When I first started investing in real estate nearly 30 years ago, a wise investor shared something that was revolutionary to me at the time, “it’s not how much you make, but how much you keep.” Nearly all real estate investors I know seem to model both before and after-tax returns, making my wise old friend’s comment ring true. With the new tax laws in 2017 and the creation of Opportunity Zones, there has never been a more attractive form of tax advantaged investing than investing in OZs. Investors get the benefits of taking unrealized gains and if invested in one of the 8,700 designated OZs for ten years, the ability to compound those gains like never before possible. This all occurs while creating jobs and providing much needed capital improvements in targeted communities.
WHAT IS COMPOUND INTEREST?
Albert Einstein is reported to have said that “Compound interest is the 8th Wonder of the World. He who understands it, earns it. He who doesn’t, pays it.” I’ve often said to my children, tongue in cheek, the only thing you really need to learn in math class is the Rule of 72 and forget the rest. Only half joking. So, what exactly do people mean by compound interest? Compound interest makes a sum of money grow at a faster rate than simple interest. It does this because in addition to earning returns on invested money, your money also earns additional money on the interest it just earned. The benefit of compound interest in its most simplistic form is to make your money grow faster. The two major components are the length of time you allow your initial principal to compound and the initial amount of principal.
Many investors have realized the benefits of compounding interest as they review their investment returns. However, once you factor in the tax advantaged benefits of investing in OZs, the benefits of compounding and reducing the taxes owed by 10% on your initial gain tax free until April 2027, adding in that all the income and gains earned over the ten-year period are tax free, investing in OZ’s are hard to beat.
To provide a clear example on the compounding benefits of OZ investing, let’s use this example: On a $1 million investment, your after-tax returns in an OZ investment are nearly double those of an identical non-OZ investment due to capital gains deferment and other tax benefits!
Let’s break this down in a simple chart to really illustrate the benefits assuming a 35% tax rate and a growth rate that doubles the equity invested over the ten-year period.
| Investment Type | OZ | Non-OZ |
| Initial Gain | $1,000,000 | $1,000,000 |
| Year Before Capital Gains Tax Payment is owed | 7 | 1 |
| Capital Gains Tax Amount (10% Savings for OZ) | ($315,000) | ($350,000) |
| Available Equity to Invest in Year 1 | $1,000,000 | $650,000 |
| Income on Principal Investment (5%) | $500,000 | $350,000 |
| Appreciation of initial Principal Investment (2x) | $2,000,000 | $1,300,000 |
| Taxes on income/gains | $0 | ($577,500) |
| Total After Tax Cash Flow | $2,500,000 | $ 1,072,500 |
| Advantage | $1,427,500 |
TAX EFFICIENCIES OF OZ INVESTING
As highlighted above, investing in real estate can be a highly effective path to financial independence. And that is because it can offer incredible returns and even more incredible tax breaks. OZ investing has provided a steroid shot to the tax benefits of real estate investing.
Let’s walk through these tax efficiencies a little deeper. There are four main areas where OZ investing provides tax efficiencies for high-net-worth investors.
1. Temporary Tax Deferral: Unlike traditional investments, investors can defer tax payments on capital gains that are invested in a Qualified Opportunity Fund (QOF) until the earlier of the date on which the QOF is sold or Dec. 31, 2026.
2. Step-Up in Basis: For investments held in a QOF for at least five years before December 2026, the basis is increased by 10%, essentially reducing the taxes owed by that amount when you exit the investment.
3. Permanent Tax Exclusion: The step-up in basis is a big tax advantage but it gets even better if these assets are held for at least 10 years. You are eligible for a permanent exclusion from taxable capital gains from the sale of an investment in a QOF if the investment is held for at least 10 years! And…You get to be part of investing in the revitalization of America.
4. Depreciation Tax Shield: The last remaining tax benefit of investing in an OZ is there are no recapture rights on depreciation declared along the way making the income you receive tax free. Unlike other real estate investments where depreciation claimed is recaptured at time of sell, an OZ investment has no recapture of said depreciation.
Several factors affect how much you benefit from OZ investing, including (but not limited to):
• The amount of funds invested
• The length of the investment
• The overall return received from the QOF
GOOD FOR INVESTORS, GOOD FOR COMMUNITIES
QOF investment opportunities clearly have some real tax advantages which make them an appealing investment strategy – specifically for patient, longer term investors. The reason the OZ program was created was to stimulate economic development and job creation in economically distressed communities by encouraging long-term investments in low-income neighborhoods. Instead of relying on taxpayer dollars and government programs, the aim is to use private investments to conquer the task of revitalizing distressed neighborhoods. Placing capital in these communities feels good and provides community and social benefits and can provide investors a healthy return and tax advantages.
DEFINING YOUR RISK PROFILE
So, we have established that there is a great deal of benefits to OZ investing, but what about the risks? Like any type of investing, it is important for investors to do their research prior to signing those subscription docs.
Make sure to ask questions and assess your own appetite for risk. Here are a few things worth asking yourself as you consider OZ investing:
• What types of communities are most aligned with your investment goal? Some investors are strictly looking to enhance returns, while others can be focused exclusively on improving the community and therefore may take more of a risk.
• Is the QOF diverse in assets and in geography? Diversification hedges risk, so investors should pay special attention to the level of diversification that the QOF targets to achieve across assets and geographical markets.
• Does the fund manager have a targeted strategy with a track record of investing in the product type and in the market? If the answer is no, the manager has never invested in this asset class or geography, you may be taking on a greater risk in the investment.
• Alignment of interest with sponsor. Does the fund manager have significant capital of its own invested alongside yours?
• Is the deal worth doing regardless of the tax advantages? Remember no deal is worth investing in just for tax advantages, it has to make sense on its own merits.
Since these investments can last 10 or more years, it is important to understand the strategy behind a QOF to minimize any surprises.
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