Are Qualified Opportunity Zones Right for Me?

Are Qualified Opportunity Zones Right for Me?

Posted by on Apr 3, 2020

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Qualified Opportunity Zones (QOZs) are not right for everyone. Despite the numerous potential benefits, like any investment, there is no perfect solution. Before investing in QOZs, you should consider the following elements and decide if QOZs are right for you.

Long-Term Investment

To realize the full tax benefits of a QOZ investment, it must be held for a minimum of 10 years. For this same reason, sponsors most likely will not be looking for an exit prior to the 10-year holding period. 

For investors, they are basically locked in for at least 10 years and possibly longer, depending on the sponsor. Some funds are structured to allow dispositions as far out as 15 years or more.

Even if the fund sponsor intends to exit at 10 years, it’s impossible to know what market conditions will be like at that time. Plus, if enough funds begin exiting at the 10-year mark, market pricing may get depressed from the excess available supply. The exact exit timing of your QOZ investment will be hard to predict, and ultimately out of your hands.

Illiquid

As noted in the previous section, your funds will likely be tied up for at least 10 years. Those funds will not be available for any other investments. While it may be difficult to quantify, it’s important to weigh the potential opportunity cost during that 10-year timeframe. In other words, do you see any potential other investments on the horizon that might be more viable?

The second round of QOZ regulations outline that the benefits will pass to a buyer in a secondary market transaction, assuming the purchaser is eligible. However, the purchaser would not inherit any of the hold time of the seller. The purchaser will instead start from zero with their holding period, potentially missing out on the 10-year tax benefit when the fund exits.

We have seen a couple of QOZ funds provide an “emergency valve” feature for limited redemptions, but in general, if you’re not prepared to have your money tied up for at least 10 to 12 years, a QOZ investment is probably not right for you.

Investment Objectives

As is the case with all investments, it’s important to make sure a QOZ investment is in line with your investment objectives. For example, if you’re expecting regular income, like that from a rental property, a QOZ investment isn’t going to fit with your objectives. Most QOZ investments don’t project to generate annual cash flow until years three or four, depending on when the project is completed. QOZ investments are growth and appreciation plays, not current income strategies.

Risk Spectrum

While real estate, in general, may seem low-risk, QOZ investments are fairly unique. They are new, long-term, and have special requirements. To qualify for the tax benefits, the investment must either be an original use (which essentially means ground-up development) or a substantial improvement (which basically means gut/rehab or change of use). These investments will also be in unproven locations due to the program’s design. Additionally, because the QOZ program is new, there’s very little track record to see how any investments have turned out. For those reasons, QOZ investments are high on the risky side of the real estate risk spectrum.

Two other risks QOZ investors should consider are regulatory and tax risks. We don’t know what QOZ or related regulations will be like in 2026 or what impact they might have on QOZ investments. Investors will likely incur tax obligations while their funds are still locked up. This is known as the Phantom Tax Date or Phantom Gain Date that occurs in 2026 (payable in 2027).

Investors need to have funds set aside to cover taxes due, even while their capital remains locked up in a QOZ fund. Additionally, investors will be taxed at the 2026 rate, which we have no way of knowing if it will be higher or lower than current tax rates.

Suitability

For most investors, QOZ investments will be a big change from what they’re used to. Those who are selling blue chip stocks to raise capital, for example, are moving into an illiquid, long-term, real estate development investment. This is a material deviation from their current position. It is not necessarily as clear cut as to whether or not a QOZ fund is an appropriate investment. 

Understanding suitability goes back to investment objectives and experience. The less you know about QOZ investments, the more research you should do before getting involved. We’ve mentioned that QOZ funds are on the risky side of real estate investing, so it is important to do your due diligence on the investment opportunity and the fund sponsor. Understanding all the nuances of QOZ investments will take time, but like any investment, it will be time well spent.

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.

Diversification does not guarantee a profit or protect against a loss in a declining market.  It is a method used to help manage investment risk.

There is no guarantee that the suggested asset mix will appropriately reflect your ability to withstand investment risk.

 


What is a Qualified Opportunity Zone?

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What is a Qualified Opportunity Zone?

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