October 31, 2018
By Anthony Azar, Realized Holdings LLC
The Qualified Opportunity Zone provision, tucked inside the Tax Cuts and Jobs Act, was barely a blip on everyone’s radar screen just a short time ago. These days, it seems as though every business or real estate publication mentions the provision in glowing terms, breathlessly extolling both the community improvement component and the tax-deferral benefit for investors who place their capital gains into Qualified Opportunity Funds (QOFs).
The QOZ allows for creation of QOFs to be used for development and business improvement in Low-Income Census Tracts (LIC) identified by state governors throughout the United States, and approved by the U.S. Department of the Treasury. Among other things, QOFs can be useful in bringing private dollars to develop, renovate and improve low-income neighborhoods. For example, there is a need for affordable housing throughout the United States, and the program could be used to develop workforce housing in targeted opportunity zones. At the same time, QOFs can be an ideal tax-deferral option when it comes to capital gains from the sale of assets.
At Realized Holdings, we’ve written extensively about the QOZ provision and its benefits. But, the program is still very new. And, it carries many risks.
Investment risks. QOFs are only as strong as their underlying investments — or the developers/sponsors in charge of property selection and investment decisions. If a multifamily property in which the fund is investing doesn’t meet its pro forma, returns to the investor could be poor. A fund backing workforce housing being built by a developer with experience only in Class A, luxury high-rises could also be problematic. That developer might not have much knowledge about affordable housing, meaning a less-than stellar result. The tax benefits the program offers are significantly dependent on the value of the investor’s fund interest increasing over a 10-year period.
Regulatory Risks. Guidance for the program has recently been released from Treasury and the IRS. However, guidance isn’t static — it will continue evolving. Investment in a QOF that doesn’t adhere to regulatory mandates could mean a sooner-than-expected hefty tax bill. Additionally, investors will need to pay taxes on gains associated with their initial investments in April 2027.
Fund Risks. QOF investors are putting their money into securities, not directly into real estate. Different skill sets and due diligence are required for investing in securities, versus real property, such as affordable housing. Other questions need to be considered, including: What happens to my investment and tax benefit if the fund I invest in doesn’t raise enough money? Or becomes decertified?
In closing, the Qualified Opportunity Zone program is on the right track; it can help investors defer taxes on profits, while putting gains toward something positive, such as creating more affordable housing. As with any investment, however, QOFs carry risk. In addition, the program is still new. As such, investors need to regard QOZ write ups, and the funds that are cropping up, with a careful eye.
For comments, questions or concerns, please contact Amy Sorter