The Tax Cuts and Jobs Act of 2017 seeks to encourage the wealthy to invest in underprivileged communities through the creation of opportunity zones, or communities where new investments can bring tax incentives to the investor. You can invest your capital gains into an opportunity zone fund and defer paying taxes on those capital gains until December 31, 2026. You can also benefit from further tax incentives the longer you leave your money in the fund.
However, opportunity zone funds may not always be a good investment. Like any other investment, you have to be sure that the project is sound. They’re also not a good investment if you need your money within the next several years, and the requirements for investing in an opportunity zone are strict. Let’s take a closer look at the pros and cons of investing in qualified opportunity zones.
Projects May Not Always Be a Good Investment
Just because a project is taking place in an opportunity zone doesn’t make it automatically a good investment. You should always vet any potential investment in an opportunity zone fund the same way you would any other commercial real estate investment. The capital gains tax benefits are beside the point – the project needs to be solid and make good sense for you financially. The capital gains tax benefits are just a perk.
So don’t enter into an opportunity zone fund investment thinking it’ll be easy or that you don’t have to do your due diligence. You have a tight timeline – just 180 days – after realizing your capital gains to roll them over into an opportunity zone investment. Make sure a contract has been signed, and that costs are stable, especially in today’s climate when the price of construction materials can fluctuate wildly. Choose a sponsor that’s already made some progress, and a project that has nailed down some financing, approvals, and anchor tenants as needed.
Your Money Will Be Tied Up for a Long Time
The biggest drawback of investing in opportunity zones is that your money will be tied up for a long time. You may not be able to withdraw money from the fund without risking losing your tax benefits. These investment vehicles are set up to encourage investors to stay in. You need to stay invested for at least five years to realize the maximum tax benefits of this kind of investment. So, you may not be able to take your money out of an opportunity zone fund for a long time, and while your money is tied up in one, you run the risk of missing out on other, better investment opportunities.
Opportunity Zone Funds Can Be Inflexible
The requirements for investing in a qualified opportunity fund can be strict. You have 180 days from when you realize a capital gains tax to roll it over into an opportunity zone fund, but that can be a tight timeline for sponsors, who may struggle to begin projects fast enough to deploy capital before the six months are up. There are annual investor reporting requirements to adhere to, and properties invested in must show improvement within 30 days of purchase.
Tax Benefits Increase Over Time
The main tax benefit of investing in qualified opportunity funds is that you can defer paying capital gains on any investment profit for a long time. In addition to the ability to defer paying capital gains taxes on investment profits, you’ll get a step-up in tax basis of 10 percent of your original investment, and after seven years, you’ll get a step-up in tax basis of 15 percent of your original investment. After 10 years, you’ll pay no capital gains taxes at all on appreciation of your original investment.
You’ll Have to Pay Fees
Funds always come with management fees, but opportunity zone funds have more than most. There will be fees for management, development, loans, and other costs, like marketing. These fees can seriously eat into your returns.
Every Opportunity Zone Doesn’t Offer the Same Growth Potential
If you’re going to invest in opportunity zone funds, you need to take a careful look at the opportunity zone where your project will take place. Some opportunity zones are located close to population centers and offer a high potential for growth and returns. Others are located in the middle of nowhere and may not provide the same potential for returns.
Qualified opportunity funds can give you the chance to help underprivileged communities, while enjoying great tax benefits and even great long-term returns. But they’re not for everyone, and they’re not an investment you should rush into without careful due diligence. Treat these investments like any other, and you’ll be more likely to realize strong returns.