Qualified Opportunity Zones

An introduction to Qualified Opportunity Zone Investments

Qualified Opportunity Zone Program

There are many worthwhile benefits to the Opportunity Zone program. It is an economic development initiative geared toward boosting opportunities within lower-income neighborhoods. Furthermore, it does offer some nice tax breaks, especially if you don’t want to pay taxes on your capital gains.

But the QOZ program is, above all, an investment, and as with any investment, there are risks you must consider. Adding to the complexity is that the program is still so new, and many missteps could occur. Those missteps could, in turn, end up costing you tax breaks.

As such, your goal is to educate yourself as thoroughly as possible about the Qualified Opportunity Fund you are considering for your capital gains investment. With help from extensive QOF due diligence, you’ll be better prepared and able to make the right investment decision, one that makes the most sense for you.

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This material is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

Hypothetical example(s) are for illustrative purposes only and are not intended to represent the past or future performance of any specific investment.

The Focus on QOFs and Their Managers

Red Pin on MapPresident Donald Trump Signed the Tax Cuts and Jobs Act into law on Dec. 22, 2017.

Amid the tax changes for businesses and individuals, the legislation contained another element, the Investment in Opportunity Act. Better known as the Opportunity Zone program, the idea behind this initiative is to channel investors’ capital gains from the sale of assets into economically challenged, federally designated areas, known as Qualified Opportunity Zones (QOZs). That money is being funneled into projects geared toward boosting economic growth, while investors receive tax deferral breaks on their capital gains.

Here is what happened since the program was introduced in late 2017.

  • The U.S. Department of the Treasury and the Internal Revenue Service (IRS) have designated more than 8,700 Opportunity Zones throughout the United States and U.S. Territories. According to data from the U.S. Census Bureau, these QOZs consist of lower-income geographic areas.
  • Treasury and the IRS have also issued three rounds of program guidelines, geared toward clarifying investments, eligibility and timing requirements when it comes to QOZ investments.
  • With guidance and explanations in hand, investors now have a framework for, and understanding of, investing capital gains into the program. These gains are invested in Qualified Opportunity Funds (QOFs) which, in turn, funnel the capital into QOZ real estate projects, as well as Qualified Opportunity Zone Businesses (QOZB) and Qualified Opportunity Zone Partnerships (QOZP).
  • Much has been written about the program, itself; the Investment in Opportunity Act has been mostly lauded for its community improvement potential and investor benefits.

The issue, however, is that, while a great deal of media focus has been on QOZs, there has been little published, or written about, concerning the program’s financial vehicle, the QOF. Yet as an investor, there are several issues you need to keep in mind before deciding to put your capital gains into this type of financial vehicle.

The Investor's Guidebook

A Qualified Opportunity Zone investment can be a great opportunity to defer taxes, however, it can be a complicated process, but it doesn’t need to be.  The key is planning, and that’s why we’ve created an investor's guide to Qualified Opportunity Zone investing. It tackles the art and science of completing your investment, and the pitfalls to avoid.



The QOZ Investment Vehicle: An Overview

Risk BlocksIt is important to remember that QOZ investments are considered among the highest-risk investment opportunities available. It is also difficult to research background information on many of these investments.

When it comes to creating Qualified Opportunity Funds, legally established partnerships and LLCs can do so by:

  • Filing IRS form 8996 with their federal tax returns, and
  • Ensuring at least 90% of their assets targeted for improvement are in designated QOZs.

The potential danger here is that those setting up a QOF aren’t experienced in doing so. In 2019, research company Preqin indicated that a little more than 70% of QOFs are being run by “emerging managers,” in other words, managers with little or no experience.

This brings us to the second point: many QOZs consist of ground-up developments or rehabilitation in unproven locations. You need to know your fund, before you invest in it.

But the third factor here is that it’s highly difficult to find much information on the QOFs that are forming and/or currently in operation. Because the program -- and its funds -- are still new, no previous track records exist. There are few, if any, metrics pointing to QOZ successes or high rates of return. 

QOF due diligence isn’t out of the question, however. It does mean you will have to work a little harder to find that information. And, you should focus on digging up such intelligence. While you might want to invest in a QOF to “do good,” you are also examining this funding vehicle to defer taxes on your capital gains. Any misstep from the QOF in which you are investing could put you on the hook for a sudden, hefty tax bill.

The following will share ideas and best practices to help you vet a Qualified Opportunity Fund. While the sections, below, provide a “big picture” view of QOFs and their managers, we encourage you to click on the links provided, which will take you to more in-depth information about each topic.

