Welcome to Financial Advisor IQ
Follow

“Roth IRA for the Rich” Could Erase Capital Gains Tax Liabilities – and Family Offices Are Loving It

By Miriam Rozen November 13, 2018

Financial advisors and lawyers continue to puzzle their way through a stack of unanswered questions about the Qualified Opportunity Zone program established by 2017's Tax Cuts and Jobs Act. The program provides a tax incentive for clients to make long-term investments in 8,700 communities nationwide, which the U.S. Treasury and Internal Revenue Service have designated as economically distressed “zones.”

Known by its acronym QOZ, the program offers investors the potential to defer capital gains taxes -- and even avoid them, if they invest for the long haul – with the maximum tax benefits requiring a 10-year commitment. Given QOZ’s tax-sheltering potential, despite the vagueness that remains about all the program’s rules, advisors and lawyers remain optimistic about its potential as a marketing storyline they can rely upon to generate more transactional work.

“I think we are getting more comfortable with this now,” says Christopher Pegg, a senior director of wealth planning for Wells Fargo Private Bank. “The good news is that the overall theme is: follow the statute, and use the purpose of the new law, economic development, to be your polestar.” Under those parameters, the IRS is not expected to create “onerous restrictions,” Pegg says. But “a number of ambiguities still exist about how the rules should be interpreted,” he stresses.

In late October, the Treasury and IRS published an initial set of proposed QOZ rules, and are expected to issue additional rules within the next few months. Government officials in all 50 states, Washington, D.C., and five U.S. territories initially nominated communities for “zone” designation, based in part on the poverty levels of the surrounding neighborhoods’ populations. Treasury Department officials made the final decision about which neighborhoods made the list.

Under the program, if investors make an eligible investment in one of those zones, they can put off paying taxes on the equal amount of capital gains until the end of 2026. Almost all types of capital gains – no matter if earned on real estate, stocks or bonds – may qualify for the tax deferral. But between 90% and 70% of the capital gains on which the deferral is sought must be invested in one of the designated zones through a Qualified Opportunity Fund, or QOF, which investors can set up on their own and on which they can self-report.

With the federal agencies' release of the first set of rules, Treasury and IRS officials answered one of the most frequently raised questions about the program: What are investors required to spend on improving assets they purchase in order to qualify for the tax deferral? According to the IRS, investors must make “substantial” investments — which generally means one dollar of improvement for every one dollar of purchase price – within 30 months after purchase of an asset.

“So, this is not a moment you can become a slum landlord. You have to create economic growth in those areas,” Pegg says.

But “there are so many questions that still need to be answered,” says James Hickey, chief investment strategist for HD Vest Financial Services, an Irving, Texas-based firm which has a roster of roughly 4,000 advisors specializing in both tax and investment planning.

Is there a certain date, for example, when tax deferral opportunities expire? Can you sell the property to a REIT? “We don’t know for sure,” Hickey says about both questions.

Despite the uncertainties, Hickey says: “I think this is going to be a boondoggle for family offices.” Already, Hickey and other advisors have heard about family offices forming teams to scout for opportunities to invest in the designated zones.

What about his firm? HD Vest’s advisors “are genuinely interested in this. Some of them are championing the idea, but we are stuck in a wait-and-see mode,” he says. “The last thing we want to do is set up a QOF and find out it’s fundamentally flawed,” he adds.

James Ray, a financial advisor with IHT Wealth Management in Skokie, Ill., with more than $1 billion under management, also expects family offices to “glom onto this thing.”

The excitement over the new program is created in part by the coincidence of more than a decade of mostly bull markets, Ray says.

“It’s a really timely topic because what we are starting to see is folks who have accumulated some massive capital gains. They now have with this an opportunity to diversify,” Ray says.

The IHT Wealth advisor views the program as a “Roth IRA for the rich,” given the tax advantages clients gain if they keep their stake in the eligible investment for 10 years. Specifically, clients do have not to pay taxes on any capital gains they earned from their investment in one of the zones, other than 85% of what they owed on the taxes they deferred until then.

James Hickey

Alan Landzberg, counsel at Manhattan-based law firm Windels Marx Lane & Mittendorf, says the government took “a big bite” out of the list of questions with the IRS and Treasury guidance issued in October, but “additional information is needed. We are looking at loads of people talking about this, but I haven’t seen anybody close a deal yet,” he says.

But already funds have been established to make those deals happen. In October, PNC Financial Services Group, which owns the largest shareholder stake in BlackRock, disclosed it had raised $486 million for a fund that will target investments in the zones and will likely start another fund for the same purpose.

For financial advisors, the task of evaluating those new funds will present steep challenges, Wells Fargo’s Pegg says. “They are going to have no track record. No one has been in the business of crafting funds that are so curtailed by the tax code. It’s going to be hard to find sufficient comparable data.”