Qualified Opportunity Funds: Great Tax Saving Opportunity or Too Much Risk?

Qualified Opportunity Funds (QOFs) have received a lot of attention in the press lately and the expectation is that you will hear more about these funds by year end.   Most recently, QOF’s were prominently highlighted on a recent front page of Sunday’s New York Times.  

The attention is due to the tax benefits created by the Tax Cut and Jobs Act of 2017.  At first glance, these benefits are attractive, but there are several caveats to these investments.  

Before getting to these tax advantages though, it is important to know a bit about Qualified Opportunity Zones (QOZs).  A QOZ is an area designated by the 2010 US census as being underdeveloped.  They exist across the United States in both rural and urban areas. There are about 8,700 opportunity zones and if you are interested in reviewing these zones, you can see them here.

However, it is a daunting task to figure out which zone of the 8700 is a suitable investment. As a result, QOFs were developed to pool investor funds, provide expertise, scale, and diversification.

With the above in mind, we want to describe how these funds work and their potential benefits and drawbacks.  To be clear, we are looking at this purely as an investment and tax strategy and will not consider the social or psychic benefits of these investments.  

So, what is making these funds popular or at least gaining traction in the press? The key benefits are tax deferral, reduction, and elimination. The first two listed below are nice to have benefits, but the third piece — tax elimination — is what has resonated with investors and speculators.  

• Tax Deferral:  Any asset (real estate and stock) with unrealized gains can be invested in a QOF and the unrealized gain can be deferred for 7 years.
  • A key point is that you can split the asset by cost basis and unrealized gain. For example, you can take a $400k stock position with $300k of unrealized gains and invest the $300k (the deferred gain) in the QOF while keeping the $100k cost basis portion in the existing account.  This will allow you to diversify the remaining $100k investment.
  • If you have a risky concentrated stock position, this is a way to potentially diversify the position.
• Tax Reduction:
  • In addition to tax deferral, you will receive a step up in basis on the deferred gain. 
    • After 5 years, you receive a 10% step up in basis on the deferred gain. 
      • Assuming the same example, this means your $300k deferred gain stepped up by 30k.
    • After 7 years, you will receive a 5% step up in basis on the deferred gain.
      • Assuming the same example, this means you will increase the cost basis by 15K, for a total of $45k.
    • After 7 years (December 31, 2026 in this example), the tax on the deferred amount is due and you will owe capital gain tax on $255k ($300k -45k= $255K) versus $300k.
• Tax Elimination: 
  • The gain attributable to the QOZ investment is eliminated after 10 years.
    • This is the key tax benefit or the sizzle of the 2017 tax law changes.  Let’s say the $300k (the initial QOZ investment) grew to $630k in 10 years, a 6% return, $330k in capital gains are excluded.  This represents a potential $82k in tax savings depending on your capital gain rates.

So, what’s not to like?

Sounds too good to be true.  Well, yes, it is.  There are many concerns with the QOF that should be considered. 

The first is the investment must be profitable. QOZs are very risky and picking the right ones out of the 8,700 is a challenge. In addition, it is a very illiquid investment. You must wait at least 10 years or more to realize a gain. In fact, there is a decent chance that your investment horizon may be longer than 10 years. This is because at the 10-year mark, you may not be alone in heading to the exit doors and with everyone trying to get out at the same time, prices may be depressed. 

Another downside is if you die within the first 7 years, your beneficiaries will lose the step up in basis on the deferred gain. Rather, the deferred gain will be includible in your estate as income in respect of the decedent (IRD).  This is certainly not an investment for those with a short life expectancy. 

Fees are also problematic at 3% to 4%. The expected return will vary based on the investment, but the QOF’s we reviewed target about an 8% to 12% net return.  These fees are analogous to how hedge funds charge their fees.  At a certain point, the fund will take more of the profit depending on investment performance.

Not only do you have a risky strategy in of itself, you also have significant implementation risk. Because of these eye-popping benefits, there has been a rush to market to create new QOF’s.  Many QOF fund managers are not experienced in the real estate business, and, in fact, over 70% of QOF’s are run by first time managers.  Because of this, it is critically important to do your due diligence on the funds and work closely with your CPA.  

That said, QOFs may be a fit for those who:

• Have a significant gain in a very risky, speculative asset already.
  • For example, you own Bob’s pork belly commodity fund with gains, and you want to diversify the existing cost basis and diversify the unrealized gain with a real estate investment.
  • In this scenario, you exchanged the same amount of risk with tax benefits.
• Are comfortable with a long-term investment horizon of at least 12-13 years.
  • Remember, if you die before 7 years, then your estate will owe tax on the deferred gain and will lose the step up in basis.
  • Are comfortable with real estate speculation overall. 

In summary, QOFs are an intriguing speculative investment strategy, but proceed with caution.  We strongly suggest you complete your due diligence and bring in a competent CPA.  Or, 10 years from now, you might be saying “It seemed like a good idea at the time!”