At Realized Holdings, we spend a lot of time reminding clients that due diligence is essential when it comes to real estate investments. Due diligence is also important when it comes to investing in a Qualified Opportunity Fund (QOF) as part of the overall Qualified Opportunity Zone program (QOZ). This tax-deferral program allows you to invest capital gains into QOZs, with the added benefit of spurring lower-income community development.
We’ve written extensively about the QOZ Program. Additionally, the Internal Revenue Service and U.S. Department of the Treasury recently released its first round of guidance for the program, leading to many business publication headlines.
However, even before the first round of IRS guidance was released on Oct. 19, QOFs have been popping up, offering investment opportunities along with tax deferral. And, as an investor, you could be thinking: “There are so many QOFs out there, promising all kinds of things. How can I be sure they are legitimate?” To help answer this, here are some issues to consider and research on your targeted QOF.
Securities Versus Direct Investment. Rolling your capital gains into a QOF is not a direct real estate investment. Rather, you are buying interest in a fund (a security, per the statute) which, in turn, funnels your money, as well as money collected from other investors, into QOZ property. Securities investments require a different due diligence skill set, versus one that is focused on a direct real estate investment.
Property Track Record. Be sure that the QOF’s fund manager/sponsor is familiar with the submarkets, property types or product mixes within those Qualified Opportunity Zones it plans to invest. A QOF sponsor with experience only in high-end real estate developments in high-income population locations might not be familiar with funding needs in lower-income developments.
Investment Track Record. A QOF sponsor’s/manager’s performance with previous funds or investments is important. Just as vital is your sponsor’s/manager’s experience with institutional versus non-institutional investors. The fund manager that regularly works with corporations or pension funds might have a different outlook, approach and goals, than one that is used to working with individual private investors.
Sponsor/Manager Adaptability. The QOZ program is new; the first round of guidance has only just been released. That guidance will continue evolving, meaning our collective understanding of the current parameters could change. QOF managers/sponsors should be sophisticated enough to understand the ramifications of guidance, and be willing to seek out the right kind of tax counsel. Managers and sponsors with the wisdom and experience to make appropriate adjustments are those that may potentially help maximize the benefits for you and other stakeholders.
Future Planning. A significant element of the QOZ program is tax deferral. As such, when the clock strikes midnight on Dec. 31, 2026, you will owe taxes on that original gain you invested in the QOF, a concept known as “Phantom Gain.” Those taxes must be paid when you file your April 2027 taxes. Your QOF should have a crystal-clear plan in place, one that will provide you with the cash to pay those capital gain taxes.
A Clean Exit. Your fund should offer a mechanism allowing you to convert your interest into cash, when you sell it at year 10, or beyond. It’s great if your fund has doubled or tripled in value during your decade-long hold, but it doesn’t mean a thing if that fund doesn’t provide you with a method to sell and reap the rewards. On the other hand, if an investment is going south, a mechanism that allows you to pull your funds out may help mitigate further downside.
To summarize, the above are just a few steps to help you be more trusting that your capital gains end up in a QOF that will do right by you, and by the QOZ it is targeting. Be sure to research that fund’s parameters and ask for advice and assistance from your CPA and/or tax attorney. An abundance of knowledge about a QOF will help ensure that your investments, and portfolio, are in the right hands, and that you can fully benefit from what the QOZ program offers.