Circle of Competence Issue #41

Quote of the week: "The idea is to die young as late as possible" - Ashley Montagu, (George Bush in his late father's eulogy)

FOOD FOR THOUGHT

Opportunity Zones

This week we wanted to share some thoughts and links around Opportunity Zones, a feature of the tax cuts enacted in 2017. We have been studying these for a few weeks now and believe that these could be a huge boon to investors who 1) currently have a lot of capital gains taxes in certain investments or 2) wish to invest where capital will attract the highest return and suffer the lowest tax consequences and 3) will benefit communities that have been designated as opportunity zones.

For starters, what exactly is an Opportunity Zone? It is a census tract that has been designated by the state in which it is located as an area that will be eligible for investment from a qualified opportunity fund. These areas typically have at least a 20% poverty rate or a median income that is not more than the higher of 80% of the state or metropolitan area median income. Investors must register their fund as a 'qualified opportunity fund' and to remain eligible as such must invest at least 90% of its assets into qualified opportunity zones. In addition to the qualified opportunity fund requirements, there are specific and stringent requirements for how investors are to invest in real estate and in operating businesses inside of opportunity zones which can be found in the Bloomberg tax journal link and OFN fact sheet below.

So what's all the noise over these Opportunity Zones? It's all to do with tax implications. For starters, if you are currently sitting on large capital gains from other investments, you could roll those capital gains into a qualified opportunity fund and avoid paying those capital gains taxes until 2026 at the latest or until you sold your new investment. In addition, the longer you hold the new investment, the greater the discount you get off of your current capital gains. And finally (!), if you hold your investment for greater than 10+ years, you pay ZERO capital gains taxes on the gains from the new investment. Talk about a tax lollapalooza! We do wonder however about the second order effects of the policy, namely, the following questions we are continuing to ponder:

- How much gentrification will occur in these opportunity zones due to increases in capital flows into the area?

- Will these opportunity funds provide actual lasting value to the communities in which they are developing?

- Net net, will this policy create new jobs or just move them to opportunity zones?

- Will there be over-development or over-investment in these zones as funds move quickly to deploy capital before 2019 to fall in the 7 year capital gains discount? What if any is the implication on the cost of living when capital begins flowing into these zones?

- Will this result in a material portion of the $2.3 trillion outstanding capital gains being rotated out of richly priced assets into these opportunity zones, causing the highly appreciated investments to mean revert? E.g. FAANG stocks?

If you are a business man or woman doing deals or raising an opportunity fund in these areas, I would be most interested in talking with you about the geography that you are concentrating on, the mechanics of your real estate or operating business investments, and certainly any thoughts you have on the questions above.

To wrap it up, what I love most about this program is that it is incentivizing massive amounts of equity capital to rotate into areas that are the lowest on the socioeconomic scale. And it was a bipartisan program to boot. There is an estimated $2.3 trillion in capital gains outstanding at the moment waiting to be deployed into these opportunity funds. Suffice it to say, this is a massive opportunity - pun intended.

Links:

- Rich investors eye tax favored investment funds (WSJ)

- Bloomberg tax journal analysis on Opportunity Funds

- Opportunity Zone Fact Sheet (OFN.org)

- The Real Estate Guys Radio on Opportunity Zones

- The Alternative Investor Podcast on Opportunity Zones

Podcast

Last week I announced Neil and I would be starting a podcast. What I didn't realize, as the biblical proverb in Luke 14 goes, is that I grossly underestimated what a time suck it would be to produce the episodes on top of everything else I am personally involved in! So this will be a project that will have to wait, but on the upswing, Neil is still going to be helping me write the newsletter weekly and now you will have twice the amount of content to peruse!

Have a great week!

- Neil & Benton

ARTICLES

- Everything you need to know on Opportunity Zones (Bloomberg)

- Opportunity Zone fact sheet (OFN.org)

- Brookfield Asset Management Q3 letter to shareholders

- Seth Klarman's speech on short-termism and capitalism (Harvard Business School)

- Panera Bread's founder is on a quest to end economic short-termism (The New Yorker)

- Shane Parrish on what is staying the same (Farnam Street)

- Retail Dive's deep dive series on private equity buyouts and failures in the retail industry (Retail Dive)

- The yield curve just produced its first inversions (Bloomberg)

- The yield curve is inverting as long dated yields fall (WSJ)