There’s a lot to get excited about with Opportunity Zones but let’s be careful not to lose the forest for the trees. Don’t get caught up in the tax benefits, and forget to evaluate the viability of the deal.
For the uninitiated, here’s a primer on Opportunity Zones.
Ever since the passage of the Tax Cuts and Jobs Act of 2017 (“TCJA”), there’s been a tremendous amount of buzz surrounding the Qualified Opportunity Zone program created to spur economic development and job creation by investing in businesses located in economically-distressed communities.
To motivate investors to pour money into Opportunity Zones, the TCJA provides significant tax incentives to investors allowing them to defer and potentially reduce tax on recognized capital gains by investing in a Qualified Opportunity Fund, which in turn invests in property located in Opportunity Zones. The establishment of Qualified Opportunity Funds was meant to allow and motivate investors to pool funds to take on big projects.
What is an Opportunity Zone?
An Opportunity Zone is an economically-distressed community nominated for designation by the various states and then qualified by the Secretary of the U.S. Treasury acting through the IRS.
How does the Program Work?
The program rewards investors who have capital gains from the sale of appreciated assets such as stock, real estate or a business by allowing them to defer capital gains tax by reinvesting those gains into a Qualified Opportunity Fund. Qualified Opportunity Funds use the capital invested to make equity investments in businesses and real estate in Qualified Opportunity Zones.
What is a Qualified Opportunity Fund?
A Qualified Opportunity Fund is an investment vehicle that is set up as either a partnership or corporation for investing in eligible property located in a Qualified Opportunity Zone (i.e., Qualified Opportunity Zone Property). Although a Qualified Opportunity Fund could raise capital through a public offering, it’s expected that most will take advantage of an exempt offering under the Securities Act allowing for advertising such as Rule 506(c) of Regulation D or an offering under Regulation A+.
Summary of Tax Benefits
Investors in a Qualified Opportunity Fund can take advantage of a golden trio of capital gains tax benefits – deferral, basis step-up, and elimination. Here’s an illustration of how an investor can take advantage of this trifecta of benefits.
An investor has a $1 million gain from the sale of his business. He’s in the 20 percent tax bracket so the sale would trigger $200,000 in capital gains tax. Instead of paying the tax, he decides to reinvest the $1 million gain in a Qualified Opportunity Fund. It should be noted that the investor must reinvest the capital gains in a Qualified Opportunity Fund within 180 days of the sale of his business to qualify for the tax benefits.
How would he benefit from the Opportunity Zones program?
1. Deferment of gains
By investing those gains in the Opportunity Fund, the tax due on those gains is deferred until the earlier of the investor selling his interest in the Fund or December 31, 2026.
2. Step-up in Basis
If the investor holds the investment for five years, that payment of $200,000 is completely deferred, plus the investor gets a 10 percent step-up in basis on the original gain deferred. So now the investor pays $180,000, saving $20,000 in capital gains taxes. If the investor holds for 7 years, he receives an additional step-up in original basis of 5 percent on top of the 10% already applied, and the capital gains tax bill goes down to $170,000, saving $30,000 on the taxes owed from the investor’s initial gain.
If the investor holds his interest in the Qualified Opportunity Fund for more than 10 years, the investor pays ZERO capital gains tax on the appreciation of that asset.
Remember the Fundamentals
So with the substantial tax benefits investors can take advantage of through the Opportunity Zones program, it could be easy for an investor to get overly excited and forget to analyze an opportunity on its own merits. In other words, don’t lose sight of the forest for the trees and forget to evaluate the non-tax benefits of the deal. The tax benefits are useless if the Qualified Opportunity Fund fails.
Investing in a fund that fails could be a double whammy. Not only could you lose your entire investment, but because you were unable to meet the minimum holding requirements, the deferment of those gains could also be eliminated. Ouch!
Investors should always judge an opportunity on its own merits separately from the tax benefits.
Because the TCJA encourages pooling of investor funds in a Qualified Opportunity Fund, most of these funds will likely raise money through an exempt private offering – most likely through Rule 506(c) of Regulation D, which allows advertising.
As you come across these opportunities, here are some pointers for evaluating deals and the offering materials that go with them:
1. Track Record
Because private investments are passive, meaning investors have no hand in management, it is imperative to scrutinize the track record of the managers. Do they have the necessary experience and knowledge in the asset class and locales in which they are proposing to invest? In other words, is this particular investment in the manager’s “wheelhouse” or is this new territory? Be leery of managers undertaking a real estate class they’ve never invested in before. Due diligence is key.
Do the offering documents provide adequate disclosures? Is there enough information about the company’s proposed business and sufficient discussion about the industry and market trends that conveys management is well-informed about the investments? Be leery of salesmanship and overconfidence. Any offering declaring an investment to be risk-free or low risk should be closely scrutinized. Do not get carried away by hyperbole and weigh the facts presented objectively.
Ensure that the compensation structure of the opportunity aligns with your investment goals. Are you more interested in a long-term return and payoff from appreciation, are you more interested in cash flow with a consistent return, or are you interested in a mix of both?
Does the company’s business strategy align with the types of returns promised and the compensation you seek?
Included with most offering docs are pro forma financial statements showing the fund’s projected income for at least 3-5 years and sometimes longer. When evaluating these pro forma statements, make sure the revenue projections are realistic and not overinflated and that the expense projections are not overly conservative.
If there’s a leap in projected net income from one year to another, are these projections based on sound economic principles or are they based on speculative factors? Beware of overpromising by the manager.
5. Sponsor/Management Compensation
Is management compensation reasonable in light of the services expected to be performed? High fees or a high number of fees should be scrutinized closely and questioned whether those fees could potentially impede the profitability of the fund and therefore adversely affect profit distributions, which in the long run may negatively impact your return on investment.
6. Exit Plan
Sound business plans will have a defined exit with a defined projected hold period or range of years, contingent on market conditions, to give management flexibility.
Management should provide periodic reports on the financial performance and management of the fund throughout the lifespan of the investment. A clue to the quality of future reports you should expect can be found in the pro forma financial statements provided along with the offering docs. Sloppy reports will typically follow sloppy pro formas, and conversely, detailed pro formas are a good predictor of detailed progress reports down the road.
The Opportunity Zones program gives investors a tremendous opportunity to lift depressed communities while being able to take advantage of considerable tax benefits. However, to take full advantage of the program, don’t get suckered into just any deal. A bad deal will defeat the benefits of the program.
In considering investments in Qualified Opportunity Funds, don’t forget the fundamentals. Scrutinize deals and do your due diligence. Keeping a few key factors in mind when evaluating opportunities will save you time and potentially money. Recognizing red flags will help you avoid bad investments and allow you to maximize the benefits of investing in Opportunity Zones.
Discover how to pay little to no capital gains taxes using Opportunity Zone Investments.