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your taxes 2019

‘Opportunity Zones’ Offer Tax Breaks and, Maybe, Help for Communities

By enabling investors to postpone paying the tax man, new funds may draw money into distressed communities. But succeeding at both may be challenging.

Credit...Delcan & Company + Saad Moosajee

Affluent people have a new option for fending off the tax man: opportunity zone funds, which were included in the 2017 tax law as a way to help distressed neighborhoods.

The funds are spurring interest among investors as a way of deferring and reducing capital gains. But whether they will substantially help needy communities is another question.

Critics say that too often, the zones target the wrong districts. Amazon’s proposed corporate campus in Queens fell in areas designated as opportunity zones. The issue became moot when Amazon announced it would pull out of its planned New York headquarters.

An Urban Institute analysis found that more than a quarter of designated zones already had relatively high levels of investment.

Timothy Weaver, an assistant professor of political science at the University at Albany, said the notion of tax-favored development zones has been tried before, often with lackluster results.

“Money flows into the safe bets,” he said. He cited Louisville, Ky., where some areas that are already being gentrified have been designated as opportunity zones while some poorer tracts have not. “There’s no question,” he said, “that the primary beneficiaries of the program are the investors.”

But in financial markets, opportunity funds are creating a buzz. “It’s arguably the most significant tax break in decades,” said Ben Miller, co-founder and chief executive of Fundrise, a real estate crowdfunding site that is sponsoring an opportunity fund.

Based on recommendations from state governments, the United States Treasury has designated more than 8,700 eligible census tracts in urban, suburban and rural areas across the country.

The opportunity funds are the vehicles for investing in these zones. The idea is that investors get federal tax breaks, while the neighborhoods get new businesses and upgraded properties, like apartment buildings, retail shops and hotels.

But the rules are complex, and the Treasury and the Internal Revenue Service didn’t clarify many details until October; more guidance is still expected. The recent government shutdown didn’t help.

That said, opportunity funds are beginning to gain steam. The main questions for investors — such as what kind of investment gains are eligible for investment in an opportunity fund — generally have been answered, Mr. Miller said.

“The benefits are pretty significant,” Mr. Miller said.

Opportunity funds let investors postpone federal taxes on recent capital gains until the end of 2026; they can also reduce the taxable portion of those gains by as much as 15 percent, after seven years. Further, investors can eliminate taxes on additional gains from investing in the fund itself, if they hold the investment for 10 years.

So, if you have investments that have appreciated, you can defer capital gains taxes by selling the investment and reinvesting the money into an opportunity fund within six months. Almost any sort of capital gain qualifies, whether from the sale of stocks or mutual funds, or other investments, including the sale of real estate or a business. (One investor in Fundrise’s opportunity fund, Mr. Miller said, invested a gain from the sale of a dialysis clinic.)

Just the gains on an investment — rather than the entire proceeds of a sale — must be reinvested in the opportunity fund. That’s “highly unusual” and one reason opportunity funds may appear attractive, said Jeffrey Levine, chief executive of BluePrint Wealth Alliance.

Say you sold stock for $500,000, and $300,000 of it was a gain. Just $300,000 must be rolled into the opportunity fund and the remaining $200,000 can be used as the seller wishes, according to an example provided by Tim Steffen, director of advanced planning at Baird Wealth Solutions Group, part of Robert W. Baird & Company.

By putting money in the fund, investors not only delay having to pay tax, but are also eligible for a partial exclusion of the tax on the reinvested gains. If you remain in the fund for five years, you will reduce the taxable gain by 10 percent; if you hold it an additional two years, for seven total, you will further reduce the taxable gain by another 5 percent.

So, continuing with Baird’s example of the $300,000 reinvested gain, you would be taxed on $270,000 after five years, and on $255,000 after seven, assuming you made the investment in time to meet the various thresholds.

“It wipes out a portion of the gain,” said Mike Windle, a partner with C. Curtis Financial Group in Plymouth, Mich.

In addition, any profit you earn on your investment in the new fund is tax free, if you remain invested for 10 years. However, you must pay taxes on the initial gain that you rolled into the fund no later than Dec. 31, 2026, regardless of whether you remain invested in the fund, said Hal Zemel, a tax partner with the New York accounting and advisory firm Berdon.

The funds are generally not for small-time investors. Minimum investments are hefty — often at least $50,000 to $100,000 and, in some cases, much higher.

While the tax benefits are enticing, investors should consider that property development has its own risks, and zones targeted by the new funds are, by definition, intended to be in areas where development generally hasn’t occurred on its own.

Because the funds are so new, it’s uncertain how profitable they are going to be — and much may depend on the developers. “Picking a manager is critically important,” said David Coelho, chief investment officer for opportunity zone strategies at Bridge Investment Group, a real estate investment firm.

“It’s a bit of the wild West out there,” Mr. Zemel said. “You really have to do your due diligence.”

Mr. Levine said he was cautious about recommending opportunity funds to clients. “The last thing you want to do is take your gain, get blinded by a tax benefit, and lose your money,” he said.

It’s likely, he said, that local developers who already had projects underway in the designated zones will benefit most.

State governors naturally wanted to designate opportunity zones in areas most in need of capital, but some neighborhoods may be too depressed to appeal to investors, said Avy Stein, co-founder of Cresset Wealth Advisors, which is a partner in an opportunity fund. He said he considered many of the zones in Illinois to be particularly challenging for investors, while areas of California and the Pacific Northwest, along with Houston, Nashville, Omaha, New York and Washington, D.C., were more promising.

Fundrise is targeting areas in Atlanta, Los Angeles, Seattle and Washington, D.C., as well as the Bay Area, including Oakland and San Jose.

While it may appear that some areas had enough investment before their designation as opportunity zones, he said, a closer look reveals a more nuanced picture. For example, he said, the Manchester neighborhood of Richmond, Va., has had “pockets” of intense development but needs help to keep the momentum going.

“Lack of further investment risks the failing of neighborhood redevelopments to date and a spiral back into decay,” Mr. Miller said.

A version of this article appears in print on  , Section BU, Page 9 of the New York edition with the headline: Opportunity Zones Knock for Investors. Order Reprints | Today’s Paper | Subscribe

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