Investing in an opportunity zone is not for everyone, but for the right investor, it could be a once-in-a-lifetime tax break.
Opportunity zones are designated as economically distressed areas by each state and certified by the US Department of the Treasury.
As a result of recent tax reform, opportunity zones have emerged as a way for distressed neighborhoods to attract needed real estate development and for investors in these projects to receive favorable tax treatment. Such investments could allow you to defer capital gains taxes until 2026, reduce the amount of taxes you owe by up to 15% and pay no taxes on the fund's gains if you hold it for ten years.
Even if you're not a developer looking to invest millions into an an apartment building or warehouse, you can invest in opportunity zone funds, in which 90% of the holdings are in opportunity zones.
But there are some big risks. With the first set of opportunity zones only designated in April 2018, investments may be untested and the fees may be high. And while the IRS recently released some guidelines, regulations on opportunity zone funds are still evolving.
"Everyone is a little leery to be the first one in the pool," says Matthew Seppanen, a certified financial planner with Newpark Wealth Management.
Here's what investors need to know.
How do I invest?
The biggest benefits of investing in an opportunity fund go to those who have a large capital gains tax bill to defer.
Here's how it works. After selling an appreciated asset — it could be stocks, bonds, real estate or a business — an investor puts the money they gained from the sale into an opportunity fund within 180 days. For an investment held for longer than five years, there is a 10% exclusion of the deferred gain. If held for more than seven years, the 10% becomes 15%. Separately, investments held for ten years will not be taxed on gains earned from the opportunity fund.
"There is no central exchange of funds," says Adam Tkaczuk, tax consultant at Sterling Point Capital. "It may take some time to learn where your money is welcome."
With new funds being put together very quickly, you'll need to find out what is in the fund and how much the fees are. Tkaczuk said he spoke with the founders of a fund launching in New York, "and their proposition is: 'We're going to find a bunch of projects and you have to take our word for it.'"
A good fund, he says, are those established by a firm or real estate developer with a track record of investing, preferably someone already working in the opportunity zone. He suggests talking real estate developers, commercial real estate brokers, economic development agencies and companies operating in these areas.
Alternatively, investors with the time (as well as a lawyer and CPA on hand to look over their shoulder), can create their own fund, since this could reduce fees and provide transparency.
Tkaczuk says there is nothing to stop an investor from registering their own opportunity fund with Treasury and invest directly into qualified opportunity zone projects. To create a fund, an eligible partnership or corporation self-certifies by filing a tax form. While you will save on management costs, you will need to cover legal costs, annual compliance, and tax reporting made on behalf of the fund.
What are the risks?
Just because you could get a significant tax break from an opportunity zone fund does not mean that it is a good investment.
"This is the Wild West, right now," says Tkaczuk. "You're going into a new frontier trying to figure out what's a safe place to homestead."
Since the funds are popping up very quickly, there are risks in overpaying the fees people will charge for setting these up, says Tkaczuk. "And there could be a lot of dead-end projects."
You could do all your due diligence and the project may still not make money. "These are difficult to invest in communities, by definition."
Opportunity funds are still very new, so they're slowly gaining investors.
"There's is a lot of attention right now, but not a lot of activity," says Ben Miller, CEO of Fundrise, which launched the Fundrise Opportunity Fund in September. "A lot of people are planning and exploring, but investments aren't being made yet."
Some funds have a minimum investment of $25,000, which would likely be a capital gain earned elsewhere. Others funds have a much higher threshold.
That may change over time. Miller says he'd be interested in working with the SEC to offer funds with lower minimum investments. But the industry has to figure out its existing regulations first.
"I think it has a lot of potential as an investment, but I approach it with a healthy dose of skepticism," says Jeffrey Levine, CEO and director of financial planning with BluePrint Wealth Alliance.
Additionally, says Levine, in order to get the most out of the program, investors are already coming into the fund with big investment gains.
"These are investors who have already done very well and I take a kind of financial adviser Hippocratic Oath: Do no harm," says Levine. "Someone is going to have to show me that my client is getting a big benefit, before I make it a firm recommendation."
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