Opportunity Zone Investing: What Advisors Should Know About Deferring K-1 Gains

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.