How To Beat The Tax Man
And Help the Poor While You’re At It
I’m going to teach you a secret that could save you thousands of dollars on your taxes.
This secret is a strategy that is only two years old. Most people haven’t heard about it. Even fewer know how to take advantage of it.
Many billionaires and hedge fund managers are making this secret a major focus of their investments this year. After reading these articles and my summary, you’ll know enough to do what they are doing.
What I’m going to teach you is totally legal. It’s just a little complex. I’m here to break it down for you.
I’ll warn you that this is long and there is some math involved, but I know you can handle it and there is a potentially big payoff for muscling through it. You can decide how much deeper you want to dive with the articles, but here’s what they are:
This week’s articles:
- Will ‘Opportunity Zones’ Help the Rich, the Poor or Both?- The Washington Post
- Opportunity Zones: Can a tax break for rich people really help poor people? — The Washington Post
- New ‘Opportunity Zone’ Tax-Break Rules Offer Flexibility to Developers — The Wall Street Journal
- New opportunity zone rules answer pressing questions — GrantThornton
- Opportunity Zone Overview — LISC
Read widely. Read wisely.
Max
Taxes are complicated. The best estimate of our current federal tax code is that it is 2,600 pages long. The new tax reform act of 2017 was itself over five-hundred pages.
Tucked in the middle of the reform act is a six-page provision concerning the creation of “Opportunity Zones.” This little section is the key I’m talking about for getting smart on your taxes. Here’s the background.
While San Francisco, New York and a few other areas are growing at phenomenal rates, there are areas all over the country that have been and continue to be economically marginalized. As a society, we have three choices with this situation.
1. We can do nothing for these areas and let them suffer. This is cold-hearted and probably foolish.
2. Government can invest directly in the areas. This will likely lead to all manner of waste and corruption.
3. We can encourage private investment in these areas, to spur the market to create new jobs and businesses. The new tax act pursues this third option.
The Opportunity Zone provision gave local governments the power to designate thousands of economically disadvantaged areas as “Opportunity Zones.” That designation gives investors clear and compelling incentives to plow money into these areas that might otherwise be overlooked. The incentive allows investors to defer their capital gains taxes, reduce their capital gains tax basis, and reinvest gains in a way that eliminates taxes altogether.
Before we go any further, let me be clear that I am not a tax professional and this is not advice of any kind. I am sharing my understanding of a complex issue. Please consult an accountant before acting on anything you read about here.
To understand how Opportunity Zone incentives work, let’s describe a hypothetical investor named Mary. Mary invested in Amazon stock years ago and just recently sold it. When she sold, she realized a capital gain of $100,000. Normally what would happen is Mary would pay a capital gains tax plus an investment income tax, which, for simplicity, we’ll say totals 25% of her gain. So Mary pays her tax and has $75K left. Now that Mary is a little older, she doesn’t want to invest in another risky internet company and instead invests in an asset that grows steadily at 8%. Seven years later, Mary sells that investment, pays her capital gains tax (for simplicity we’ll assume the tax rate holds steady over that time), and so has $115K after-tax at that time. We’ll call this the base case. It is shown below:
Now let’s consider what would happen if Mary instead invested her capital gains into a Qualified Opportunity Zone (QOZ). There are three benefits. We’ll take them one at a time.
QOZ Benefit #1: Deferring Capital Gains Taxes
Mary has an alternative to immediately paying taxes on her Amazon sale. She can instead invest her gains into a Qualified Opportunity Zone. If she does, she can defer paying any taxes on her stock gain until 2026.
That means, instead of having only $75K to re-invest today, she’d have the full $100K. And that turns out to be valuable. In fact, if she pursues the same 8% investment as in the base case she will have $13,384 more dollars just by deferring her taxes. In other words, paying her taxes later allows her to end up with 12% more money than she would have in the base case. Here’s how the numbers look:
Deferring when you pay taxes is a good benefit, but if Mary invests in an Opportunity Zone, she’ll get a lot more than that.
