a half, or even maybe it’s doubled in 10 years. So it’s worth 2 million. This allows you to permanently exclude any gain from your taxes when you sell the fund, if you hold it for at least 10 years. So in the example I gave you invested in a million, you hold it for 10 years, you, it’s now worth 2 million. You are not paying any tax on that million dollar gain, which is incredible.
Jen Fox: That is incredible. Especially I think when you consider all of the layers of benefits, um, now granted it’s still an investment. So it, there’s an element of risk that comes associated with being able to be invested in that fund that it may not, that it may not return that level, uh, over the 10 years. But the potential for the return and did additional benefits could be worth that risk potentially.
Jen Marshall: Well, absolutely. Of course we’re talking about investments. So you know, there’s always a degree of risk that’s involved there and there’s a certain degree of risk. I think too, for taxpayers, when you’re deferring paying the tax, when it doesn’t correspond in the same tax year when you receive the cash from the sale itself. So one of the things you have to ensure is that at whatever point that the tax man is going to come calling, that you have the liquidity and the cash to then pay on that deferred tax. And then again, it’s just the risks from investments, you know themselves, what is, you know, the quality of the properties that are being held in the and how, you know, how are they performing and you know, what is the expected future? Are there. And there could also, there could be interest rate considerations to be made because of course we’re talking about real estate and, and we know how sensitive real estate is to swings in the interest rates.
Jen Fox: Sure. And I think another benefit that we really haven’t discussed is perhaps the nonfinancial benefit of the sense of satisfaction of investing in an opportunity zone and seeing material meaningful, positive changes in the lives of those who are benefiting from that investment.
Jen Marshall: Oh, absolutely. I would say, you know, that was the onus behind providing that. It’s, it’s not just about providing, you know, tax incentive, it’s, it’s really about revitalization of the economy in the areas where we all live. And you know, this, this type of investment. It’s, you know, not only provides revitalization for distressed areas, um, but it has a chain reaction. And if you sort of think of it in, you know, the example of a startup company, just as, as you bear that risk of the unknown and it doesn’t, wouldn’t necessarily have a history of performance. At the same time, it also has the upsided potential benefit of a fantastic expansion as well. Um, and my understanding, um, from these funds and, and what they are invested in, many of these were real estate deals that, you know, folks were planning for, you know, the last 10 or 15 years. It’s not as if all of a sudden everyone’s scrambling, uh, to invest in real estate. Um, so there is some fantastic potential as well to realize incredible gains in the funds themselves.
Jen Fox: So I’m hearing a lot of positives. Um, and we’ve talked about the risk potentially in the fund itself. We’ve talked about the risk of perhaps not planning properly for cashflow and making sure that you have cash available to pay the taxes. What are some other considerations that may not be as positive as the ones that we’ve spoken about so far?
Jen Marshall: Well, it always comes down to the unknown. I think for many people and there’s tons of coverage that is been on this tax incentive because it is potentially such a fantastic incentive, but of course you have to wait to get all of your I’s dotted and your T’s crossed with the IRS as well. Um, so we’ve wait, waited for final regulations to be issued. Um, because of course no one wants to jump in and sort of be the Guinea pig to, you know, find out later, uh, sort of some of the restrictions that would be, um, imposed upon. So now that we have those final regulations to look at, you know, there’s a lot more that to known, um, about it is two and some other considerations that you have to think about as well. And for, I think a lot of folks they wanted, you know, folks needed to know what would happen if I want to gift this.
Jen Marshall: I mean when you talk about investments, a lot of things can happen to those investments. And you know, what would happen if I make this investment but I haven’t held it and I were to pass on. What would happen to my beneficiaries of my estate? Would all of a sudden would they be required to find this liquidity to pay the tax on this game? Um, so thankfully now there’s, you know, a lot more clarification on that. The IRS has come back to specifically say, uh, that transfer by a gift while while you’re alive is, I think they refer to it as an inclusion event, meaning that at that point then you have recognition of gain. So that’s one of the limitations. You’re not going to be able to transfer that and you have your funds tied up now, um, are part of your funds tied up in that?
Jen Marshall: Um, but they did also clarify though, that if you were to pass on and while holding onto this fund, they will not consider that an inclusion event, which means that you are beneficiaries of your estate will still qualify for the tax benefits that this provides. They’ll actually be able to utilize your holding period while you were alive and then they can actually continue to hold it on their own. So that will provide some peace of mind to folks that really weren’t sure, you know, items like that that hadn’t been addressed. Well what will happen and that creates some hesitancy. So I think now that we have a lot of those questions answered, this will become more popular before your end.
Jen Fox: So it does sound that if you have someone who’s interested in this, they should not only consult with their tax advisor, but they should really also consult with their attorney in the event of a situation where someone dies before the end of the period, that the attorney’s aware of this and can make sure that the documents reflect the investment.
Jen Marshall: Oh, absolutely. And you know, we always need to remember too that you know, liquidity and cash flow is, is always an important thing, um, to be mindful of. And it’s always important to pull in all of your advisors so that it makes sense from every standpoint of your planning.
Jen Fox: Excellent. So Jennifer, first I want to thank you so much for providing all of this background on opportunities, zone funds and all of the benefits that ignore to these type of funds. It sounds like there’s a reason for a lot of the interest and excitement around this given all of the positive benefits. And I’ll just reiterate that with all those benefits there’s still risk to be considered and a determination of it makes if it makes sense for a particular client in their overall investment in tax and estate planning. So thank you so much and I appreciate your time today.
Jen Marshall: Absolutely. Jen. Thank you.
Conclusion: This has been a production of Bryn Mawr Trust. Copyright 2019 visit us online at bmt dot com slash wealth. The views expressed herein are those at Bryn Mawr Trust as of the day recorded and are subject to change without notice. Guest opinions are their own and may differ from those of Bryn Mawr Trust and its affiliates and subsidiaries. This podcast is for informational purposes only and should not be construed as a recommendation for any product or service. B and T wealth management provides products and services through Bryn Mawr Bank Corporation and its various affiliates and subsidiaries which do not provide legal tax or accounting advice. Please consult your legal tax or accounting advisors to determine how this information may apply to your own situation. Investments and insurance products are not. Bank deposits are not FDIC. Insured are not backed by any bank or government guarantee and may lose value. Past performance is no guarantee of future results. Insurance products not available in all States. Any third party trademarks and products or services related thereto mention in this podcast are for discussion purposes only. Third party trademarks mentioned in this podcast are not commercially related to, or affiliated in any way with BMT products or services. Third-party trademarks mentioned in this podcast are not endorsed by BMT in any way. BMT may have agreements in place with third party trademark owners that would render this trademark disclaimer not relevant