Should You Invest inOpportunity Zones? January 18, 2019 Mimi Nguyen Looking for your next investment opportunity? You may have to first get into the zone. Opportunity Zones have been created for investors to defer capital gains for a period of time while pouring much needed investment into economically deprived areas. The end goal is that everybody wins. Investors can sell any property or security and then reinvest the capital into a Qualified Opportunity Fund (QOF). This fund finances the development or redevelopment of a property or properties that are to be located within a designated Qualified Opportunity Zone (QOZ). State governors select the zones — usually low income or rural areas — which are then certified by the U.S. Treasury Department. Currently, there are about 8,700 Opportunity Zones throughout the U.S. As of December 3, 2018, there are at least 53 funds that are now or will soon be operating. The QOF can be started by anyone, and the funds can be unlimited as long as the paperwork is completed and approved by the IRS before the tax deadline. QOF investors defer paying taxes on any capital gains used to fund the QOF investment. This deferment can be extended all the way to December 31, 2026. Taxes are paid by April 2027 or when the investment is sold, whichever comes first. Hold onto the opportunity zone investment for five years and get a 10 percent deduction on those original capital gains. Hold it for seven years and get 15 percent off your original capital gains taxes. Hold onto the investment for a decade or more and pay no capital gains tax on the asset appreciation. Investors don’t need to directly invest in the opportunity zone property itself, only in the QOF. The fund’s prospectus will give the actual investment details. However, time is of the essence. Investors have to invest the capital gain into a QOF within 180 days of that gain. Note that the QOF is not to be confused with the traditional 1031 exchange, in which an investor rolls over gains from property sales into the investment of another property. With an QOF, you’re rolling your gains into a fund, not directly into a new property. The IRS will keep a close eye on the QOF to make sure it’s doing what it’s supposed to do. Twice a year, the fund is reviewed, and 90 percent of it is expected to be invested in a QOZ property. If not, the fund gets a 5 percent penalty. It can even get decertified. The QOF has its work cut out for it. It has 30 months from the initial investment date to double the value of the property being funded. Of course, with pros also come cons. Here’s the dreaded con list and some reasons why you may want to look before you leap: No guarantees. Just because an area is selected as an Opportunity Zone does not mean that investment there will automatically happen, especially if the area doesn’t seem promising for improvement. Accountability and quality control issues. Although the IRS and Treasury Department will be monitoring these funds, there is not yet any proven track record for making sure the investment goes to the right property or a foolproof way to avoid tax penalties in case of errors or miscommunications. Guidelines are incomplete for now. For instance, the program dictates that, over a 30-month period, substantial improvements must be equal to the fund’s initial investment in the property. The guidelines don’t yet list specific substantial improvements that are deemed acceptable for certain properties, like vacant land. As a social experiment, the research isn’t promising so far. Studies looking to assess the effects of Opportunity Zones seem to find that the program is not working as well as intended. Alan Peters and Peter Fisher, professors of urban planning, found that the tax incentives had “little or no positive impact” on the community’s economic growth. University of Louisville political science professor Timothy P.R. Weaver found in his research that the effect of empowerment zones was negligible in terms of reducing poverty. Opportunity zones in Louisville, Kentucky have already seen major capital investment, yet seven of the 18 poorest areas were not deemed as Opportunity Zones. “There are very few guard rails on this investment,” Jesse Van Tol, CEO of the National Community Reinvestment Coalition, a group of community organizations that promotes lending to underserved areas, tells CNBC. “There’s very little in the way of ensuring that the social impact of what comes out of this is beneficial to low-income communities.” The opportunity zone concept was first developed in 2017 by senators Tim Scott (R-SC) and Cory Booker (D-NJ). The goal is to inspire economic development in “distressed areas,” as designated by the Internal Revenue Service. The idea was widely accepted by Congress (imagine that!) and got a green light. The legislation was included in the Tax Cuts and Jobs Act of December 2017. Opportunity Zone payoffs remain to be seen, but as with all investments, time will reveal the degree of its success. Mimi Nguyen is executive vice president of underwriting at KBS.