QOZ Benefit #2: Reducing Capital Gains Tax Basis
The second benefit of investing in a QOZ is that you get to reduce your tax basis (the amount of money the government is taxing you on). Here’s how it works:
If Mary invests her $100,000 of Amazon gains into a Qualified Opportunity Zone (QOZ) and holds the investment for five years, she gets a 10% reduction in basis. In other words, when she finally pays taxes in 2026, she would only pay the capital gains tax rate of 25% on $90,000 of her gain. The other $10,00 would be tax-free.
And it gets better. If Mary holds her QOZ investment for seven years, she gets a 15% reduction in basis. She would only pay taxes on $85,000 of her $100,000 capital gain. When you add these first two benefits together, at the end of seven years Mary would be $17,134 better off than the base case if she invested in an Opportunity Zone. Again, here is the math:
Mary is doing pretty well. She is 15% better off now than she would have been if she hadn’t invested in a QOZ. But if she is patient, it gets better still.
QOZ Benefit #3: Money invested in Opportunity Zones grows tax-free
This is potentially the biggest benefit financially, but it is also the hardest to achieve because it only works if you hold your investment for ten years. If Mary doesn’t sell out of her investment in the Opportunity Zone for ten years, then her tax liability for her capital gains is completely erased. Gone. How much tax will she pay when she sells her QOZ investment after ten years? Zip. Zero. Zilch. Even if she made millions of dollars on it.
Again, I think it will help if we look at the numbers. First, here’s what it would look like if Mary pursues the base case, sells her Amazon stock, pays 25% on the gain, then reinvests it in an asset yielding 8% growth every year. Then after ten years, she sells it. Her original $100K would be worth $183.6K after tax.
Mary got an uninterrupted 8% annual return and ended up with an 83.6% gain after-tax after ten years. That’s nothing to be ashamed of. I’d like that return stream. But both Mary and I could do better.
If Mary pursued the same exact strategy but instead that 8% investment was in an Opportunity Zone, she would end up with $32K more money in her pocket after taxes. That’s an 18% improvement. Many fund managers would kill for that kind of alpha. Here is what the OZ scenario looks like:
Mary was already doing well. Heck, she had $100K in gains to work with. But an investor with only $10K in capital gains would make an additional $3.2K from the same strategy. That’s significant.
And still, there is more.
The value really piles up if Mary can invest in an asset that is not only growing in value by 8% a year but that also distributes cash to her along the way. Imagine Mary had the opportunity to invest her money in a business that grew at 8% a year but also paid out a 20% cash-on-cash return every year. In other words, imagine every year Mary gets a $20K check from the company she invested $100K. Sound too good to be true? I understand. But these deals exist. we’re doing several of them.
One last time, let’s compare a non-QOZ investment with a QOZ investment, each sharing the traits I describe above. Here’s what a non-QOZ return looks like:
This is a great investment for Mary! In ten years she took her $100K and increased it by 2.5x after taxes. In year 1 she gets $15,000 paid back to her from her investment (20% x $75,000). I assume Mary is in the 37% tax bracket (the highest federal rate). So she pays $5,550 in ordinary income tax on that distribution, leaving her with $9,450 net.
As the company grows, so do her distributions. I calculate the value after ten years as the sum of her after-tax distributions along the way ($136,898) plus her after-tax sale proceeds when she exits the investment after ten years ($121,440). The total after-tax value of her original $100K after ten years is $258K.
Now, let’s see what happens if the same investment is in an Opportunity Zone and she gets the advantages of 1) deferring the original capital gains tax, 2) reducing her basis by 15% and 3) not paying taxes on new capital gains.
Whoa. By investing in this same deal in Opportunity Zone, Mary is 54% better off! She makes nearly $200K more than the base case and has turned her pre-tax $100K into nearly $400K after-tax in ten years. That is a smokin’ deal.