Targeting the “Right” Qualified Opportunity Zone -- and its Fund

In April 2020, financial consulting firm Novogradac LLC reported the existence of 621 Qualified Opportunity Funds (QOF), which had raised a combined $10.09 billion. Some of the funds support workforce housing renovations and developments, while others invest in Qualified Opportunity Zone Businesses (QOZBs) or Qualified Opportunity Zone Partnerships (QOZPs). Still others focus on brownfield clean-ups or adaptive re-use.  There is a myriad of QOZ projects that require funding.

It probably goes without saying that the sheer number of available QOFs can make it difficult to find one that is appropriate for you. However, you can make your way through the plethora of QOFs by understanding their set-up and strategies, as well as the entities that oversee and manage them.

Funds Charts iPadThese funds are set up either as identified funds or semi-blind funds.

  • Identified funds already have specific QOZ projects in the works, or under contact. The advantage to this fund structure is that you know, up front, what project is being financed and developed. These funds are more transparent, and you can actually visit the development sites.
  • Semi-blind funds are committed to raising capital first, then finding likely projects on which to spend that money. While these funds aren’t as transparent as their identified counterparts (and are riskier), their advantage is that of available financial resources. This can help lead to a quick acquisition and closing.

In addition to determining your level of comfort with identified versus semi-blind funds, you also need to be sure that the QOF and its manager have experience in the real estate or other projects it is financing. If a QOF is investing in workforce housing in a downtown Chicago QOZ, it’s important that the fund has previous experience with developing and maintaining workforce housing in other large cities.

Additional information about project and fund types can be found here.

Location Matters

While there are 8,764 QOZs throughout the U.S. and American Territories, not all of them will automatically be great investments with the potential for outstanding returns. Projects that made absolutely no financial sense before being located in a Qualified Opportunity Zone are not going to suddenly become great investments, with the potential for outstanding returns.

QOZ Map This is why it’s essential that your targeted QOF and the fund manager have experience in the geographic regions in which it is planning to operate -- or, at the very least, has personnel on board with that experience. Because real estate -- and Qualified Opportunity Zones -- is about location, the QOF in which you are interested should understand that local market’s population, economic and demographic trends. Your targeted QOF must also understand the characteristics of each QOZ. Requirements for successful investment in rural Colorado will be vastly different than those mandated for Brooklyn, NY. And yes, there are funds that target both of these locations.

For instance, it doesn’t make sense for the fund to back a medical office building if there is no demand for that type of real estate product in a QOZ. This not only impacts a return on investment, it could also seriously impede a main factor of the QOZ, the “substantial improvement” clause, which we’ll examine in further detail, below.

Additionally, while the QOZ program is a federal initiative, it is designed to operate locally, in tandem with state and local municipalities. During the past couple of years, a plethora of state-specific rules and legislation has been passed and put into effect. Each state also handles its QOZ program differently. Some have created specially-designated governmental departments to handle QOZ-related issues, others rely on oversight through departments of commerce and economic development groups. Your due diligence should focus on whether your QOF is in regular touch with state and municipal leaders, to ensure regulatory compliance.

Finally, the Investment in Opportunity Program is, above all, a community program. This means the QOF in which you are interested must know how to communicate with community stakeholders, many of whom have not worked with developers, architects or civil engineers before.

For additional information about QOF geographic research, click here.

Understanding “Substantial Improvement”

ImprovementA Qualified Opportunity Fund has two goals.

  • It must find and buy a property in a QOZ, one that meets a myriad of federal and state requirements.
  • Once it has acquired the asset, the QOF is under a 30-month deadline requirement, set by the IRS and Treasury, to “substantially improve” it.

This means that the QOF is required to double a QOZ property’s adjusted basis (excluding the land on which it sits), within two and a half years after buying the property. So, the fund has to invest at least as much as the property is worth (less the land costs) to meet the “substantial improvement” clause.

Delving into this in more detail, the projects in which your QOF is targeting will likely focus on:

  • Those that are already under construction
  • Those that are shovel-ready
  • Those consisting of renovation and/or adaptive re-use

Unless you have a crystal ball, it’s difficult to determine if a QOF will succeed in this endeavor. We mentioned, above, that QOZ investments are high-risk. There are ways to manage this risk, however. An experienced QOF manager will have track records available from previous projects. Additionally, getting a clear idea of the QOF’s goals and milestones can help provide some confidence that the entity is taking the “substantial improvement” deadlines seriously.

For additional information about substantial improvement and an explanation about basis and adjusted basis, click here.

Finding the Money

magnifying-glass-computer-IS-1147405001Along with timing, the QOF you are targeting needs to have enough money to buy projects and substantially improve them -- all within the above-mentioned two-and-a-half-year window. That capital will be obtained through a few sources that include investors such as yourself, equity partnerships and loans.

To better understand this, it’s a good idea to delve into the QOF’s sources of capital -- including yourself and your fellow investors. Past history can be a good indicator of potential success. If the QOF manager has had a good track record when it comes to borrowing and/or forming lucrative equity partnerships with others on previous projects, you can feel confident that you are in pretty good shape.

