It seems you can hardly go a day without seeing a headline or two about Opportunity Zones.
Created by the federal Tax Cuts and Jobs Act of 2017 to spur long-term private investment in economically distressed communities, the Opportunity Zone program has been the subject of a tremendous amount of press coverage and investor interest. The program allows investors to reinvest capital gains into the creation or expansion of businesses and into the development or renovation of real estate located in opportunity zones. In return, the investors receive tax deferral and tax reduction benefits.
Understandably, many investors are intrigued by the prospect of making money, easing their tax burden and reinvigorating poverty-stricken neighborhoods at the same time. According to data released in June by the National Council of State Housing Agencies, 143 Qualified Opportunity Funds have been established, and the vehicles are expected to invest more than $29 billion in Opportunity Zones. In all, nearly 9,000 areas—scattered across all 50 states, the District of Columbia and five U.S. territories—have now been designated by the federal government as Opportunity Zones.
However, for a variety of reasons, investors would be wise to exercise a great deal of caution when it comes to investing in Opportunity Zones. In the end, after a careful review, they might conclude that other real estate investment vehicles are better destinations for their dollars.
Tax Benefits Overstated?
The tax benefits of the Opportunity Zone program have generated a lot of discussion. In short, the program enables an investor to reinvest a capital gain in a QOF within 180 days of the sale of the appreciated asset. The tax due on the gain then is deferred until the investor sells her or his interest in the QOF or Dec. 31, 2026, whichever comes first.
Additionally, if an investor holds the QOF investment for five years, the taxable amount of the deferred gain is reduced by 10 percent. If they hold it for seven years, it’s reduced by another 5 percent. Finally, if an investment in a QOF is held for more than 10 years, any capital gain that occurs as a result of the QOF investment is not taxable.
Deferring a capital gains tax payment certainly sounds great, right? Well, consider that there’s no guarantee that capital gains tax rate will be the same when it comes time to pay these bills. In fact, with the political environment being what it is these days, an investor could very well be facing a higher tax rate down the road, significantly negating the benefits of deferral.
Also, other vehicles offer tax deferral benefits as well, such as private real estate funds, in which the cash flow investors receive is typically tax deferred for the first six to eight years of an investment (distributions are tax deferred until investors receive all of their investment capital back).
In the end, the tax concerns regarding Opportunity Zone investments can be nuanced and varied, and investors would be wise to seek detailed professional advice before taking the plunge.
Is This a Good Overall Investment?
When sinking money into real estate, investors should be looking for more than tax benefits. They should be looking for a good overall investment. And Opportunity Zone investments can present considerable risk.
For starters, investing in Opportunity Zones requires the construction of new real estate or the extensive renovation of an existing property in an underdeveloped area, which in and of itself carries risk. On top of that, add in all of the variables surrounding the zoning, entitlement, construction and lease-up processes, and it could be five years before a property is generating cash flow for investors, if it ever does. By contrast, a traditional private fund that invests in existing core real estate can experience a positive cash flow right away.
Investors should also pay extremely close attention to a QOF’s fees, which can be considerable and sometimes can’t be paid out of the original investment, meaning an investor would have to pull out their checkbook to pay it.
Are You Investing in Truly Distressed Areas?
Another question investors should ask is if the QOF they’re considering is really investing in a depressed area. We think it’s fair to say some Opportunity Zone designations may not match the spirit of the original legislation. Consider these disclosures from actual QOF documents about the areas the funds are targeting:
“Affluent, high barrier to entry submarket in Lake Oswego, the premier suburban submarket in Portland.”
“High barriers to entry: Residents of Denver and Olde Town Arvada in particular, exhibit a strong sense of NIMBYism.”
“Location highlights – Chino Hills, CA is a growing suburban city known for its high household income of $106,826 and great schools.”
In the final analysis, we’re not here to say investors should stay away from Opportunity Zones. But we are cautioning investors to look past the hype and excitement and take a thorough, sober-minded look at all the ins and outs of these investment vehicles. When they do, they may conclude that more traditional real estate investment vehicles are a better fit for their dollars.