Pulling back the curtain in the land of Oz by Randy Fox & Suzanne Jack
From the late 1970s through the mid-1980s, there existed every kind of tax shelter imaginable. It was the Opportunity Zone or “Oz” of planning since we weren’t in Kansas anymore. We were in a place we didn’t understand that was far, far away from our usual behavior. There were wicked witches unleashing their flying monkey tax shelters on the unwary investor. The tax law at the time featured a top marginal income tax rate of 50% and capital gains rates were 20%. Top bracket payers were enticed by the idea that they could invest $1 and save $1.50 in taxes, making their investment “free” and their potential return infinite. Or so they thought. What many ended up with were 100% losses, IRS audits and promoters who really weren’t even investing the investor’s money but instead living a gratifying and expensive lifestyle with investor money. It was chaos and mayhem and ended badly for too many. The 1986 tax act did away with many of the shelters. Planning settled into a real profession with a more thoughtful approach to investing and tax planning. Now, we have Opportunity Zones that have the potential to become the tax shelters of the 70s and 80s. The Wizards of Opportunity Zones, the wonderful lawmakers in Washington, D. C., have passed into law a mysterious set of incentives and tax rules that is luring many unwary investors down the yellow brick road with promises of tax benefits and of making the world a better place by ridding cities of urban blight. It all sounds so good.
The idea of the Opportunity Zone on its surface is well intended. Attracting private capital to rehabilitate disadvantaged and impoverished areas of America by offering tax relief, a government subsidy using soft dollars instead of direct budget expenditure, has merit in its intent. It is almost philanthropic but instead of a tax deduction, investors only defer or delay capital gains tax. Honestly, if you truly believe in community re-development, it might be better to find a great local agency that is interested in improving the lives and opportunities for their community residents who are struggling. Instead of gentrifying the area and displacing them, help create jobs and training that will elevate the community. Donate your appreciated assets to them.
Much like the tinman, the cowardly lion and the scarecrow who already had the answers, potential investors who are enamored with the capital gains deferral or elimination are ignoring several fundamentals:
There is NO ONE with a proven track record of success in creating a positive long-term return through investing in Opportunity Zone assets. Period. That’s not anyone’s fault. Opportunity Zones are new, and no one has had a chance to establish a successful track record. But many of those eager to save taxes seem to be ignoring this fact. Due diligence for this type of financial commitment should be rigorous and thorough. Still, projected results are based on someone’s idea of growth and revenue that are fundamentally only a guess. The fact the government is granting a tremendous tax incentive should alert investors to the risk involved.
These are long term investment commitments with no opportunity for liquidity without an adverse tax consequence. Investments should be considered in the context of an overall portfolio and while the thought of a community improvement investment is intriguing, it also should have real investment merit on its own. Since it’s an investment, not a structure, it should be considered as such, but this seems to be missing for many investors seeking tax relief.
In the context of overall planning, investors must consider whether the lack of liquidity and lack of control is worth the tax savings. Again, it seems that the tax tail may be wagging the dog, and that’s never good. The Opportunity Zone law is only available until 2026, so there is not much incentive for fund creators to think very long term. Essentially, you get one shot and it’s over. Since virtually anyone can form an Opportunity Zone fund with almost any purpose, the danger of a long-term commitment is elevated.
Most importantly, there are many other proven, legal methods to avoid or defer capital gains tax. Many of these present much lower risks to the investor and have decades of legal authority behind them. Opportunity Zones appear to be the next “bright shiny object” that is attracting the attention of the taxpayers while they ignore other safer and often better strategies. Let’s examine a couple of these ideas
Consider charitable planning strategies that include charitable remainder trusts and young pooled income funds. Both offer capital gains tax relief. In fact, both offer income tax deductions in addition to capital gains tax relief. Family can receive income for lifetimes and, in the case of the young pooled income fund, for multiple generations. Further, the donor/investor can maintain control over investment management and select a money manager with a track record that is ascertainable. While assets eventually pass to charity, good planning can keep the heirs “whole” if that’s desired. The tax code has allowed these trusts for fifty years (both enacted in the 1969 tax act), so no one is paving new territory.
With creative planning, the use of certain private life insurance contracts may allow the relief of capital gains tax with a conversion to tax free income to the investor. Further the investor retains the ability to select investment advisors and investment diversification. These types of vehicles have been available for many years and the open architecture allows for great flexibility.
There are, of course, other tax savings ideas that do not carry nearly the amount of risk that Opportunity Zones present. It would be prudent to consider and evaluate multiple strategies to evaluate the risk and reward inherent in each. One such strategy that is often utilized allows a seller of any capital asset to defer taxes for thirty years while getting cash at the time of sale. This is done with utilizing various installment notes in a specific, strategic methodology. While not available for all assets or for all amounts, the intention is to illustrate that there are often other, better, safer ways to reduce or eliminate capital gains taxes. Tunnel vision has many believing that Opportunity Zones are the only way or the best way to defer or eliminate capital games taxes. Many will be disappointed by this approach.
If Opportunity Zones were proven and exemplary from every aspect, we as charitable planning specialists would be delighted. In theory, this is exactly the kind of commitment we hope more high net worth investors make into their communities, so it’s truly an opportunity lost in our minds. The beauty of free markets and private wealth working to strengthen families and make direct investment into communities, deploying wealth for social good is the passion and the purpose to which we devote our life’s work. Unfortunately, however, the current state of Opportunity Zones appears to be the man behind the curtain pretending to be someone he isn’t.
Suzanne Jack is the principle of ADEO Financial, a national consulting firm emphasizing creative solutions for wealth transfer, philanthropy and income tax planning. She currently serves on the board of the Alliance Community Foundation.
Randy Fox is the founder of Two Hawks Consulting, LLC. His collaborative practice serves advisors to affluent families. He is a board member of Alliance Community Foundation and serves as editor in chief of Planned Giving Design Center
Randy and Suzanne are strategic alliance partners