I began trading at 26 years old and spent the next ten years of my life in the Eurodollar pits of the Chicago Mercantile Exchange competing against banks and hundreds of other traders. My ability to process information in fractions of a second and my work ethic were the keys to my success. Vacations and lunches were a rarity as leaving the pit for even an hour could have an opportunity cost in the tens of thousands of dollars. I knew those days would eventually end, but it wouldn’t matter because I would have amassed enough wealth to set me up for life. I had experienced a great run, but around my tenth year of trading, I was ready to step away. I retired from trading in 2005 and faced a different financial challenge, now that my day trader income went away entirely.
Rearranging my investment portfolio to grow my assets and produce a passive income stream was my primary goal. I had liquidity, assets and investments but my portfolio wasn’t constructed to support me in life after trading. I suddenly found myself living off the cash I had saved from my day trader income and the principal of my investments. I needed to replace this active day trader income with a passive income stream without depleting my asset base. Having your assets work for you is the hallmark to staying wealthy and was one of my overarching goals for investing in real estate.
Being asset rich but cash poor is a recipe for disaster and having too much cash isn’t wise either. There are countless stories of wealthy individuals who chose to spend their hard-earned money on boats, cars and vacation homes only to sell them for pennies on the dollar when the money ran out. While those items qualify as assets, they don’t qualify as investments. Keeping your money under the mattress isn’t wise either because tomorrow’s dollar is worth far less than today’s. You would have been in a very elite class in 1980 if your net worth was more than $1 million but that amount of money doesn’t go very far today.
Also, the government doesn’t make it easy for Americans to earn their way to wealth. With every government body looking for revenue to pay ballooning debts and an ever-increasing pile of bills, tax laws are generally bad news for high income earners. Illinois just increased its top tax rate to 7.99%, California’s tax rate is more than 12%, and a handful of states are in excess of 10%. When you add those rates to the highest federal tax rate of 37%, high income earners are paying close to 50% of their income to the government. And, that doesn’t include all of the other taxes such as sales and property tax and certainly doesn’t take into account the much talked about “wealth tax.”
However, some tax laws are incredibly beneficial to high income earners and it’s more important than ever today to figure out how to use them to your advantage. The Qualified Opportunity Zone program is one such law to pay attention to, as it provides some very favorable tax benefits. The program was one of the provisions within the Tax Cuts and Jobs act of 2017 and incentivizes the investment of capital gains by offering the deferral, reduction and elimination of taxes for those who invest in a private real estate QOZ Fund. A QOZ Fund in turn must invest in a business or property in an “economically distressed” area as defined by the U.S. Census Bureau.
The purpose of the law is to create jobs and improve under-served areas by unlocking the trillions of dollars in capital gains held by wealthy individuals. Investing in a QOZ Fund is really no different than investing in a traditional real estate fund or deal. Many of the best risk-adjusted real estate investment opportunities are located on the perimeter of the designated opportunity zones and are opportunities you would want to invest in even without the tax breaks.
For some commodity traders, the QOZ program is especially interesting because 60% of commodity day trader income is classified as a long-term capital gain and 40% is categorized as a short-term capital gain. This means that this income qualifies for the tax benefits of the program, whereas income from a W-2 employee does not. However, not all trader income qualifies and anyone with 1256 income considering a QOZ investment should consult with their tax accountant prior to investing. Even if your day trader income doesn’t qualify, you still may have capital gains to invest from the sale of stock, real estate, or some other appreciated asset.
Here’s how the Qualified Opportunity Zone Program works in practice. If you have a $1 million long term capital gain in 2019, your federal tax liability will be a little more than $200,000 and would be payable in 2020. You can reduce or eliminate this tax liability by investing $1 million in an Opportunity Zone fund. You won’t have to pay any tax on that gain in 2020. However, this tax is deferred, not eliminated. It still must be paid, but you don’t have to recognize it as income until tax year 2026, which allows you to invest the tax liability through 2026 and into 2027, when the tax is due. The opportunity to invest $200,000 for seven years can be very lucrative in the right investment. The tax deferral is just the first of three benefits and isn’t nearly the best benefit.
The second benefit is a tax reduction, or what’s referred to as a step-up in basis, which means that the $1 million gain will be reduced by 15% if the investment is made in 2019 and reduced by 10% if the investment is made in 2020. In other words, a $1 million investment made in 2019 will be recognized as an $850,000 gain in 2026. The biggest risk with the deferral is that tax rates are much higher in 2026, but the step-up in basis somewhat offsets this risk.
The last tax benefit is by far the best. An investment in a QOZ fund held for more than 10 years grows tax free. In other words, if your $1 million investment grows to $3 million and you sell it in 10 years, no taxes are due. If you hold it for 20 years and it grows to $5 million and you sell it, you pay no taxes. The QOZ tax benefits have the potential to increase your after-tax returns by more than 75%* as compared to an investment in a traditional real estate fund with the same return potential. QOZ investments enable individuals to create wealth in one of the most tax-efficient manners.
A QOZ Fund will generally be engaging in ground up development because the law requires the Opportunity Zone fund to more than double the basis of the acquired property. While this is a riskier investment, the development phase is only two to three years of a ten-year hold and it’s also where the most value is created. This is where most of the wealth creation happens in real estate and where your wealth will compound. For example, once all our assets in the Origin QOZ Fund have been developed, the Fund will produce ample cash flow (between 6% and 10% of invested equity) from the portfolio of stabilized assets for the next seven or more years, depending on when you decide to sell. Combining the development phase with a long-term cash flowing phase solves the age-old issue of growing and protecting your capital, while also building a passive income stream. Plus, investments can be made into QOZ Funds until 2026, so individuals can ease into real estate over time and use this as a tax shelter for the next several years.
There’s no better asset class than real estate to grow wealth and deliver a tax-efficient income stream. This law is only beginning to gain traction and early movers will be rewarded for tying up quality sites and being first to market. Having a tax-efficient investment strategy is imperative to staying wealthy and this new law provides a mechanism to achieve this. If you have ever considered investing in real estate, this law tilts the after-tax risk adjusted returns heavily in your favor. It not only provides an immediate tax break but also sets you up perfectly for life after trading. QOZ investing can replace a significant portion of your active day trader income with a passive income stream, setting you up for continued success in the future.
*Assumes 2.5x equity multiple return over 10 year period. Assumes deferred taxes on original capital gains with 15% step-up in basis return. Assumes same investment basis as equivalent taxable investment ($762,000). For the full analysis in greater detail, download the Fund Overview.
The views expressed herein are exclusively those of Michael Episcope, are not meant as investment advice and are subject to change. This information is prepared for general information only. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. You should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed or recommended in this article.