Qualified Opportunity Funds (QOF) can be used as an investment vehicles to defer taxes on any type of capital gains event and also allow your gains to grow tax-free with a 10 year hold. As a followup to my previous blog on Opportunity zone investments, I wanted to talk through some of the due diligence aspects from a passive investor perspective specific to OZ investments.
OZ funds require only capital gains to be diverted to them and you can deploy the principal as you wish into other projects that are non-OZ. For example if you have a stock sale netting $200K and your cost basis is $120K then your capital gains are $80K. You only have to deploy the $80K into an QOZ to defer taxes and get all the other OZ benefits. This means you still have your original investment of $120K that you can deploy into other projects. I encourage you to look at shorter term investments (1-5 years) for this so your entire capital is not locked up for 10 years in an OZ fund. This also allows you to generate income to cover your tax liability for the OZ gain portion and provides diversification into non-OZ funds that typically offer better returns.
Also good to separate are long-term capital gains (that are generally taxed between 15-20%) versus the short-term gains (that are taxed as ordinary income at your tax bracket). It might be worthwhile to consider an OZ investment for short-term gains while paying the taxes on the long-term gains and deploying them into other investments. This might be a good strategy if a good chunk of your capital gains are short-term gains (held < 1 year).
The list of Opportunity Funds can be found at this website and will be a good starting point in your search for your ideal investment opportunity. I have been in several meetups and discussion groups on OZs in the last few months. A lot of investors are not sure how to narrow down and vet the investments on this rather huge and ever-growing list and I wanted to share my own experience of going through this process earlier this year. I hope this might help some of you with the due diligence process on your OZ investments.
You have 180 days from the capital gains event to deploy your funds into an OZ investment and thta should be plenty of time for you to complete your due diligence process. Here are a few things that are important to consider when evaluating an OZ investment-
- Target Markets – As an investor narrow down your target markets. Think about where the job and population growth is and where you’re comfortable parking your money for the long haul. Since OZs are 10 year investments think long-term. What markets are you familiar with that are poised for that long term growth? Personally, I wanted to be in landlord friendly states and avoid California, Washington, NY/NJ and other markets that are not only overpriced but also tenant-friendly (aka not landlord friendly – think rent control, harder evictions = loss of income). Some of these also tend to see bigger swings during downturns. I also tend to have less confidence in the midwest market from a job growth perspective (with exceptions like Nashville, TN, Columbus, OH and a few others). I favor Texas and Arizona right now and for the next 10 years from a growth perspective so I wanted to be invested in these states. Using this criteria, I was as able to whittle down the list of funds pretty quickly which helped reduce the noise.
- Target Submarkets – Location is everything in real estate. The submarket growth is also important in addition to broad market growth. Phoenix and Dallas are growing markets but not all submarkets within them are good investments. Real estate is hyper local. Do some research on the specific target locations. Opportunity zones are generally low-income areas that need capital infusion and revitalization. These come with their own set of problems and it’s good to be aware of them. There are some OZ locations with high median incomes in almost all the states and these are the ones that hold most promise. Some things to think about – Is this OZ in a path of progress? is this a high-median income OZ? Websites like city-data.com have a ton of demographic and statistical data that you can use to drill down as deeply as you wish short of driving around in that area and experiencing it yourself.
- Asset Type(s) – Are there specific asset types that you want to be invested in. In my own search, I didn’t want exposure to office buildings and retail for the next few years due to a potential recession. Cashflows might be affected after construction or rehab in these asset types because of occupancy issues in downturns. Multifamily family, RV Parks, Self storage etc tend to hold out better during downturns and I further narrowed down my list of OZ funds based on this criteria of asset types they were investing into and my comfort level with this asset type. In the long haul however office buildings and retail might be just fine (10 year hold) but short-term I felt the likelihood of distributions being affected was more with these asset classes. During a recession businesses might shut shop but housing is not a discretionary expense. Although you can’t build a class B/C apartments, lower cost/affordable housing communities are always needed in most of these growing markets due to ever rising housing expenses. They are likely to be easy to fill and generate good income through any economic corrections.
