Opportunity Zone Funds -- Risks and Rewards
Back in April the IRS published a second set of regulations providing clarity around Opportunity Zones. You may have heard of Opportunity Zones before, they were included in the 2017 Tax Cuts and Jobs Act. State officials were tasked with nominating up to 25% of their low-income census tracts as Opportunity Zones. There are over 8,000 zones throughout the country, and 72 in my home state of Connecticut. The aim of the program is stimulate private investment into disadvantaged areas that may otherwise not be able to attract investment by offering investors tax incentives.
Tax incentives for investors
There are three primary tax-based incentives for investors:
- Deferral of capital gains tax from other investments
- A step-up in basis of the capital gains invested into an opportunity zone
- Tax free growth of the Opportunity Zone investment if held for a total of 10 years
An investor sells a large tranche of stock and realizes $1MM of capital gains. The realized capital gain is invested in a Qualified Opportunity Zone Fund (QOF) within 180 days. After holding the interest in the QOF for a total of ten years, the taxpayer may sell the investment in the QOF at any time before 2048 and exclude the gain from the resulting sale. So for instance, if the $1MM capital gain grows to a $2MM interest in the QOF, after 10 years the investor's basis is stepped up to the $2MM and the $1MM gain from the sale of the OZF is forgiven. This is a rather simplistic example, but gives you a sense of how it works. The capital gains tax on the original $1MM stock sale is reduced by 10% if held in the fund for 5 years and by 15% if held for 7 years in the OZF.
The tax is always due on the original sale of the $1MM stock but it is deferred and 100% of the gain is invested in the OZF, so more of your money is working for you. The real kicker is if the OZF appreciates and you own the fund for 10 years, your appreciation in an OZF is tax-free when sold. That is the real benefit of investing in an opportunity zone -- 100% of your original gain gets to work in the fund and your appreciation in the OZF can be sold tax-free if held for 10 years.
Like any investment, there are risks. An investment in an Opportunity Zone Fund has several, here are some to consider:
- Lengthy holding period: Generally your investment is locked up for a very long time, 10 years if you want to realize the maximum tax advantages.
- High minimums: Most Opportunity Zone Funds have high minimums such as $100k or $250k. In addition, an investor generally has to be an "accredited investor" meeting certain income and net worth criteria.
- Fees: Most Opportunity Zone Funds have several layers of fees that can detract from performance including an upfront origination fee, performance fees, marketing fees, dealer origination fees and acquisition fees for example.
- Real estate development problems: An investment in an opportunity zone is an investment in an economically distressed town or city. These zones may not perform well relative to the broad real estate market.
- Competition for acquisitions and a flood of capital: There could be a large influx of money into Opportunity Zone Funds and managers of funds will have to deploy these funds. This could create competition for Opportunity Zone assets and may bid up the prices, causing inflated valuations. In addition, on the back end, if after 10 years investors want to redeem their shares in the fund, this could cause a wave of selling to meet the demand for distribution requests. This wave of selling could cause significant downward pressure on selling prices of assets in Opportunity Zones.
To help minimize the risk of an OZF, an investor should have other assets available so he or she can wait out the 10 year period. An investor should also realize there is significant risk that comes with investing in illiquid real estate in Opportunity Zones. Management experience is key when it comes to picking an Opportunity Zone Fund. Also, what is the type of asset the QOF is buying? Some only buy hotels for example. There are risks unique to the asset being bought by the fund. Investors should understand those risks.
Given all this investors may be dissuaded from investing in Opportunity Zone Funds. But it's hard to overlook the tax advantages. Deferring the gain on the sale of a capital asset and receiving a step up in basis down the road is a very attractive way to potentially grow one's net worth. Like all investing, it may come down to diversification. Using an OZF for only a portion of your net worth or a portion of the capital gain for example. Though the risks are real, Opportunity Zone Funds are unique and may not be available again in the future. If you'd like to learn more, including how to invest in an Opportunity Zone Fund, please feel free to call or email me.
My job is to help high-net-worth investors maximize their tax and financial planning opportunities. Sophisticated investors need sophisticated advice. -Michael Aloi