Weighing the Pros and Cons of Qualified Opportunity Zones

Monday, February 18, 2019

By Matthew Camrud, CFP® and Brian Tall

The idea of designating economically distressed communities as Qualified Opportunity Zones was introduced in the Tax Cuts and Jobs Act of 2017. The Q&A below provides background on this new tax provision, explains the tax treatment of these investments over time, and evaluates possible avenues for investing in these zones.

Q: What is a Qualified Opportunity Zone?

A: In establishing the Qualified Opportunity Zone program, governors from each state were asked by the Treasury Department to nominate specific low-income communities that stood to benefit from increased investment—places underserved by existing private industry, but with clear growth potential.

The Qualified Opportunity Zone program encompasses 8,760 census tracts containing more than 31 million people within the United States. The final tracts approved by the Treasury Department have an average poverty rate of 31 percent (compared to 15 percent nationally) and household income below 60 percent of the median (the requirement for inclusion was below 80 percent of the median).

Q: Why were Qualified Opportunity Zones created?

A: From a policy perspective, Opportunity Zones were created as an economic development tool. They are designed to bring capital into distressed communities to spur job creation and redevelopment.

Q: What tax benefits are associated with Opportunity Zone investing?

A: For the Qualified Opportunity Zone program to be successful, most believed that powerful incentives would be needed to unlock more investment capital in distressed areas. To that end, Opportunity Zone tax incentives rest on three principles:

  • Tax Deferral: to “unlock” some of the trillions of dollars in unrealized stock market gains of U.S. investors, the program enables investors to (1) sell appreciated assets, (2) roll over the capital gains into a Qualified Opportunity Fund, and (3) defer taxes on those gains until the fund is sold or until December 31, 2026, when the tax provision sunsets. Once the appreciated assets are sold, investors have 180 days to invest in a qualified fund.
  • Capital Gains Discount: the capital gains an investor defers may be discounted if the investor holds the Qualified Opportunity Fund for a minimum of five to seven years. After five years, the cost basis of the original investment sold is stepped up by 10 percent of the gain deferred. After two additional years, the cost basis is stepped up by another 5 percent.
  • Tax-Free Capital Growth: after a holding period of at least ten years, investors receive a step up in basis of their investment in an Opportunity Fund equal to the fair market value when it is sold; therefore, they are not taxed on any capital appreciation related to the investment.

Opportunity Zones were designed to bring capital into distressed communities to spur job creation and redevelopment.

The graphic below illustrates the timing of these tax incentives:

qualified opportunity zones

Q: The tax benefits sounds very favorable. What are some of the investment realities of Qualified Opportunity Funds?

A: Qualified Opportunity Zones may have a meaningful impact on a narrow group of investors with high appetites for risk and illiquidity and stand to benefit from the tax incentives offered by the program. But, for the majority of investors, many details of the program pose a mismatch for more traditional investor expectations. Below is a non-exhaustive list of risks and considerations: 

  • Based on funds we have reviewed thus far, fees are high. A typical fund is charging a 2 percent management fee, 20 percent carried interest, and project development fees. We question to what extent the tax incentives offered by the program are negated by high-fee structures.
  • Rental income earned by the real estate investments is not tax-free, only the capital gains upon sale. As such, it’s important to consider how much of the return potential of a Qualified Opportunity Fund will come from income vs. capital appreciation.
  • A tidal wave of capital is potentially heading for this space in search of opportunities. Whenever a large base of capital chases a limited set of opportunities, we become concerned that investors/funds will be buying up properties at unattractive prices with minimal due diligence.
  • Once the required hold period is met, we also have concerns about what happens in 10-12 years when the Qualified Opportunity Funds wish to sell their investments. Just as we’re concerned about a tidal wave of money going into new projects, we’re concerned about everyone heading for the exits at the same time.
  • Qualified Opportunity Funds may make investments which promote gentrification, which may price existing residents and workers out of the area. While many Qualified Opportunity Funds are being pitched as impact investments, the potential displacement of local residents should be considered in any long-term assessment of community investment.
  • The Qualified Opportunity Zone program was enacted into the tax code only one year ago. To receive the maximum tax benefits offered by the program, investors must invest in a qualified fund by the end of 2019. This is a very short time frame for the following to take place: (1) IRS to provide clear guidance and interpretations on how the tax incentives work, (2) state governors to finish designating certain communities as qualified opportunity zones, (3) asset managers to learn the ins and outs of the tax provisions, structure investment vehicles, and research investment opportunities that lie inside attractive zones, and (4) individuals to conduct thorough due diligence on prospective asset managers.
  • Because investors must invest in a qualified fund by the end of 2019 to receive the maximum tax benefit, and because investors must invest gains realized from capital gain property within 180 days, investors may be forced to sell their appreciated assets at inopportune times. Considering market performance in Q4 2018, investors should be concerned about committing capital to a fund only to have their appreciated stock position(s) decline meaningfully.

The potential displacement of local residents should be considered in any long-term assessment of community investment.

In summary, Opportunity Zones are a major win for asset managers and a potential windfall for those who already own property in designated zones. Just as important, the program might very well accomplish its aim of revitalizing economically distressed areas, bringing much-needed capital and economic development to previously underserved or neglected communities.

But, we’re not convinced end investors who commit capital to funds are going to benefit nearly as much. The math behind Opportunity Zones shows the tax benefits equate to about 2 percent/year for investors, which is largely negated by high fees. While we are certainly going to hear about individual funds that make a killing, just as we do with venture capital funds, there will undoubtedly be many more mediocre funds that ultimately disappoint investors.

If you’re interested in investing in a Qualified Opportunity Fund, we advise proceeding with realistic expectations, recognizing the pros and cons of this economic development tool, and balancing these considerations with the costs of investing and expected returns.

Matthew Camrud, CFP® serves as an advisor at Brighton Jones. Brian Tall is the firm’s chief investment officer. 

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