Real Caveats For Real Estate Qualified Opportunity Funds

Real Caveats For Real Estate Qualified Opportunity Funds
Posted by on Nov 2, 2018

Due Diligence

The Qualified Opportunity Zone program offers a slew of potential benefits for investors facing capital gains taxes. Investing your gains in a Qualified Opportunity Fund can help defer taxes on those gains, while supporting economic growth in a low-income area.

With the good that the Qualified Opportunity Zone program can provide, what could go wrong? In a word: Plenty.

The program is still new, with the first round of regulatory guidance about, and requirements for, Qualified Opportunity Funds (QOF) just released from the U.S. Department of the Treasury and IRS. This newness, combined with the types of assets in which QOFs are likely to invest, requires in-depth, thorough due diligence, if you decide to participate.

Realizing Different Risks

First of all, the QOF in which you put your capital gains will only be as successful as the underlying real estate in which it invests. If the fund targets questionable real estate, your returns could be questionable, as well. It’s also important to keep in mind that properties, projects or assets that previously might not have been feasible for conventional funding could now attract capital, only by virtue of the fact that they are located in QOZs.

Available information is another potential issue. It’s one thing to invest in blighted areas. It’s another to put your money in areas with little investment history. The nature of QOFs, and the fact that they most likely encompass lower-income areas requiring economic growth, can make it more difficult to secure enough information on which to base a pro forma or forecasted rate of return.

More broadly, any investment decision should take economic and real estate cycles into account. As of this writing, we are arguably nearing the end of a strong economic expansion; any slowdown could have an impact on a QOF investment. The later in a cycle you invest, the weaker your returns might be.

On the other side of the coin, the QOZ Program is designed to encourage long-term equity investments. As such, you need to hold that investment for at least 10 years to realize significant benefits. And, come April 2027, you will owe capital gains taxes on your original investment that you deferred, with the potential of capturing a 5% and 10% step-up in basis depending on how long you held your capital gains in the fund.

To realize no capital gain liability on any appreciation within the fund, the IRS has ruled that you must hold your investment for a minimum of 10 years. Because the deferral period ends before this 10 year hold period, however, you need to plan for a “phantom gain” payment if your cash is still tied up in the QOF. In other words, if you invest in a QOZ fund in 2019, you must hold until 2029 to avoid paying taxes on the appreciated proceeds in the fund. Thus, having to bring in outside cash to pay your deferred tax liability in April 2027, which would result in this “phantom gain” payment.

As an intelligent investor, you already know investments carry degrees of risk. However, in the case of a QOF, many believe that the benefits (tax deferral) outweigh the risks (loss of capital). While this is true in some cases, a failed QOF means you could lose your entire gain. Furthermore, additional taxes resulting from debt forgiveness (i.e., insult and injury) could result.

Protecting Your Gains

The above is not meant to dissuade you from QOF investments. But given the recency of the program, and where we are in the current real estate and economic cycle, consider the following steps to protect yourself and your money.

  • Study the underlying investment. Any reputable fund will offer information about where your monies will be directed, as well as a specific focus and plan. A QOZ fund at its core is an investment in real estate or a business, as well as an investment in the sponsor, and one must conduct their own due diligence to understand what potential risks they are taking on.
  • Be sure the fund supports an experienced operator. If the QOF is investing with a developer that is renovating multifamily housing in a Qualified Opportunity Zone, that developer should understand workforce housing, versus only having expertise in Class A, luxury high-rise residences.
  • Understand the downside risk. Get a sense of what could happen if the QOF doesn’t raise enough money, or dissolves before a specified timeline. Also, know the potential penalties for early withdrawal from the fund. In some cases, this action could trigger additional taxes.
  • Ensure the fund is and remains certified. If you invest in a QOF fund that doesn’t follow governmental guidance, you could be on the hook for capital gains taxes you are trying to defer, plus potentially your proportionate share of any penalties that maybe assessed.
  • Be certain that the fund’s sponsor is reputable. Many trustworthy financial institutions and investment firms are forming QOFs. Then, there are funds being created by inexperienced, opportunistic companies. Find out who is managing your fund before you invest.

To summarize, due diligence is necessary for any kind of investment. Due to the many unknowns about the QOZ program, it’s important to conduct a thorough investigation before entrusting your capital gains to a Qualified Opportunity Fund.

 


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