photo by Pixabay user cegoh
The “Opportunity Zones” program has offered new opportunities to investors – at least in theory. In reality, a lot of Qualified Opportunity Zone funds are subject to a Catch-22 that is keeping them from taking off.
The Opportunity Zones program originated with the tax reform package that passed in late 2017. As my colleague Melinda Kibler explained for our firm’s Sentinel newsletter, the program offers tax incentives to investors who redeploy capital gains into projects intended to support economically weak communities. By design, communities will benefit from an infusion of funds while investors will receive generous tax benefits in return.
Qualified Opportunity Zone funds offer several attractive benefits. Investors may defer tax on capital gains invested into the fund for up to seven years, for instance. Depending on the timing of their investment, investors may also be able to permanently exclude some deferred gains from tax. But the biggest advantage is the potential for tax-free appreciation as long as the investor holds the fund position for at least 10 years. Because of the rewards of compounding, as long as a given fund performs well, investors stand to benefit from holding onto their fund investment as long as they can, even beyond the 10-year requirement.
Unfortunately, while lawmakers succeeded in making these funds attractive in theory, in practice investors will need to proceed carefully. This problem may not last forever – Qualified Opportunity Zone funds are still in their very early stages. But for now, a fundamental issue remains.
Investors want funds to be diversified before they commit their money. Yet Qualified Opportunity Zone funds cannot build out fully diversified portfolios until they receive sufficient money from investors to do so.
So far, many of these funds have raised only relatively small amounts. A particular fund may be able to raise capital quickly and build out a diversified portfolio in the future, but my colleagues and I have not yet seen a fund that has managed to do it. The fundamental tension between investors’ caution and fund managers’ needs is likely a big part of the reason. Investors are rightly wary of investing in an undiversified fund, but funds can’t build the necessary diversification without investors to seed them with assets.
To understand the problem from an investor’s point of view, consider the risks involved in an undiversified fund. If an investor chooses to invest capital gains into a small fund that is just starting out, he or she likely will be exposed to only a few underlying real estate deals – in some cases, maybe only one. If a project failed and it represented a third, a half, or the whole of the fund, the investor would lose some or all of his or her initial investment. It might be difficult or impossible to recover it, in such circumstances. Investors who wait until a fund involves, say, 10 or 20 deals are exposed to much less risk that one deal falling apart will cause significant problems.
Of course, getting into a Qualified Opportunity Zone fund early has potential upsides, too. One of the few underlying deals could seriously take off, pulling the fund along with it. And a longer time horizon increases the potential tax benefits for an investor. But making such an undiversified investment in hopes of a good outcome skirts the line between investing and outright gambling. Distressed real estate investments are already risky by nature; an overly concentrated fund accentuates that risk.
Qualified Opportunity Zone funds face another challenge in fundraising. Typical investors for large illiquid funds are tax-exempt institutional investors, such as pensions and endowments. But such organizations will not benefit from the tax-exempt growth meant to motivate investors to take part in these funds. By design, Qualified Opportunity Zone funds are mainly looking to raise cash from wealthy individuals. But unlike institutional investors, individuals generally are not interested in writing eight- or nine-digit checks that will serve to jump-start the fund.
All this is not to say Qualified Opportunity Zone funds can’t succeed, or that investors should stay away forever. As with any investment, it is important to perform due diligence on the particular fund or funds you are considering. Beyond diversification, investors should look at a fund’s fee structure, the experience of its management team and other details, which may make it more or less appealing. And, of course, investors need to consider a potential investment’s place in their overall portfolio and long-term financial plan.
Investors should resist the temptation to rush into investing in a small, undiversified Qualified Opportunity Zone fund. Yes, waiting until after 2019 to take the plunge means forgoing a 5% reduction in your deferred capital gain. But the real benefit of Qualified Opportunity Zone fund investments is long-term tax-free growth, and that benefit isn’t going anywhere. The program is slated to continue until the end of 2047. Investors will be better served by taking their time and waiting to see how these funds grow.