Is Opportunity Zone Investing for You?
Most investors may be put off by the prospect of investing in run-down inner-city neighborhoods or tumbleweed-infested rural towns. However, a program included in the 2017 Tax Cuts and Jobs Act provides investors with a tax incentive to do just that. As a result, a new type of fund that invests in low-income neighborhoods has emerged, and investors and institutions alike are taking notice. Chances are you’ve heard of opportunity zones. If you’re wealthy enough, you might have been approached about investing in an opportunity zone fund. These new investments appear appealing, but they are not suitable for everyone.
The new OZ funds pool money from multiple investors and invest in businesses and real estate development projects in economically distressed communities identified as in need of investment by the federal government. Parts of nearly every major American city, including Chicago and Los Angeles, as well as all of Puerto Rico and remote towns in Alaska, are included among the more than 8,700 opportunity zones. Investors who invest in OZ funds can postpone and eventually reduce taxable capital gains, depending on how long they remain invested.
Tax relief on three levels. The tax breaks only apply to capital gains, but it’s a three-pronged incentive. To begin, you can defer federal capital gains tax on money earned from another investment by transferring it to an OZ fund. Assume you sell stock and make a $100,000 capital gain (though a gain on almost any kind of investment qualifies). If you roll over the $100,000 gain into an OZ fund within 180 days, you can postpone paying capital gains tax on it until you sell your stake in the fund or until December 31, 2026, whichever comes first. (The idea is to get investors to sell their existing investments and put the proceeds into an OZ fund.)
Second, the longer you keep your investment in the fund, the more you can reduce the amount of taxable rolled-over gain. Investors who hold the fund for five years get a 10% tax break on the gain; hold for seven years and you get another 5% break. For example, if an investor rolls $100,000 in capital gains from a previous investment into an OZ fund in 2019, she will owe capital gains tax on only $90,000 if she sells after five years and only $85,000 if she sells after seven years.
“The December 2026 date is set in stone,” says Frazer Rice, senior wealth strategist at Calamos Wealth Management, regardless of when you invest. Whether you sell or keep your investment in the OZ fund for the 2026 tax year, you must pay any federal capital gains tax you owe on the profits you rolled into the OZ fund.
Hold for ten years or more, and a third benefit becomes available: Any profit from your investment in the fund is tax-free if it was made with capital gains from a previous investment. Some funds require a 10-year commitment, but the vast majority allow you to sell at any time.
According to the National Council of State Housing Agencies, a nonprofit organization focused on affordable housing, 130 qualified OZ funds have opened since the tax act’s passage (it maintains a directory of OZ funds on its website, www.ncsha.org). The funds, which have assets ranging from less than $1 million to $3 billion, are mostly managed by investment firms and real estate developers.
For example, HHKirby Real Estate Ventures’ fund aims to transform a former cotton mill in Burlington, North Carolina, into a complex with a live event center, restaurants, and sports facilities. The North Country Opportunity Zone Fund, managed by American Ag Energy, a greenhouse construction company, invests in agricultural facilities in Berlin, New Hampshire.
According to Tim Steffen of Baird Private Wealth Management, as interest grows, high-net-worth investors may see OZ funds offered at larger money-management firms such as Charles Schwab or Merrill Lynch.
But not everyone is convinced. Most OZ funds require you to be an accredited investor, which means you must have a net worth of $1 million, excluding your primary residence, or two years of annual income of at least $200,000 if you’re a single taxpayer ($300,000 if married). Most funds also have a six-figure investment minimum.
Fee structures are like those found in hedge funds and private equity investments: Investors pay an annual fee of 1.5% to 2.0% in expenses and another 20% of any excess return a fund earns over the amount promised to the investor when they sell. According to Quinn Palomino, CEO of Virtua Partners, a private equity real estate development firm that offers opportunity zone funds, the typical promised rate of return for funds with diversified portfolios is between 6% and 10%, and higher for funds that invest in a single project.
Not quite ready for primetime. It’s too early to tell what kind of returns, if any, these OZ funds will provide, or which OZ funds are worthwhile investments. Indeed, the rules governing what an OZ fund can invest in and how it should operate are still being developed. This can be a problem because an OZ fund must follow a slew of IRS regulations. If it does not, it may be fined, or, worse, the fund’s investors will be ineligible for capital gains tax breaks.
An OZ fund must generally invest at least 90% of its assets in businesses located in a qualified opportunity zone. Many types of businesses are eligible under the current rules, but a few are not, including golf courses, massage parlors, casinos, and liquor stores. Nonetheless, Neil Faden, a partner at Manatt, Phelps & Phillips, a law firm that advises OZ fund managers, says that real estate development projects such as single- or multifamily housing and commercial real estate are typical investments.
If you qualify and want to invest in an OZ fund, think about whether the investment is good regardless of the potential tax benefit. “Don’t let the tax tail wag the investment dog,” advises Bill Smith, managing director at accounting and consulting firm CBIZ MHM.
Understand that distressed real estate transactions are inherently risky. “These funds don’t have a lot of beachfront property in Malibu.” “You’re investing in an area where people wouldn’t normally invest,” says Steffen.
The more serious issue is whether the manager is new or inexperienced. According to a survey conducted by alternative investment research firm Preqin, many OZ fund managers are untested.
Some research on the contractors and developers who will carry out the investment projects is also required. Ideally, an OZ fund should be working with established developers who have experience with the types of projects outlined in the fund’s documents. “A developer may have experience in hotels but not in multifamily housing.” “You can help mitigate some of the risks if you ask about these things before you invest,” Rice says.
However, with little track record, inexperienced managers, high fees, and a high barrier to entry, OZ funds are not suitable for retirement savings or money that cannot be lost or locked up for the required holding periods. They’re aimed at wealthy, savvy investors rather than average savers. “These probably aren’t for you if you’ve never invested in private equity or a closely held investment in which you’re a minority investor,” Smith says.