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Is the Triple-Tax Break for “Opportunity Zone” Investing Worthwhile?
In 2017, Congress passed the 2017 Tax Cuts and Jobs Act. Since the tax act passed, more than 500 qualified OZ funds have opened. The fund’s popularity seems to be growing with some $2 billion of $6.7 billion invested in December alone. As a rule, 90% of a fund must be invested in one of 8,700 qualified opportunity zones and receive at least 50% of the gross income from the zone. Most of these funds are run by money managers and/or real estate developers.
The funds allow investors to defer capital gains tax from stocks, real estate or other investments by rolling over the proceeds into an Opportunity Zone (OZ) fund that invest in low-income communities. In addition to deferring capital gains taxes, investors may be able to reduce their cost basis and eliminate capital gains on any increase in value during the fund’s life. Sound too good to be true? As you would expect, there are negative aspects associated with the funds, specifically high management costs and a loss of liquidity. Still the funds may be worth considering for wealthy investors.
The Positive
Capital Gains are deferred. Investors can defer federal capital gains tax by putting it into an OZ fund. The funding investment could have been almost anything including stocks or real estate. If the investor invests in the OZ fund within 180 days of the asset sale, he will be allowed to defer the payment of capital gains tax until the time the investment in the OZ fund is sold or until December 31, 2026. Note that if the fund dissolves, capital gains will become due. With the market near all-time highs, many investors would like to diversify away from the stock market or individual stocks that have performed well and become a larger part of their portfolio. Investors may feel trapped into holding the stock because of large capital gains. OZ funds allow the investor to exit the stock without large tax payments. Investing in an OZ fund may also make sense for investors selling a real estate property with large capital gains who want more diversity than utilizing a 1031 exchange to purchase another real estate property.
Cost basis is reduced over time. In addition to deferring an investment’s capital gains tax, investing in an OZ fund may even lower the tax. Investors who hold the fund for five years get a 10% reduction on the capital gain. If they hold the fund seven years, the reduction will increase to 15%. However, the tax benefits end December 31, 2026 whether the investor has sold its ownership in the OZ fund or not. Therefore, investors must invest in an OZ fund by December 31, 2021 to get the 10% reduction. Investors must have already invested in the fund to qualify for the full exemption.
Capital gains of the fund may be eliminated. As a final incentive, investors who invest in an OZ fund and hold it for ten years will get an additional tax benefit. Any gain in the investment in the fund is tax free. This is true even if the fund is sold after December 31, 2026. So, for example, if an investor puts $5 million into a fund in 2020 and sells it in 2031 for $12 million, he will escape paying capital gains tax on $7 million. He will have paid capital gains tax on December 31, 2026 for the capital gains from the initial investment that was deferred.
The Negative
Management costs are high. The fee structure of an OZ fund is comparable to that of a hedge fund. Typically, investors pay 1.5%-2.0% in expenses and 20% of any excess return over a designated return (6-10%).
Investor must be accredited investors. To qualify to invest in a fund, investor must have a net worth of $1 million (excluding primary residence) or have two consecutive years of at least $200,000 in annual income ($300,000 for joint filers). Investors in OZ funds can invest in a fund only one time to defer capital gains tax, and the investment can’t exceed the proceeds from the sale of the original investment.
There is a loss of liquidity associated with the funds. Some funds require investors to hold their investment a full ten years. Others allow investors to sell their investment in an OZ fund at any time. Doing so, however, will often mean forfeiting tax breaks. OZ funds should be viewed as a long-term investment with a time window of at least five years.
Short management track record. OZ funds have been in existence for only three years. As a result, the managers of these funds do not have a long track record on which an investor can make comparisons. Many of these managers are long-time real estate managers who have been successful. Others are not. Investor should become familiar with a fund’s management team to decide if the large fees are justified.
Big Picture
Like most investments, there are positives and negatives associated with investing in an Opportunity Zone fund. OZ funds offer a great way to defer and possibly avoid taxes. On the other hand, the funds have large management fees and require long holding periods. Investors should become familiar with the details of any OZ fund before considering an investment and consult their financial advisor and tax consultant to determine if the fund is appropriate for the investor.
https://www.institutionalinvestor.com/article/b1fjptxryzv07y/Is-Anyone-Actually-Investing-in-Opportunity-Zone-Funds, Alicia McElhaney, Institutional Investor, May 23, 2019
https://www.kiplinger.com/article/investing/T041-C000-S002-opportunity-zone-investing-is-it-for-you.html, Ryan Ermey, Kiplinger, June 5, 2019
https://www.irs.gov/newsroom/opportunity-zones-frequently-asked-questions, IRS
https://smartasset.com/investing/opportunity-zone-funds, Ashley Chorpenning, Smartasset, January 27, 2020.
https://www.fool.com/millionacres/taxes/complete-guide-real-estate-opportunity-zones/, Liz Brumer-Smith, millionacres