Her cash pre-tax cash distributions are $20K instead of $15K because the 20% cash-on-cash return is based on a $100K investment instead of a $75K investment. Then when she sells, she gets $215K after-tax instead of $121K.
How do you invest in a Qualified Opportunity Zone?
If I’ve succeeded in the first part of this article, I’ve persuaded you that Opportunity Zones are a potentially attractive strategy for reducing your taxes and increasing your take-home investment returns. So how do you invest in them?
1) There are two types of assets you can invest in: Qualified Opportunity Zone Property (QOZP) and Qualified Opportunity Zone Businesses (QOZB). QOZP is real estate. QOZBs are operating businesses located in one of the designated zones.
2) But you cannot invest directly in these assets. For your tax savings to qualify, you must invest through a Qualified Opportunity Zone Fund (QOZF) whose managers will invest in the underlying assets on your behalf. Each fund must register with the IRS for the purpose of investing in Opportunity Zones and at all times must have 90% of its’ assets invested in Opportunity Zones.
There are lists of QOZFs online. They each have their own requirements for minimum investments and their own focus for what they are trying to do. So in addition to the risk of needing to hold an investment for a longer-term, you need to trust that the QOZF manager knows what he is doing and can be trusted.
3) Regardless of which QOZF you invest in, in order to maximize the tax benefits, you need to invest by the end of this year. All QOZ capital gains tax deferrals must be paid by the end of 2026, so to qualify for the seven-year holding period / 15% basis discount, you need to invest by December 31, 2019.
4) For your capital gains to qualify, you must have recognized them in the last 180 days before investing.
Why I’m Sharing This Information
The best way to make sure you learn something is to try to teach it to others. I’m interested in these investments so writing about it here forced me to dive deeper to learn more.
My business partner and I are buying a business that happens to be located in an Opportunity Zone. We like the business on its own merits. It’s one of these deals like I described above, where I think investors will receive at least 20% cash-on-cash returns every year. We are going to buy it because of that (among other reasons). The fact that it is also located in an Opportunity Zone is just icing on the cake. But it has given me an excuse to go deep.
Based on this research, we think the Opportunity Zone landscape is attractive enough that we are opening our own Qualified Opportunity Zone Fund: The Saturn Five Opportunity Fund.
At a minimum, we will acquire this $5M business we are already targeting. It generates $1.5M in free cash flow each year and has lots of room to grow. But we plan to do more. We are raising a $25–30M fund aimed at making 4–6 Opportunity Zone investments in the next two-and-a-half years. This is small potatoes compared to some other funds raising hundreds of millions, but we think it is a good size for our strategy and is more realistic given our goal of raising the money before the end of 2019.
We started Saturn Five with a vision for building businesses that gave investors fantastic returns while simultaneously investing in projects that create meaningful social impact. Opportunity Zones are designed to marry those two goals through the incentives to invest in and build up economically struggling neighborhoods.
If you are an accredited investor (see definition) and would like to learn more about our fund and opportunities to invest, please email me at max@saturnfive.com. Unfortunately, we cannot share investment materials with unaccredited investors or talk about investment opportunities with them.
Whether by investing with us or another group, I hope this information is ultimately useful to you and that you save some money and do some good before the end of the year.
Read Widely. Read Wisely.
Max
Recommended Readings
1. Will ‘Opportunity Zones’ Help the Rich, the Poor or Both?
The Washington Post
SUMMARY
History of Opportunity Zones and a good high-level overview of what they are.
SELECTION
It was hatched in a 2015 white paper by Jared Bernstein, who was an economic adviser to Joe Biden when he was vice president, and Kevin Hassett, who is now chairman of the Council of Economic Advisers for U.S. President Donald Trump. They wrote it for the Economic Innovation Group, a think tank co-founded by Sean Parker, the Napster creator and first president of Facebook Inc. A group of Republicans and Democrats introduced bills in the House and Senate to create opportunity zones in 2016, but the measures never reached a floor vote. One of the sponsors, Senator Tim Scott, a Republican from South Carolina, successfully pushed for a modified version that was tucked into the tax overhaul.
