The Tax Cuts and Jobs act of December 2017 created a new type of capital gains exemption for investors in low-income areas. Qualified opportunity zone funds (QOFs) have proliferated since that time, and are worth investigating and understanding.
In order to maximize the tax benefit, the investor begins by selling appreciated securities. If invested into an qualified opportunity zone fund within 180 days, the capital gains tax on the realized gains will be deferred until 2026 (or as long as the investment in the QOF continues). This date is important, because the capital gains tax is also reduced by 10% if the QOF investment is held for 5 years, or 15% over 7 years. In order to hold the investment for 7 years, an investment into a QOF made from appreciated realized gains must take place by the end of 2019.
As implied above, another key to this tax reduction strategy is long term investment into the opportunity zone fund. Taxes on the gains from the QOF are eliminated after 10 years. The IRS has released several iterations of guidance on how these funds or companies must be set up and managed in order to meet the requirements for tax exemption.
For an investor considering a QOF investment, the taxes and holding period are far from the only considerations. Most QOFs are real estate development projects, although they can also be other types of businesses. Some funds include a single property or development, while others include a specific list of projects. Blind pools are also available, meaning the sponsor will choose the properties or businesses and the investor does not know what they are at the time of investment. Another important detail: if the QOF is dissolved prior to the 10 year period, the tax benefit is lost.
QOFs are set up similarly to traditional real estate deals. There are varying minimum investment requirements. The sponsor will usually charge management fees ranging from 0.375% to 2% of fund assets per year. There may be placement fees of 1-2% paid to brokers. There is a preferred return set to be paid to all investors, often in the range of 5-8%. The payouts for these funds are lower than those seen in traditional real estate, probably due to the tax benefit. QOFs also include “promote,” which is similar to carried interest. Once the preferred return is paid, the sponsor will retain the promote, often 20-30%, of any additional profits. In this way, QOFs are similar to hedge funds or private equity, but with a very long (10 year) lockup period and the attractive tax exemption.
Obviously, the due diligence requirements for these funds are substantial:
- What is the fund investing in? Is it possible to evaluate those properties or businesses?
- Who is the sponsor? Do they have the proper capabilities? Will they be an ongoing concern in 10 years?
- Has the sponsor invested in the QOF? As Taleb would say, “skin in the game.”
- What assurances does the investor have that the QOF will, in fact, meet the IRS requirements? It would be an unpleasant surprise to get to the end of 10 years and find out that the exemption is disqualified.
- Can the investor afford the 10-year lockup period?
- What are all the fees and costs associated with the QOF?
The benefits of these qualified opportunity zone funds accrue not only to the investors, through tax benefits, but also to the low-income communities that are targeted, through additional infusions of investment. The idea here seems to be a win-win. However, investment professionals looking with a more cynical eye may see a 10 year lockup and an investment structure created by a real estate developer. Regardless of your view on the concept, this is definitely a case for “buyer beware.”