At Aperio, we’ve been asked by many wealth advisors and family offices about our views on opportunity zones (OZs), a tax incentive that allows for deferral and even elimination of some capital gain for taxable investors. In our view, the best way to look at these structures requires incorporating three different angles: 1) tax implications; 2) investment analysis, including risk, return, and asset allocation issues; and 3) social impact in cases where that’s a motivation for investors. To try to help address the questions advisors may have on the topic, we assembled a panel of experts across these three areas for a public discussion held in San Francisco on September 5, 2019. On the tax side, we were fortunate enough to hear from Orla O’Connor, a Tax Principal and part of the national team on OZs for KPMG. For the impact side, we benefited from the insights of Kunal Merchant, President and Cofounder of CalOZ, a nonprofit organization that sees transformative potential of OZs in California, and advocates for policy and legislative change. For investment analytics, we heard some research and analysis from Pete Hand, Aperio’s Director of Quantitative Strategies and Tax Economist.
Why was Aperio, which doesn’t offer OZ funds, sponsoring such an event? We wanted to encourage a holistic view that reflects all three areas, which is how we think good tax economics should be analyzed, i.e., incorporating together tax, risk/return, and impact (if applicable). In addition, we were responding to the high interest level and press coverage, such as an August 31, 2019, article from the New York Times, “How a Trump Tax Break to Help Poor Communities Became a Windfall for the Rich.”
As the panel addressed all of the issues, we saw that one of the risks of analyzing OZ investments is that so many concerns are in play at once that wealth advisors can easily lose track of all the competing goals. In addition, the panel emphasized how different every investor situation can be given unique tax considerations and asset allocations. Unlike some investment strategies where it may be appropriate for an advisor to apply a certain strategy across all clients, OZ strategies need to be tailored to the specific situation for each investor. For example, an investor who had a recent nondiscretionary capital gain (say, from an acquisition) might find the economics of tax deferral much more compelling than someone who is considering selling an asset in order to defer gain more advantageously through an OZ investment. The latter investor has the choice to defer for potentially many decades anyway, so the benefit may be far less valuable. Furthermore, those looking to eventually liquidate a position will generally have more favorable tax economics than those for whom an asset may pass through an estate or be donated to charity, as the liquidation savings from an OZ investment may not apply.
In addition to the focus on after-tax returns, the panel also pointed out the potential risk of underperformance on the pre-tax side, particularly around the possibility of price increases for real properties in OZs with good prospects for extra investment, a condition of the OZ tax break. In a June 2019 paper, researchers from the Massachusetts Institute of Technology and the University of Maastricht found some evidence that a price increase for “redevelopment properties” had already been captured by real estate owners as a result of the new tax incentive.1
As for the timing of investors moving capital into OZ investments, some on the panel commented that the extra incentive to invest in 2019 as opposed to waiting until 2020 or 2021 was potentially overblown. Participants speculated that allocations could even potentially increase in those later years as more sophisticated ways to capture the tax benefits are refined and implemented.
On the impact side, panel members pointed out that when such tax breaks are offered, a broad spectrum of beneficiaries will arise to fit any narrative, economic or political. With OZ investments, that range can span from unscrupulous fund packagers to compelling instances where local communities benefit enormously from the new structure.
Panel members mentioned that patient capital will be rewarded in OZ investments, and we’d suggest that patient analysis that incorporates all aspects of such an investment will also be the most likely to reap benefits. For those marketing OZ investments and those covering them in the press, simple soundbites and easy answers to the question of how good or bad these investments are may sell more than the unsatisfying answer based on the actual complexity of the real world: “Well, that depends.”
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