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Treasury Finally Gives Much-Anticipated Tax Shelter Guidance For Wealthy Investors

By Miriam Rozen April 22, 2019

Anticipation ended last week for financial advisors aching for more regulatory clues from the U.S. Treasury Department about the tax-sheltering Opportunity Zone program.

On Thursday, Treasury officials issued 169 pages of new guidance about the program. So, as much of the nation waited for the release of the 400-page redacted Mueller report, financial advisors, lawyers and accountants pored over the newly-proposed Opportunity Zone regulations.

The newly-proposed rules translate into more clarity and more flexibility for investors in the Opportunity Zones, particularly those seeking stakes in operating businesses, and not just real estate.

Opportunity Zones entered the investment world’s lexicon with the passage of the Tax Cuts and Jobs Act of 2017. With that legislation, Congress identified capital gains tax relief as a way to induce investment into long-neglected U.S. neighborhoods.

Ultimately, the Treasury approved some 8,700 census tracts located in all 50 states as economically disadvantaged enough to be eligible for Opportunity Zone investments.

With the program, investors may be able to defer capital gains taxes — and even avoid some entirely — if they use recently-realized capital gains to buy stakes for the long haul in the designated communities.

To achieve the maximum tax benefits, investors are required to make a 10-year commitment, and to receive maximum tax-sheltering benefits investors must purchase their stakes by a December 2019 deadline.

The newly-proposed rules make the program attractive not just to investors purchasing real estate assets, but also to those acquiring stakes in operating businesses. The previously proposed Treasury rules for operating business investments had been off-putting and vague.

The Treasury’s newly-proposed rules will be game-changers for many investors and their financial advisors. The guidance “brings added regulatory clarity for investors, fund managers and others seeking to bring much-needed equity capital to operating and real estate businesses in OZs,” concludes Michael Novogradac, a managing partner and CPA of Novogradac, a professional services organization that had focused on Opportunity Zones. “The biggest takeaway is that the guidance addresses gating issues that were limiting OZ-incented investment in operating businesses,” Novogradac says.

Specifically, Treasury officials adjusted and broadened the options of how operating businesses in the zones could qualify investors for the tax shelters, Novogradac writes. The previously-proposed set of regulations stipulated as qualifying only operating businesses generating at least 50% of their gross income from trade or business in the zone.

But the newly-proposed rules specify several options to meet the 50% requirement.

The operating businesses qualify investors for the tax shelter if half of the products sold, or services performed for customers or clients, are generated in the zone — with either employees’ hours or wages as the measuring criterion. (Independent contractors’ compensation also counts.)

Alternatively, investors also qualify for the tax breaks if the operating businesses have tangible property in the zone, or management and operational functions take place in the zone, and either of those generate 50% of the company’s gross income.

“Now we have a bunch of regulations and actually know what this means,” says Neil Faden, a law partner at Manatt, Phelps & Phillips in New York, who has helped organize Opportunity Zone funds and has counseled investors eyeing the zones.

The new rules allow qualified Opportunity Zone funds that own operating businesses to hold away cash “working capital” for 12 months, without losing the tax benefits, Faden says. Otherwise, the rules require 90% of a fund’s assets be invested in zone-located operating business or real estate.

The newly-proposed rules also give operating business the flexibility to lease property, which will help them avoid capital inefficiencies, Faden says.

For both investors in real estate and operating businesses, the Treasury clarified what happens if they die before the end of the 10-year required investment period for the full tax benefits, both Faden notes. The good news: Their heirs continue to eligible for the capital gain tax exemptions.

But don’t expect any sudden new strategies to surface because of the Treasury guidance at Wells Fargo Advisors’ parent bank’s ultra-high-net-worth advisory unit, Abbot Downing.

“Nothing changes our strategy of what we offer clients,” Lisa Featherngill, head of legacy and wealth planning for Abbot Downing, writes in an email after she read through the proposed new rules. In part that’s because the Treasury’s proposals were ones “we anticipated,” Featherngill writes.

As FA-IQ previously reported, UBS and Morgan Stanley have added private placement Opportunity Zone funds to their roster of investment products available to clients. Bank of America’s Global Wealth & Investment Management unit and Abbot Downing are also preparing to add such funds.

The Treasury has not completed its rulemaking at this stage. It will accept comments on its guidance for the next 60 days and has scheduled a public hearing on July 9 for the newly-proposed rules. It also is expected to issue additional guidance, perhaps before then.

“There remain questions and there will new ones,” Faden says.