There appears to be some confusion among financial advisors about the deferral opportunities related to gains allocated on an investor’s K-1 related to potential investments in opportunity zones. For investors considering deferral of allocated K-1 gains to reduce their current tax liability for 2018, the deadline for making the deferral election is rapidly approaching.
I have been discussing some of the key issues impacting an investor’s election to defer with advisors to provide them with a decision-making process that maximizes the investor’s options with respect to investing allocated K-1 gains in opportunity zones.
Most investors are aware of the benefits of deferring K-1 gain allocations and making opportunity zone investments, including a potential 15% reduction of the taxes due in 2026 if the deferral occurs before Dec. 31 of this year and the exclusion of any gains realized on their opportunity zone investments if held 10 years. However, failure to make a deferral election within the specified time period eliminates any chance for the investor to take advantage of the deferral benefits provided by the new tax law. While advisors are aware of these tax benefits, many are unaware of the strategies that can extend the investor’s timeline to make a final decision on deferring gains and for finding appropriate investment opportunities in opportunity zones.
The law provides investors with 180 days to make the deferral election. K-1 gain allocations are deemed to have been realized by an investor on Dec. 31, so the 180 day period ends on June 28. For investors to be fully protected, they should make the deferral election of K-1 gains no later than June 27 so that the proper paperwork can be filed within the 180-day timeframe.
Setting Up a Qualified Opportunity Fund
To fund the deferral of K-1 allocated gains, an investor does not need to use funds from the investment generating the gain. A deferral election can be made for tax purposes with the funds capitalizing the Qualified Opportunity Fund (“QOF”) coming from any source including funds that are borrowed on margin or under a loan agreement. This allows investors to maintain their investment in the fund generating the K-1 gains while simultaneously deferring the tax on those gains until 2026. Advisors should be aware that an investor can borrow funds to create and capitalize a QOF. For certain investors, this capability can create additional tax benefits depending on the source of the borrowed funds.
In addition, investors can defer all or part of a realized gain or an allocated gain appearing on a K-1. Should an investor generate a $5 million gain on the sale of Google stock, for example, the corresponding tax on any portion of that $5 million gain can be deferred. For investors receiving allocated gains on K-1s, the same holds true where all, or a portion of, the tax attributable to allocated gains can be deferred.
As an example, for an investor who is allocated $2 million in short-term capital gains and $2 million in long-term losses on multiple K-1s and realizes $2 million in long-term capital gains from various sales of portfolio securities, an investor would owe $750,000 in federal income tax at the highest marginal tax rate of 37%. However, if the investor chose to defer the $2 million in allocated short-term capital gain income, the current federal tax liability would be eliminated as the LTCG and LTCL net to zero, and the liability would be deferred and due in 2026. This example reflects the current impact on federal taxes at the highest marginal rate with no consideration for state tax impact. For investors in states with high marginal state tax rates, the savings could be more significant.
If the investor has provided for the $750,000 tax liability in their estimated tax payments, making the deferral election by June 28 gives the investor until Oct. 15 (the date returns are due for those filing extensions) to find suitable opportunity zone investments without any risk of penalty or interest. Effectively, making the deferral election and creating a QOF gives the investor an additional 3½ months to consider whether making Opportunity Zone investments are appropriate for them. However, failing to make the election by June 28 terminates any ability the investor has to reduce their 2018 tax liability through this deferral opportunity.
Significant Tax Planning Opportunity
The benefits of opportunity zone investing through the deferral of capital gains represents a significant tax planning opportunity for high-net-worth investors. Investors making the deferral decision should have sufficient resources to support their lifestyle as the law requires holding opportunity zone investments for a minimum of 10 years to obtain the full tax benefits.
For investors interested in deferring current tax liabilities, setting up a QOF before the 180-day period for allocated K-1 gains expires gives the investor optionality. When creating a QOF, the structure should anticipate and manage for potential tax consequences over the long investment holding period. Furthermore, using a pre-designed QOF structure can reduce costs and decrease the time necessary to form and fund a QOF.
To Defer or Not to Defer
We are constantly asked what the consequences would be for deferring a gain currently but ultimately failing to find suitable investments to deploy capital into opportunity zones. While the consequences can’t be fully anticipated, an investor would likely be required to pay the tax that would have been due if no deferral election was made plus late payment interest. The potential of penalty assessment remains unclear for investors who create a proper QOF with documented intention to deploy the capital in accordance with the law and corresponding regulations.
As the implications of updated rules and regulations related to investing in opportunity zones become clear, investors are becoming more comfortable with making these investments. Advisors need to be prepared to help their clients evaluate the deferral decision. Given the ability to minimize the risk, if the client believes they have an interest in pursuing investments in Opportunity Zones for whatever reason, we advocate making the deferral election before the expiration of the 180-day deferral period. If, after further consideration, the investor decides not to pursue these investments, the QOF can be unwound with limited cost and consequence.
Sam Weiser is the founder and CEO of JMP OppZone Services and oversees the operations and growth of the company’s financial and administrative platform for opportunity zone participants. Weiser has over 30 years’ experience as a C-level executive in asset management, operational consulting, fund operations and management.