Disadvantages Of Qualified Opportunity Zones

Disadvantages Of Qualified Opportunity Zones

Posted by on Feb 24, 2020

cranes-construction-AS-63181133

On realized1031.com, we’ve discussed the benefits of the QOZ program extensively. Some of the primary highlights are:

  • Deferral and reduction of original gain.
  • Dismissal of gain in the fund if held for 10 or more years.
  • Opportunity to grow tax-optimized wealth.

Fund managers like to flaunt these benefits. But listening to only the benefits of an investment opportunity doesn’t tell the full story. In this article, we’re going to cover three areas that present real risks to QOZ investors.

The Disadvantages And Realities Of QOZ Investments

Illiquidity

To take full advantage of QOZ tax benefits, the investment must be held for 10 or more years. It’s difficult to forecast what an investment will look like 10 years down the road, which makes comparing QOZ investments to other long-term investments a complicated task, to say the least. But one thing is for sure; your capital will be tied up for at least 10 years. If some unforeseen opportunity comes up during this time and you need the QOZ capital to take advantage of it, you’re basically out of luck.

Another liquidity problem is the 2026 phantom gain. Meaning, taxable proceeds not sold by December 31, 2026, will result in a phantom gain. Some sponsors are pitching cash-out refinances of the properties upon stabilization to pay taxes that will eventually be due. But again, 7 years down the road, there’s no guarantee that this will happen.

Of course, QOZ interests are capable of being sold in the secondary market. That will be easier said than done if tax benefits have expired as buyers for that market will become scarce.

Also, QOZ interests derive a large part of their value from the tax incentives tied to them. The result is that you may have to sell at a steep discount to get out of the fund. Before you invest in a QOZ, you should be prepared not to see those funds for at least 10 years and have additional funds available to pay taxes in 2026.

High Execution Risk

As with any passive real estate investment (such as a REIT, DST, etc.), there is a strong emphasis on the sponsor’s ability to perform quality due diligence and get the deal done. This risk is even more prevalent in ground-up developments.

Some of the obstacles sponsors face include navigating regulations and executing business strategy/development. Finding a sponsor with the right experience and a stellar track record is critical for getting the job done. It’s not only sponsors that you have to look out for. JV partners (i.e., local developers) face similar challenges to that of sponsors.

Uncertainty

In December 2019, the Treasury released what was described as the “final” set of regulations. While that adds reassurance for now that regulations won’t change, there’s still quite a bit of uncertainty. 

  • What will the real estate market look like 10 plus years from now?
  • Sponsors may have an idea of a potential exit strategy years down the road, but there’s no real clear-cut answer. As the landscape evolves, so will the exit strategy.
  • We can’t possibly know what tax rates will be in 2026. It’s anyone’s guess.
  • As always, the looming threat of new regulations is ever-present, regardless of what the government has stated.

QOZ investments offer some great tax benefits, but those advantages need to be balanced against the potential negatives. Since these tax benefits are years out into the future, the biggest risk is the unknown (regulations, real estate landscape, sponsors, etc.). Because capital is dedicated to the QOZ fund during this time, investors must consider opportunity cost with both potential current investment opportunities and those that might arise while capital is locked up in the QOZ fund.

Realized is here to help you navigate sponsors and the QOZ landscape. We offer one of the largest QOZ marketplaces with established sponsors. Learn more here

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.

 


What is a Qualified Opportunity Zone?

QOZ Guidebook Cover

Download The Investor's Guidebook

What is a Qualified Opportunity Zone?

qoz-ebook-cover-150x176
=