If you are interested in investing in an Opportunity Zone, you should consider weighing the benefits and risks. In our previous blog post, we shared some basic information regarding Opportunity Zones and how they work.
To recap, the Opportunity Zone Program allows an investor to sell an asset (it does not have to be a real estate asset), and defer the capital gains from said asset into a real estate asset or business that is located within a Qualified Opportunity Zone (QOZ).
Weighing the Benefits
- The greatest benefit of investing in a QOZ is the tax incentive. If an investor incurs a capital gain, rolls it into an Opportunity Zone Fund (OZF) and holds the OZF investment for at least seven years, then the investor is able to defer paying the original capital gains taxes for those seven years. After seven years has passed, capital gains are incurred but only on 85% of the original amount. If the investment is held for an additional three years (for a total of 10 years), then the appreciation on the new investment is not taxable.
Real estate asset
The investor defers or avoids a large tax bill and hopefully has acquired a valuable asset for his or her portfolio.
Economic development growth
The investor is contributing to the economic growth in underdeveloped areas across the U.S.
If you are looking for a long-term investment and have the flexibility and time to ride a 10-year wave, this type of investment opportunity may be appealing.
Weighing the Risks
The first question investors should ask themselves is: Do I want to be locked in for the next 10 years? Remember, pulling out of the investment before the 7 and 10-year period will result in capital gains and the asset being fully taxed.
- Not every deal is a great deal
Beware, not everyone pitching deals has a real estate background. These groups are creating pools or funds to acquire multiple OZs. Typically, these blind pools will raise a large sum of money and go out and purchase 10 projects not knowing much about them.
General Partner Conflict of Interest
Currently there are a number of managers raising OZFs. It appears to us many of these managers are raising money in a “hot” sector because of the significant interest of taxable investors. But there appears to be a lack of concern for deals that make economic sense to the end investor.
Once a project has been identified and purchased by an OZF, the manager will have 31 months to develop the property. Additionally, the manager is required to invest at least as much in the project’s development as the purchase price of the project.
Quality of Qualified Opportunity Zones (QOZs)
The majority of QOZs are in distressed areas, which means the most attractive locations will be snapped up quickly. In addition, the attractive locations may become expensive as developers compete over the best locations.
Not all OZs are good investments. Some OZs may not be redeveloped within the 10-year period, thereby potentially triggering another economic down cycle.
Fees might range from 1.75% to as much as 2% or higher. Most managers work for carried interest, but in a 10-year deal, they won’t receive their carried interest until the end of that period.
The end of the 10-year period
What goes up can come down. When funds reach the 10-year mark, most assets will fully qualify for the tax deferment. However, prices driven up during the purchase period could be driven down during the exit period.
One of the biggest risks is that this is a new area of investment (since April 2018); there are rules that have yet to be finalized and many questions yet to be considered or answered.
Before making any investment decision, consult with your wealth management advisor. If you’re interested in setting up an appointment to discuss OZs investments, send us an email at email@example.com.