This piece was originally published on WealthManagement.com.
Opportunity Zones are the subject of endless speculation and conference fodder, especially in commercial real estate investment circles. As most know, these zones allow investors to defer and reduce taxes on any gains from property or business equity from investments in Qualified Opportunity Zones. A recent Prequin survey found that to date, capital raised by private real estate has reached $946 billion, with $124 billion raised in 2018 alone.
Despite the hype, wealth advisors and financial professionals need to be diligent in how they research and evaluate Opportunity Zone investments before recommending them to clients.
I’ve found that as the excitement grows around an investment vehicle, and advisors and reps are inundated with endless marketing spin, it can be hard to see the forest for the trees. Capital gets raised too quickly and is funneled into projects that meet the tax benefit criteria, but do not meet other fundamental requirements for sound investing. Before recommending an Opportunity Zone investment to a client, it is critical that you have a firm understanding of the investment in question, and the OZ program itself.
Understanding Tax Structure
There are three main benefits offered by Opportunity Zone investments: temporary capital gains tax deferral, a step-up in basis, and permanent exclusion of taxable income from OZ capital gains. It is important to note that temporary capital gains tax deferral is only pertinent to capital gains that are reinvested into a Qualified Opportunity Fund. In addition, investors must recognize their deferred gain prior to the OZ disposal date or before December 31, 2026. As with any client counsel, it’s important to determine if an investment of this length is suitable for that individual. It’s also equally important that the client understand what this expiration date means and can adjust other investments to ensure they meet their capital needs for everyday life.
On this topic of liquidity and how it relates to an investment cycle, the second benefit is a step-up in the basis for any capital gains reinvested in an Opportunity Zone project or business. I am constantly troubled by the apparent lack of understanding surrounding these nuances. Keep in mind that the basis is increased by 10% only as long as the investment is held for five years. If the OZ investment is held for seven years, the basis goes up by an additional 5% for a total of 15% — no small sum when we’re talking large investment opportunities and real estate developments.
The third and final benefit is a permanent exclusion from taxable capital gains income from the sale of an investment in an OZ Fund, as long as the investment is held for 10 years. This is relatively straightforward, but still must be communicated effectively to clients who may not realize just how long their investment is illiquid.
Beware of Misrepresentation
In order to meet the criteria to become a “Qualified Opportunity Fund,” a corporation or partnership must invest 90% or more of their holdings in a Qualified Opportunity Zone. The investments that qualify include partnership interests in businesses that operate in a QOZ, stock ownership in a business that conducts most of their operations within a QOZ, or ownership of assets that sit within an Opportunity Zone, like machinery or real property. All of this must be articulated by an advisor directly to their client so they know what they’re options are and what’s suitable for them.
Opportunity Zones work best as long-term investments that benefit both the investor and the local community. What I’ve found to be effective is moving capital gains from other investment opportunities into the right OZ Fund or property development, not just jumping into the OZ sphere with no regard for traditional fundamentals and due diligence.
Because of the tax benefits offered by Opportunity Zones, the term has become a popular buzzword in financial and real estate circles. Advisors and their investors need to be cognizant of the developers and money managers out there using the hype around OZs to raise capital, and act accordingly. As always, be thorough in your due diligence to determine whether a money manager is putting lipstick on a pig or providing a sound investment opportunity.
As a financial advisor, it is ultimately up to you to determine which of your clients might benefit from Opportunity Zone investments, even if real estate tax-deferral or reduction is the goal. If your client needs liquidity, or if they need to realize gains before the five, seven, or 10-year holding periods, OZ investments might not be the best choice.