Don’t Let Tax Benefit Lead to Poor Opportunity Zone Investment

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Opportunity zones are an intriguing investment opportunity to some investors because of the tax benefits of participating in the program. Created under the Tax Cuts and Jobs Act of 2017, the program aims to spur economic development in low-income rural and urban areas around the United States.

In an attempt to pair investors with designated opportunity zones in Indiana, the Opportunity Investment Consortium launched an online portal Nov. 19. The goal is to transform these areas and neighborhoods (there are 156 designated opportunity zones in Indiana) into vibrant, attractive, and sustainable communities for residents and businesses. In addition to the online pairing tool, the Opportunity Investment Consortium will have regular meetings to gather support for challenging projects. (You can read more about the portal in the Indianapolis Business Journal.)

We discussed investing in an opportunity zone’s qualified opportunity fund in a previous blog post and questioned whether investing in an opportunity zone is a prudent action for investors. We continue to believe that investors need to do their homework before choosing to invest in a qualified opportunity fund. It is imperative to not let the tax benefit lead to a poor investment decision.

Waiting for More Information

Currently, there is a lot of information on the benefits of tax deferral under the program, but little on the investment merits of funds and investments. A key component of the investment is that it must create a “substantial improvement” to qualify for the tax deferral. Within the real estate context, that means development. In other investments, it may mean jobs being created; however, it cannot simply be relocating an existing business to a new area.

Investors need to keep in mind that the rush of capital by smaller players attempting to raise funds has been swift, as well as competition for deals, which leads to higher purchase prices. Many of these funds will wind down in 2026, which will potentially lead to a flood of sellers. As a result, you may end up buying in a “seller’s market” and selling in a “buyer’s market.”

The funds being raised so far are typically by smaller, less institutionalized firms attempting to be first to market and catch the early capital. Additionally, much of what we have seen thus far have been single asset funds (i.e., not diversified). A few larger firms are placing some capital through their private bank or private client arm, but those aren’t broadly marketed to their institutional investors.

Where Is the Capital Gain Coming From?

The desire to defer taxes can potentially lead to an investment with a very different risk or liquidity profile. Qualified opportunity funds are illiquid strategies, so coming from a daily liquid mutual fund or individual stock will be a different experience for many investors. These qualified opportunity funds will likely be fairly concentrated, which means the potential for a negative return could be higher.

In addition, the drawdown structures may pose a problem for realizing the tax benefits. The funds raised will have to invest or call capital within 180 days in order to satisfy the time requirements for tax deferral for the investor.

There are still several unknowns around investing in a qualified opportunity fund. Further regulations are to come near the end of the year, and it is unknown how larger funds will move forward because of the unanswered questions about partnership interests and operating businesses.

If you are interested in investing in a qualified opportunity fund, we recommend meeting with your financial advisor to discuss the benefits and drawbacks of utilizing this strategy. We’re happy to meet with you to determine if investing in an opportunity zone is the right fit for you and your family’s long-term goals.

Disclosure: While this article addresses generally held investment philosophies of Fi3 Advisors, it does not represent a specific investment recommendation for any individual client or prospective client. Please consult with your advisor, attorney and accountant, as appropriate, regarding specific advice. Information has been obtained from a variety of sources believed to be reliable but not independently verified. Past performance does not indicate future performance.