Will the current stock market volatility lead to a massive selloff?
“There is simply no telling how far stocks can fall in a short period”. This is from one of the premier investors of our lifetime, Warren Buffet, in his recent letter to shareholders in February of 2018. He’s referencing a number of market downturns and crashes since he began investing 6 decades ago. In fact, since the end of WWII, the US economy has gone into recession every seven years. Until now. As the United States heads toward an 11th year of consecutive economic growth, it is time to address the roughly $6.1 trillion in unrealized capital gains, the majority of it held by American households.
Total Amount of Unrealized Capital Gains in America
Don’t let this $6.1 trillion number get you too excited just yet. Lets take a look at this number to decipher what it really means. According to the US Department of Commerce, the total amount of unrealized capital gains in America right now is made up of gains held by corporations and gains held by households. At $2.3 trillion dollars of unrealized capital gains, Corporations are actually sitting on less profits than American households, holding the remaining $3.8 trillion. So how do we classify these two groups and how does this classification affect Qualified Opportunity Zones (QOZs)?
What Are “Unrealized Capital Gains”?
First, lets look at what we mean by the term ‘unrealized capital gains’. For many in the financial industry, the meaning is simple. But for others, it may not be so straight forward. An unrealized capital gain is any profit earned from the sale of property or of an investment. For instance, if you invested $10,000 in stocks in 2015 and you sell these stock positions in 2018 for $15,000, you have earned a capital gain of $5,000. By law, if you invest in America, you must pay a federal capital gains tax of 23.8 percent on the profits you’ve made during the lifetime of the particular investment. In our stock case above, you would pay $1,190 in capital gains taxes ($5,000 x 23.8%). Your total after-tax profit would be $3,810. Likewise, if you bought your house 20 years ago for $200,000 and sold it in 2018 for $300,000, your capital gains would be $100,000, and your tax owed would be $23,800, making your after-tax profit $76,200 ($100,000 x $23.8%).
But what if you haven’t sold your stocks or your real estate? What about mutual funds, IRAs, income properties and other types of investments? If you were today to go into your stock portfolio and calculate the increase in value from the time you purchased and appraised your house or income properties to find the increase in value, you could add these together to find your household unrealized capital gains. If we were to add these up across America, the total, according to the US DOC, would equal roughly $3.8 trillion.
Corporations are not too far behind. Over the past decade, American corporations have purchased an astonishingly high amount of stock back from their investors. These corporations have been sitting on large piles of cash and have been using it to purchase their own stock back on the open markets. After the recent Trump tax cuts in 2017, US corporations reportedly purchased $437 billion worth of stock buybacks with the money they saved. Companies buy back their own stock for a number of reasons, one of which is to keep the price high by driving up demand for a more limited number of shares available. Another is that this then creates less equity to flow away from the company if that company feels that tougher times are ahead and they’re going to require all the profits they can earn. But the biggest reason we’re seeing now is that, with fears that the economy is beginning to slow, they need to do something with this cash before the downturn to ensure their companies do not sink as far as their competitors.
This leads us into our assessment of what this $6.1 trillion in unrealized capital gains, with the focus on the that portion held by American households, means to the overall economy. What happens when the market begins to turn? We’ve had 10 years of a predominantly bull market, exceeding by nearly three years the average run by the US economy. Those who see the markets beginning to soften, including stocks and housing, will soon be looking for a way out. But to sell means immediately losing 23.8% of your gains to taxes. For American households, this number would mean a staggering $900 billion windfall in taxes paid to the US government the moment they receive their profits. And herein lies the key to the value of Qualified Opportunity Zones.
Over the past 10 years, the US economy has not flourished completely and thoroughly. There remain pockets of each state in many cities and counties that did not see the gains that the rest of the nation enjoyed. These areas were scrutinized by economists and federal and state law makers until 8,700 census tracts were identified and then chosen to be labeled QOFs. Now, anyone selling their stocks, mutual funds, IRAs, residences, income properties or any other type of long-term capital gain can defer these tax payments until 2026. Those holding these investments for longer than five, seven and 10 years respectively can even step up their basis on the original investment, meaning that the capital gains tax they pay will be only on 90 or 85 percent of their total investment. And those holding these investments for over 10 years will pay zero capital gains on the investment located in the QOZ. These investments can include anything from real estate development to business, with a wide range of possibilities to drive growth into these underserved communities. In essence, instead of this 23.8 percent tax going to the government, it will be going instead to these underserved areas to finance growth and opportunity. Or so the minds behind this plan are hoping.
What does this all mean for Opportunity Funds
So what does this all mean for Opportunity Funds and the projects they are funding? Simple; as the economy slows and US investors begin to calculate their tax implications, Opportunity Funds will be ready to take this money and deploy it to QOZ projects over the next few years. Many restrictions apply, but those investing their money into a fund before the end of 2019 will see the most benefit. As we have yet to see what the next economic recession looks like, we do know one thing for certain: its coming. How bad, and to paraphrase Warren Buffet, ‘how far stocks can fall in a short period’, nobody knows… except maybe Warren himself. But he doesn’t seem to be telling anyone.