Opportunity Funds May Supercharge After-Tax Yields, But Risks Remain
A new type federally qualified investment vehicle known as an opportunity fund allows individuals and entities facing capital gains taxes to defer and reduce their tax bite, while paying no additional tax on appreciation of the investment. The only catch is that investment has to be limited to designated areas known as opportunity zones, and the real estate investment requires significant capital improvements to the asset (generally ground up construction).
It sounds like a great deal for investors, and it is. But in the rush to defer gain and supercharge yield, it’s important to remember that these deals have to pencil out. Otherwise not only the yield but the initial investment can be at risk.
What Are Opportunity Funds?
Opportunity funds were created by the Congressional Tax Cuts and Jobs Act of 2017 to encourage affordable housing and business development in economically struggling communities. Opportunity Zones have been designated nationwide by Federal and state economic development authorities.
Real estate investors can defer and even reduce federal tax liability on current capital gains by reinvesting the capital gain in qualified Opportunity Zone assets and businesses. In addition, the investor’s capital gain on the new Opportunity Zone investment may be tax-exempt if the investment is held for 10 years.
The program is designed to make it easier for Opportunity Zones to draw different types of investment that contribute to the community development “ecosystem.” So an Opportunity Fund might be focused on real estate development and redevelopment, or on supporting and growing businesses within the zones—or a combination.
- Defer federal taxes on any recent capital gains until the end of 2026
- Reduce that tax payment by up to 15 percent if the investment is held for seven years
- Pay no capital gains tax on any appreciation if the investment is held for 10 years
Real estate related investment in Opportunity Funds include:
- Filling a funding gap for new or updated mixed-income and workforce housing;
- Upgrading commercial property to draw businesses and jobs;
- Investing in local firms engaged in development , property management and other services
Not for Everyone
While the benefits are great for deferring capital gains, Opportunity Funds aren’t right for every situation. Opportunity Zone investments require significant capital improvements with inherent construction and market risk associated with value-add investment strategies.
Investors should also understand that Opportunity Funds are meant to be a long-term investment, between seven and 10 years for maximum benefits. Longer term generally translates into lower annualized yields, but generally a higher multiple return on equity.
Overall, the national market for workforce and low-income rental housing offers attractive supply/demand fundamentals, given the lack of new supply recently generated in urban areas.
Opportunity Zone investments may not offer the best risk-adjusted yields in the market. Market risk may be higher given the socioeconomic profile that qualifies an area as an Opportunity Zone. These are typically deals that might not pencil out without the extra tax incentives.
Therefore, it’s important that opportunity zone investments are fully vetted to identify risk factors, structured in ways that advance community development and quality of life, while providing an overall benefit to investors.