- Sponsor – This one is especially important. Knowing the sponsor personally would be ideal. Someone you can talk to and hold accountable is definitely a big-plus, but it might not be always possible especially with OZ investments. So how do you vet the sponsor? No one has a track record in OZ investments because it’s all fairly new and has only been in existence for about a year. But you can always look for the sponsor’s track record in non-OZ investments. If it’s a large fund look for their other investment opportunities outside OZ and see the online reviews. Ask friends or colleagues or your investing group. Look at their track record on previous deals. How have they delivered on their projections, how many previous deals are full cycle, what is their real estate/development experience, anything and everything you can find out to feel comfortable. Make a list of questions to ask the sponsor when you hop on the call to keep you on track.
- Communication – Communication is important when investing as a passive. You want to be kept up-to-date on your investment. You want a sponsor that stays accountable and communicates transparently. How often they communicate, how do they plan to communicate, are they transparent in communications, how responsive are they when you have questions. All of these are important things to consider.
- Investor Relations – How accessible and responsive is their investor relations team? The sponsor might not always be accessible but their investor relations team should be on top of things and be equally well versed. This one goes hand in hand with communication but a responsive investor relations team can be especially important in delivering documents to you in a timely manner. In my case I needed a few calls with them to get some information before my tax filing deadline and I was thankful for a quick turnaround on my requests.
- Investor Portal/Access- Most large sponsors that are doing a sizable deal should have an investor portal setup that you can not only view your investment details but also catch up on investor reports, progress reports, tax documents and more. This can be very handy and efficient way to handle communication.
- Knowledge of OZ regulations – I found this to be a big one in talking to several sponsor teams. Most folks didn’t understand all of the OZ regulations and had just self-certified and setup an OZ fund. Educate yourself a bit on OZ regulations before you do this. There are IRS guidelines released and also a variety of blogs, youtube videos and articles about OZ regulations. How often the sponsor has to report, how quickly does the sponsor need to deploy your funds, do they have a project lined up to deploy the funds. Ask the sponsor questions about the regulatory and reporting requirements they have to adhere to and make sure they are well-versed in that. I found in talking to some sponsors that I was teaching them about it and they were just winging it. Needless to say they got crossed off my list pretty quick.
- Distribution Timeline – When would the first distributions start? How much cash would I expect to recoup by year 7 or Dec 2026 since my taxes would be due (with 15% step up in basis). Would the distributions cover the tax liability I would have? Did they plan to do a refinance potentially to cover the tax liability? How open is the sponsor to explore different avenues to ensure that I can get access to my money sooner while still satisfying all the requirements to be a qualified OZ fund? All question to ask and think about.
- Exit Strategy Last but not least what exit strategies is the sponsor considering? Would it be a 10-year hold. As new guidance comes out on OZs in increments we are getting more clarity on what a OZ fund can do or not do with their investments. Recent guidance allows sponsors to move the funds from one property to another as long as funds are redeployed within a specific timeline. All these are useful to make sure the sponsor team and you are on the same page. And you know what to expect from the OZ investment
Although this seems like a long list of to-dos a lot of it becomes easier when you have a list of due diligence questions prepared that are sorted by categories that you can simply go through with a sponsor of a potential investment opportunity. I plan to release a checklist soon to ease the process. Stay tuned for this!
Final thoughts, if you wouldn’t consider an investment into an OZ fund if it weren’t for the tax benefits I think it would be best if you passed up on it. While deferring taxes and allowing for tax-free growth is definitely an attractive proposition in an OZ fund, the fact that it is a good investment comes first – OZ or not. Objectively evaluate an investment as if it were a non-OZ and then factor in the OZ benefits.
Bottomline, a sub-optimal investment is a bad investment OZ or not! OZ should just be a cherry on top! 🙂
Disclaimer – Please consult with your financial advisor, CPA or attorney as appropriate for all your investments. All material here is for educational purposes only.
