Three Tips for Navigating Opportunity Zones
Opportunity Zones are attracting significant interest across the investor community. But just like with any new investment or market, it’s important to understand both the opportunity and potential areas of caution. To help guide that discussion with clients, here are our current thoughts on how to navigate this new market.
What are Opportunity Zones?
In December 2017, the Tax Cuts and Jobs Act created a new tax incentive designed to help spur investments into low-income communities across the US. The program, which was billed as a response to the uneven economic recovery that followed the 2008 Financial Crisis, allows investors to defer and reduce their capital gains tax by investing those gains in designated low-income census tracts, called Opportunity Zones.
Any taxable investor with a capital gain can participate in this program. To participate, investors must roll all or a portion of their capital gain into an Opportunity Zone Fund within 180 days of realizing said gain. That Opportunity Zone Fund must then re-invest those assets into real estate projects or operating businesses located within Qualified Opportunity Zones (“QOZ”). Today, there are over 8,700 QOZs within the United States and its territories.
What are the benefits of investing in Opportunity Zones?
The Opportunity Zone program is designed with escalating tax benefits for longer holding periods as part of an attempt to encourage long-term investments in low-income communities. For example:
- Investors can defer their capital gains tax until 2026 and reduce their capital gains tax by 15% if they roll their gain by December 31st, 2019.
- Investors can defer their capital gains tax until 2026 and reduce their capital gains tax by 10% if they roll their gain by December 31st, 2021.
- Investors can eliminate the capital gains tax on new gains generated by their Opportunity Zone investment, provided it is invested by 2026 and held for at least 10 years.
While each of these tax benefits are attractive, it’s the third tax benefit – the exclusion of the capital gains tax on new gains – that delivers the most economic value to investors. In effect, the policy rewards long-term investors, as long as the investments are made by 2026. Given there are strict deadlines for taking advantage of these different benefits, we believe that Opportunity Zones can and should be an aspect of ongoing tax planning.
What are the risks of investing in Opportunity Zones?
While investors are right to be intrigued about Opportunity Zones, we want to highlight three potential risks that investors should be aware of as they explore this new market.
1. Navigating Regulatory Uncertainty
Given that regulatory guidance for Opportunity Zones has yet to be finalized, we believe investors should favor investment strategies with minimal regulatory uncertainty. For example, potential investors should consider Opportunity Zone Funds that plan to invest in real estate, as this sub-sector of the market is well understood. In contrast, market players are still waiting for further clarification on rules about investing in operating businesses located within Opportunity Zones
2. Sizing Risk
An increasing number of Opportunity Zone Funds are entering the market. According to the accounting and consulting firm Novogradac & Co., there are now more than 100 funds in the market seeking a total of $23 billion in capital, with several funds targeting $500 million or more. When navigating this market, potential investors should be careful to invest with Opportunity Zone Funds that are appropriately sized to the market opportunity, keeping in mind that Opportunity Zone Funds have a limited amount of time to deploy investor capital. For example, an excessive influx of capital has the potential to increase competition for deals and distort prices. To preserve flexibility, investors should consider Opportunity Zone Funds that are large enough to be diversified across geographies and small enough to be nimble and price-disciplined.
3. Conflicts of Interest
For Opportunity Zone Funds, there is always the potential for a conflict of interest because the tax benefits only accrue to the investor, not the Fund’s GP. To illustrate this challenge, consider the requirement that Opportunity Zone Funds must invest 90% of their assets in designated Opportunity Zones for at least 10 years. But if the Fund receives an attractive offer and decides to sell an asset before the 10-year holding period is up, thereby dipping below the 90% threshold, the GP would receive a performance fee but the LP would forfeit their tax incentive. In talking to a number of Opportunity Zone Funds, we have yet to find one that has adopted legally binding language that would obligate them to protect the investor’s tax benefit.
The Opportunity Zone program offers a compelling tax incentive for high net worth investors. That said, the program is not without its risks. Chief among these risks is a potential for conflicts of interest, regulatory uncertainty and distorted pricing. While these complexities are addressable, they require a thoughtful and measured approach. At Tiedemann, we are in the process of designing a standalone solution for clients that can preserve that tremendous tax advantages while navigating these complexities.
Important Notes and Disclaimers
Tiedemann Advisors, is a registered investment advisor. This information is for illustration and discussion purposes only. It is not intended to be, nor should it be construed or used as, investment, tax, accounting, legal or financial advice. This information is intended as an illustration of the services offered by Tiedemann and to serve as the basis of a discussion with a Tiedemann professional. Tiedemann’s services may not be suitable for all clients. Individual investor portfolios must be constructed based on the individual’s financial resources, investment goals, risk tolerance, investment time horizon, tax situation and other relevant factors. You should consult with your tax and legal advisors prior to entering into any wealth planning or trust arrangements. Any information that may be considered advice concerning a federal tax issue is not intended to be used, and cannot be used, for the purposes of (i) avoiding penalties imposed under the United States Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter discussed herein.
Economic, regulatory and market forecasts presented herein reflect our judgment as of the date of this presentation and are subject to change without notice. These forecasts do not take into account the specific investment objectives, restrictions, tax and financial situation or other needs of any specific client. These forecasts are subject to high levels of uncertainty that may affect actual performance. Accordingly, these forecasts should be viewed as merely representative of a broad range of possible outcomes. These forecasts are estimated, based on assumptions, and are subject to significant revision and may change materially as economic and market conditions change. Investments in securities involves significant risk and has the potential for partial or complete loss of funds invested. Investments, when sold, may be worth more or less than the original purchase price. The investment decisions Tiedemann will make on your behalf are subject to various market, currency, economic, political and business risks, and will not necessarily be profitable. You understand and agree that any investment made on your behalf is subject to loss of principal and certain investments may be illiquid.