By David O'Brien, CFP, CAIA
The Opportunity Zones Program, enacted as part of the Tax Cuts and Jobs Act of 2017, has great potential to create jobs and spur economic growth while creating a potentially powerful tax strategy for investors and asset managers. The Opportunity Zone Program is designed to attract long-term investments in designated urban and rural areas throughout the United States. Investors have the opportunity to reduce, defer, and ultimately eliminate capital gains tax to promote economic growth in designated urban and rural areas, or Qualified Opportunity Zones (QOZ’s), through a tax-efficient investment vehicle, called a Qualified Opportunity Fund (QOF). Tax breaks are powerful motivators for investors and asset managers. QOFs allow investors to unlock unproductive investor assets and deploy this fresh pool of capital back into designated Qualified Opportunity Zones, creating jobs and spurring economic growth.
There are an estimated $6 to $7 trillion dollars in unrealized capital gains sitting on the balance sheets of US Investors. If only a small percentage of these gains are realized and invested into QOF's, hundreds of billions of capital could be unleashed into the economy. It is no surprise that there has been a bit of a gold rush mentality for investors, asset managers, and program sponsors eager to launch funds in anticipation of this potential river of capital flowing into QOZ's.
We believe many QOFs will be successful investments. Other QOFs will not be. Still other QOFs may turn out to be complete failures. It is impossible to predict what the economy will look like in 10 to 12 years, or which funds will perform better than expected and which will disappoint. To ensure investment success, it is important to fully understand the history, structure of, and laws and regulations surrounding this new asset class. Here are some things prospective investors can do to help reduce the odds a QOZ Fund investment will not disappoint.
Be Vigilant with Your Due Diligence.
Due to the short history and time constraints of the QOZ program, it can be easy to let your guard down and leap, or invest, before you look. Be sure to conduct proper operational due diligence first. Research which questions to ask about QOF investments before investing. Investors that perform proper due diligence have a better chance of avoiding investing in funds with a high likelihood of failure, or being victims of Ponzi and other investment schemes, and potentially being hit with losses and tax penalties. Don’t be lured by a slick website and the promise of great tax-advantaged returns.
Know the Relevant Code(s).
No other tax law has created an asset class like the Qualified Opportunity Fund (QOF) before. QOFs are an entirely new asset class. This new asset class has its own unique characteristics and investors need to become familiar with or consul a knowledgeable professional regarding the rules of investing. The tax code lays out what a QOF needs to do to be compliant with the law and accrue tax benefits to its investors, which can be quite complex. The code does not say who can set up a QOF. Literally anyone can start one; simply file a form, self-certify as a QOF and you are in business. However, if a fund manager plans to raise money from more than 100 investors, they have to comply with the Securities laws that regulate private funds. This can be fraught with its own set of potential pitfalls for the inexperienced.
Avoid First-Time Fund Managers
While it is almost impossible to know the total number of funds that have been created, a recent report published by Novogradac & Co. LLP, a leading QOF consulting firm, is tracking 346 funds seeking to raise over $66 Billion. The majority of these funds have been launched by first-time fund managers according to a survey conducted by NES Financial, a leading QOF fund administrator. In fact, many of the early QOFs were single project funds that were started and funded by one or a few investors that did not seek funds from outside investors. There are many risks associated with investing in Real Estate Development. A first-time, inexperienced fund manager is one investors seriously need to consider.
Real estate development is a difficult business. If done well, it can be very profitable. If done poorly it can be a disaster. Raising funds from investors can be difficult. The financial industry is littered with the remains of funds that did not reach a large enough size to be sustainable. If the fund you are considering is the sponsor's first and only fund, be wary. If you invest in a QOF that fails, you may have not only difficulty recouping your investment, but you could get stuck with an unanticipated tax bill to boot. Be wary of firms that see the Qualified Opportunity Zone program as a way to start a business, or QOFs that are the sponsor’s first and only fund. Look for established, fund managers who have worked with new funds, ideally in Real Estate Development, and who are fully trained and versed in all of the finer nuances of real estate investing. Invest with asset managers with other funds in the market and who see the QOZ program as an extension of what they are already doing successfully in other markets.
Consider Size and Long-Term Strategy
Size matters. One of the unique features of the QOZ program is its timing aspects. To maximize the tax benefits for investors, investments must be held a minimum of ten years. After ten years, if and/or when the assets are sold, there is no tax due on the capital gain on the QOZ fund investment. Ten years is a long time to have assets tied up. After such an extended length of time, investors will not only want, but expect the QOZ funds they invested in to be returning capital or provide another path to liquidity. If a fund is too small, the costs of managing the fund and servicing shareholders could eat into investor returns. Large funds may take longer to liquidate and may have trouble sourcing enough compelling investments. Look for funds in the $200 to $500 million range. Also look for fund sponsors who plan to launch a series of medium-sized funds, as opposed to one “mega” fund. Make sure any fund you are considering has a well thought out exit strategy.
Be Wary of Blind Pool Offerings
Blind Pool Offerings are funds that have only vague business plan and source investments as they are raising funds. Because investments are sourced as funds are being raised, investors do not know what they are buying into until the fund manager identifies the projects the fund has invested in. Look for QOFs that have identified all, or substantially all, of the projects that the QOF will be investing in. Ideally, a sponsor will reach their funding goal, close the fund, and launch a new fund if there is sufficient demand to ensure the investment timeline is not significantly extended for early investors. The investors in the sponsors first fund should not have to worry about a sponsor keeping a fund open longer to take in as much capital as possible, which is good for their business, but not necessarily for their investors.
Limit Your Investment
QOFs are illiquid investments. As with any illiquid investments, you do not want to have a large percentage of your net worth tied up in them. Remember, no matter how well you do your homework, some QOFs will be successful, some QOFs will be very successful, and some QOFs will likely disappoint. We believe investors should limit their overall exposure to QOFs and diversify your QOF investments into more than one fund, diversification seeks to help mitigate the impact on an underperformer on your portfolio.
While the QOZ program may offer significant tax breaks, QOFs are speculative investments. Do not chase a tax incentive or an investment deadline without first performing due diligence or consulting a professional to do it for you. Doing so in the present will greatly help avoid potential problems in the future. Remember that ultimately, while the QOZ program’s tax benefits may enhance the return of a successful investment, these tax benefits but cannot rescue a losing one.
Caveat Emptor: Let the Buyer, or Investor, Beware
The information herein has been prepared for educational purposes only and does not constitute an offer to purchase or sell securitized real estate investments. There are risks associated with investing in real estate properties including, but not limited to, loss of entire investment principal, declining market values, tenant vacancies and illiquidity. Because investors situations and objectives vary this information is not intended to indicate suitability for any particular investor. This material is not to be interpreted as tax or legal advice. Please speak with your own tax and legal advisors for advice/guidance regarding your particular situation. Securities offer through Concorde Investment Services, LLC. (CIS), member FINRA/SIPC. Advisory Services offered through Asset Strategy Advisors, LLC (ASA), a SEC Registered Investment CIS and ASA are separate companies.
 Economic Innovation Group. “Opportunity Zones: Tapping into a $6 Trillion Market.” EIG: Opportunity Zones: Tapping into a $6 Trillion Market, 2018, eig.org/news/opportunity-zones-tapping-6-trillion-market.
 Novogradac and Company, LLC. “QOF Summaries.” Novogradac, 2019.
 Thomas, Reid. “The Real World Impact of Opportunity Zones.” NES Financial, 2019.