Finally, that QOF manager must also be investing in the project. We believe this is a non-negotiable item. If that manager is willing to throw your capital gains (and those of others) into a project, but doesn’t have any of his or her own skin in the game, it’s time to consider another fund.

For additional information about capital sources, click here.

Looking into Partnerships and JVs

Chess StrategyOnce you’ve delved into the background, goals, geographic understanding, milestones and fund-raising prowess of your targeted QOF, your job is only half done. Adhering to the Opportunity Zone Program’s many mandates requires a lot of moving parts. Any QOF manager who indicates he or she can handle it all is not someone you should trust.

This is where partnerships and third parties will come into play. While your QOF manager might have experience with raising capital or project development, he or she will need to tap the expertise of others for a QOZ project. These “others” can include architects, accountants, real estate brokers, marketing professionals, lawyers . . . and more.

These relationships could take the form of:

  • Joint ventures, in which the experts are actual partners
  • Corporate set-ups, in which the QOF manager hires the experts for specific jobs

Your QOF manager should be willing -- and able -- to pass along the names of companies and entities with which it is working/will be working. Once you have those names, you need to research their background and experience, as well. Find out previous projects these third parties or partners have worked on, and try to dig up any success metrics.

For additional information about a QOF’s partnerships and third parties, click here.

Steps to Take

As mentioned earlier in this document, the challenge with performing due diligence on a QOF and its manager is that the Qualified Opportunity Zone program is still very new. QOZ-specific metrics are lacking, which can add to the complexity of researching such investments before becoming involved.

But experienced QOF managers will have a trail of successful previous projects and outcomes, which can be useful for your investigative efforts. If no such projects are available, consider looking elsewhere. Meanwhile, when researching, consider if the QOF manager you target:

  • Has experience in development and/or management of the fund’s specific property type and fund’s structure.
  • Understands the rules, regulations and guidance involved with buying, developing, maintaining and owning QOZ assets.
  • Has actual skin in the game, that he or she has actually invested his/her funds in the project.
  • Has extensive experience in the market/markets in which the fund will be operating, as well as an understanding of state incentives and tax breaks.
  • Has background experience and a deep-level understanding of the property type(s) the fund is managing and supporting.
  • Can provide a detailed investment plan, including targeted properties, timelines and exit strategies. QOFs can sell QOZ properties, and invest the proceeds into other Qualified Opportunity Zone projects.
  • Will give you a list of the third parties and partners involved with the fund/projects, which you also should research.
  • Has a communication structure set up for regular news and information to investors. You should be receiving, at the very least, a quarterly report. Furthermore, it’s essential that the fund manager be available to answer any questions or concerns you might have.
  • Tells you the fee structure, up front, rather than burying it in the fine print.

Finally, when you have completed your research on the fund, the project and everything else involved with this investment, you must take a step back. Just because a project carries a “QOZ” label doesn’t mean it makes sense as part of your portfolio. You need to be sure that the QOF matches with your current portfolio and investment goals, before handing over your capital gains.

Putting those profits into a QOF means your money will be tied up for at least seven years, with no way to pull it out if you need it. Because it is highly illiquid, investing in a long-term fund of this nature might not be worth the potential tax breaks you would receive.

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.

Selected Blog Articles

Can an Opportunity Zone Flip Houses?

Oct 23, 2021

Can I Pull Equity from an Opportunity Zone?

Oct 20, 2021

Can a Partner of an LLC Defer Capital Gains Taxes on QOZs?

Much of what is written about the Opportunity Zone program involves investors with capital gains from the sale of capital assets. Those gains can be invested in Qualified Opportunity Funds (QOFs) which, in turn, place those resources ...

Oct 15, 2021

Terms to Know

Rule 144A

Introduced in 2012, Rule 144A reduces the amount of time a qualified institutional buyer must hold privately placed securities from 2 years to six months for a company that reports to the SEC or a year for a company that does not. The ...

Original Use

In order to qualify as a qualified opportunity zone business property (QOZBP), property acquired by a QOF or QOZB must satisfy the requirements of an “original use” test or a “substantial improvement” test. Original use is defined as ...

Intangible Property Test

In order to qualify as a QOZB, a firm must deploy a substantial portion of its intangible property in the active conduct of a trade in a QOZ, defined as at least 40 percent.

50% Gross Income Test

In order to qualify as a QOZB, an investor must demonstrate that a property or business generates at least 50 percent of its gross income from the active conduct of a trade or business in a QOZ. A trade or business will satisfy the 50% ...

Inclusion Event

An inclusion event occurs when a QOF investor chooses to recognize some or all deferred gains. An inclusion event will occur on the earlier of the occurrence of the event or December 31, 2026, per the Proposed Regulations.