David from Placencia in Belize asks:
“I was wondering your thoughts on opportunity zones. Specifically do you feel this can trigger a mass exit in the market that will drop stock prices for ones wanting to get into Opportunity Zones and trigger a crash or at least a a major correction?”
David, that’s a great question.
First let’s define the opportunity zone and what it’s used for, and then we’ll talk about the source of funds for opportunity zone investment.
Opportunity Zones are low income census tracts nominated by governors and certified by the U.S. Department of the Treasury into which investors can now put capital to work financing new projects and enterprises in exchange for certain federal capital gains tax advantages. The country now has over 8,700 Opportunity Zones in every state and territory.
They make up about 25% of the low income areas in the country.
Opportunity Funds are new private sector investment vehicles where the fund must invest at least 90 percent of their capital in qualifying assets in Opportunity Zones. Opportunity Zone investments offer a number of benefits for the investor.
- A temporary tax deferral for capital gains reinvested in an Opportunity Fund. The deferred gain must be recognized on the earlier of the date on which the opportunity zone investment is sold or December 31, 2026.
- A step-up in basis for capital gains reinvested in an Opportunity Fund. The basis of the original investment is increased by 10% if the investment in the qualified opportunity zone fund is held by the taxpayer for at least 5 years, and by an additional 5% if held for at least 7 years, excluding up to 15% of the original gain from taxation.
- A permanent exclusion from taxable income of capital gains from the sale or exchange of an investment in a qualified opportunity zone fund, if the investment is held for at least 10 years. (Note: this exclusion applies to the gains accrued from an investment in an Opportunity Fund, not the original gains).
So virtually any capital gain would qualify to be reinvested in an OZ fund. You might have made a ton of money in, say, Bitcoin, or a piece of rare art work.
There is a ton of money in the stock market. But remember, less than 10% of the transactions on the stock market are made up of actual bona-fide value investing. About 90% of the volume on the stock market are program trades by the brokerage houses for their own account or for institutional investors. Those vast sums of money are largely seeking arbitrage profits. These short term trades fall under the category of trading, and not investing. The hold period is often too short to be considered eligible for treatment as a capital gain.
There are likely a spectrum of opinions on the topic and there are likely people who disagree with me.
I really don’t see the advent of opportunity zone tax sheltering as driving a selloff in the equity markets. There is a mismatch between liquidities in those two types of investments. I really don’t see stock market investors who have the ability to execute a trade on a moments notice then agreeing to tie up their money for the next 10 years. I think those investors are fundamentally different investors. Most of the long term money in the stock market is in the form of mutual funds, and a lot of that money is tied up in retirement accounts.
I expect that the majority of money going into opportunity zone investments is going to come from the sale of businesses where there is a substantial capital gain from a single event, the sale of other real estate assets where the purchase of a suitable replacement asset is proving to be difficult under a section 1031 exchange.
