Opportunity Zones: Windfall or Pitfall?
Opportunity Zone Funds seem to be popping up everywhere even though the final ruling are yet to be out. Are they really a good deal for family offices,or just for the developers?
By Steffi Baker – The Family Office Real Estate Magazine
Family offices with real estate holdings have probably heard something at this point about opportunity zone funds.
In a nutshell, an opportunity zone is an economically depressed area that the federal government earmarked in the Tax Cuts and Jobs Act (TCJA) in 2017 for special investment treatment. The governor of each state could nominate certain areas for the IRS to certify to receive investment from Qualified Opportunity Funds (QOF), and the investors would receive tax breaks that would incentivize them to leave their money in the fund for up to 10 years and possibly longer.
At first blush, it looks like a pretty sweet deal? along with the chance to make a positive social impact for disadvantaged businesses and people living in the O-Zones, as they’re known. Thanks to the tax benefits, family offices are reportedly lining up to invest.
One early entrant into the QOF space is Phoenix-based Virtua Capital Management, which has launched a $200 million QOF. The firm’s president, Derek Uldricks, says they’ve been seeing the most interest from family offices and high net worth individuals. To accommodate demand, they are allowing FOs and HNWIs to co-invest alongside the firm in individual deals or write a check for 100%of the capital in a specific deal, as well as invest in the main fund.
“Some FOs are still weighing up when to get in. We are being flexible,” says Uldricks. “There is no reason they have to sell in 10 years, they can hold for longer. They’re looking at this as a way to diversify. A lot of them have highly appreciated assets of all kinds (capital gains from any type of investment can be placed into QOFs or O-Zones). They can sell that, roll the gains over and put the principal into an O-Zone or QOF. Mostly, the social impact is a secondary reason. They want to build or protect their wealth and be tax efficient as much as possible.”
A QOF is a good alternative to a 1031 exchange for many family offices, Uldricks notes.
Ricky B. Novak, the managing partner of Atlanta-based Strategic Capital Partners, also reports he’s had high interest from family offices.
“Since I’ve been talking the zones publicly, we’ve had number of advisors and family offices knocking on our door,?says Ricky B. Novak. “They want to get in on this before the end of the year. We’re very busy helping people figure out what to get into and where.”
However, not everyone is convinced family offices should jump into QOFs right this red hot minute.
“The IRS has’t finished defining the terms for QOFs,?says Steve Thayer of Chicago-based Handler Thayer, a prominent family office law firm. “We don’t really know what the long-term implications are yet. There are a lot of questions that haven’t been answered, such as, what happens if you put money in now but take it out before the fund invests? Or, what if the fund doesn?t invest all its money? How is that money going to be treated if you take it back? You don’t want to put your money into a fund and then have the IRS change the rules on you later. That could be very costly.?
Thayer says family offices would be wise to check their land holdings to see if any of their parcels happen to fall in opportunity zones, as new options are now open to them.
“I have a client who has some holdings (in one state) and I looked it up” it happens to be in an O-Zone,” Thayer says. “So maybe it’s time for him to talk with a QOF or sell.”
Bryan Mick, president of Omaha-based Mick Law PCLLO, believes family offices should consider the underlying merit of the deal before getting too excited about the tax advantages.
“It(the tax breaks) will be a powerful aspect of the overall return, but the deal still needs to be fully underwritten,?notes Mick. “I have seen plenty of tax-driven deals, like Section 8, LIHTC and solar, that have blown up because investors focus on a tax angle versus a fundamental analysis.”
Thinking of holding off for a while?Here?s where the plot thickens and it may not pay to wait. An investment in a QOF before January 1, 2019 held for 10 years is allowed to exclude 15 percent of the pre-acquisition gain and defer 85 percent of the pre-acquisition gain until December 31, 2026. The investor may also exclude all of the post-acquisition gain after the investment date.
Publishers Insight : In a recent article that, I wrote in Forbes on Opportunity Zones there were many things that family offices should consider when making an investment into an opportunity Zone. The following is an excerpt from the Forbes article:
“For many family offices, Opportunity Zones might be just the, well, opportunity they are looking for, investment-wise. However, families should not move forward without digging deeper into the investment. With various tax benefits for investors, it all may seem like it’s just too perfect for a family not to participate in a real estate investment within an Opportunity Zone. However, the fundamentals should not be lost when looking at these projects within the area. Just because it’s in an Opportunity Zone doesn’t make it a good investment.
The creators of this program claim that employment in these areas should increase as well as spurred growth and reduced poverty, but will this be the case? The fundamentals for the Opportunity Zones are to help investors, through tax incentives, to transform areas that are declining or already have failed to thrive and create economic hubs.
Timothy Weaver, professor of Urban Policy and Politics at the State University of New York at Albany, writes: “Numerous efforts have been made to assess the effectiveness of such zones, both in the U.S. and the U.K. On the whole, scholars have reached the strikingly similar conclusion that the programs did not work, at least not as hoped.”
The Opportunity Zone is being considered the next best investment opportunity, but the fundamentals still need to be followed. You still need to make sure you dig deeper into the real estate opportunity. What is the demand of the property type, what kind of property type is best for the location, what is the experience of the developer, what is the track record of the developer, how much are they putting in of their own money and what is their plan to protect the downside if the area doesn’t take off like they think it will -or the investment doesn’t do as well as they had hoped? A bad investment – even one in the Opportunity Zone – is still a bad investment.
The Opportunity Zones definitely have the potential to be a great opportunity, assuming that the operator can produce their intended results and the area agrees to grow accordingly. In the end, just remember, the real estate investment is only as good as the underlying asset and the operator.”
Lower benefit is available for QOF investments done after December 31, 2018. The IRShas not yet commented on whether any benefit will be available after December 31, 2026.
This means there is plenty of incentive to act now and explains why QOFs have suddenly become all the rage over the summer months. Enter “opportunity zone” into an online search and a number of results come up with “ad” next to them, which signifies a pay-per-click ad is in place.
Uldricks says there are about 8700 zones in total, and calls it a “mixed bag.”
“There are certain deals that are strong that just so happen to fall into what I’ll call O-Zone 1.0. Those deals are going to go fast, you can?t wait until next year to get into those.”says Uldricks.
“The 2.0 batch are on the cusp. They’re still good deals but not as good as 1.0. The batch we call 3.0 are tough deals. They may or may not get done, and for a variety of factors are just not that attractive.?
On the bright side, Uldricks points out the census data the O-Zones are based upon is old and can be skewed, resulting in some O-Zones being better deals than people would think. For example, he says there are O-Zones in downtown Scottsdale, which is an affluent area near Phoenix.
What’s a family office to do? Check, check and check again on QOF suitability before deploying funds with legal and accounting professionals familiar with the legislation and the IRS interpretation available so far.
“You have to get advice on your own situation,” cautions Thayer. “What works for your friend or the guy down the street or another family office may not turn out well for you.”