2. Opportunity Zones: Can a tax break for rich people really help poor people?
The Wall Street Journal
SUMMARY
A thoughtful and cautious argument for Opportunity Zones from one of the creators. He emphasizes the need to study whether these investments really payoff for the people they are designed to help.
Today the New York Times ran a front-page story speculating that 1980s junk bond king, and current philanthropist, Michael Milken lobbied the White House for rules changes to make hundreds of millions of dollars worth of property he owns fit in the Opportunity Zone definitions. Whether or not it is true, we will have to watch how much this law benefits investors vs. people living in these zones. — Max
SELECTION
OZs don’t assume that just because they get a tax cut, wealthy people will make investments that will somehow lead to higher incomes for others. The tax break is conditioned on investing in economically left-behind places where patient, equity capital is a scarce commodity. To push back on sheltering risk, investors can’t just park their deferred gains in OZs. They must be used to build new homes or businesses, finance new or expanding companies in the zones, or substantially rehabilitate preexisting structures and/or businesses.
As an early contributor to this idea, I was motivated by two realities. One, the United States is fraught with capital scarcity in most places amid race/gender unbalanced capital accumulation in just a few places. The vast majority (over 75 percent) of venture capital goes to white male founders in Massachusetts, New York and California. Two, it is increasingly well understood that the facile economic solution to being stuck in a depressed area — move to a better place! — isn’t working. Diminished geo-mobility has left too many families in places with too little opportunity. If policy is going to help them, it needs to bring jobs and investments their way.
It is inconceivable that a few white guys in three states are the only people and places where untapped potential exists. Instead, I’m sure the status quo underinvests in the future of ailing regions and less-advantaged demographics. Hence the bipartisan backing the Opportunity Zones idea garnered in both chambers of Congress before it was wrapped into the tax overhaul package.
3. New ‘Opportunity Zone’ Tax-Break Rules Offer Flexibility to Developers
The Wall Street Journal
SUMMARY
Explanation of some of the rules clarifications that came out last fall. These rules are guiding investors.
SELECTION
Earlier this year, after getting recommendations from governors, the Treasury designated nearly 9,000 census tracts as opportunity zones, spread across urban and rural areas and including almost all of Puerto Rico.
Nearly 35 million Americans live in the zones, which have higher poverty and unemployment rates than the rest of the country, according to the Treasury. Developers have been planning projects that would qualify for the incentive, including a Marriott hotel in Arizona, affordable housing in Los Angeles and a 22-story office building and hotel in New York’s Washington Heights neighborhood.
4. New opportunity zone rules answer pressing questions
GrantThornton
SUMMARY
This piece is a little dense, but good for those of you who want to geek out on the topic. Covers the new guidance offered by the IRS in April of this year.
SELECTION
The unique nature of the Dec. 31, 2026, mandatory gain recognition date requires taxpayers to make investments in a QOF by Dec. 31, 2019, in order to receive the additional 5% basis increase for holding the asset for seven years before the deferred gain is recognized.
Only gain from the sale or exchange of a capital asset to an unrelated party may be deferred by investing in a QOF. A taxpayer generally does not need net capital gain on the year, and can defer gain even if it only increases a net capital loss. The investment must be made within 180 days after the sale or exchange that created the gain. Ordinary gains are not eligible.
5. Opportunity Zones Overview
LISC
SUMMARY
Good, short PDF with an overview of Opportunity Zones.
SELECTION
More than half of America’s most economically distressed communities contained both fewer jobs and businesses in 2015 than they did in 2000.
New business formation is near a record low. The average distressed community saw a 6% decline in local businesses during the prime years of the national economic recovery.
The U.S. economy is increasingly dependent on a handful of places for growth. Five metro areas produced as many new businesses as the rest of the country combined from 2010–2014. Now is the time to diversify.
