Opportunity Zones Offer Big Benefits & Big Challenges

The Opportunity Zone investment program ushered in by the 2017 Tax Cuts and Jobs Act provides an unprecedented ability to reduce capital gains taxes.

If an investor realizes and rolls a capital gain into a Qualified Opportunity Fund (QOF) this year and holds the investment for 10 years, he or she gets a step-up in basis on the original gain of 15% and pays no capital gains tax on the new investment. These benefits could boost after-tax returns 2 to 6%, depending on the investment.

But caution is warranted.

Opportunity Zone locations are economically distressed, making return on investment more challenging and viable investments scarcer. Still QOFs are proliferating and raising incredible amounts of capital.

That could mean there will be a lot of money chasing too few good deals, and a lot of projects offered up won’t make sense for investors. Adding another layer of difficulty are strict timing considerations that funds and investors must follow to qualify for the tax benefits. An investor must roll capital gains into a QOF within 180 days of realization, and the fund must deploy the capital received within 31 months. This means that without a well-defined pipeline of projects, funds will struggle to deploy capital in time, and investors will pay the price. A final consideration for investors is long-term illiquidity given the current uncertain tax environment. If an investor believes that the capital-gains tax rate is likely to increase over the next seven years before taxes are due on the original investment, he or she might want to take profits now and pay the tax to avoid higher future taxes.

Whether the Opportunity Zone program will improve distressed communities or boost investor returns is still up for debate, and only time will tell the result. In the meantime, investors should ensure that they understand the rules and challenges associated with Opportunity Zone investing and beware of unabashed promoters with differing incentives.