Potential Tax Benefits
One of the primary reasons QOFs are popular is that they represent very generous tax benefits. These benefits are available to investors who realize capital gains and then re-invest the capital gains portion (as opposed to the total sales proceeds) of the proceeds within 180 days. The potential benefits include:
Ability to defer capital gains tax for seven years (as of 2019)
A reduction in capital gains tax liability (up to a 15% reduction for investments made by 12/31/2019)
No capital gains or recapture tax due on gains from QOF investments, assuming certain criteria are met.
Although QOFs are relatively illiquid, they do represent an opportunity for some investors to unlock some tax-advantaged liquidity. While previously-enacted legislation (such as 1031 exchanges) offered tax benefits for rolling sales proceeds into a new investment, the opportunity zone legislation allows for tax benefits when only the capital gains from a sales are invested in a QOF.For example, if an investor bought an asset for $50,000 and eventually sells it for $100,000, then the investor could invest and defer tax on the $50,000 gain while also receiving the initial $50,000 basis (on which no tax is owed). In this example, the asset has "only" appreciated by 100% and the investor can take a fair amount of cash off the table. However, many investors have cost bases near zero, such as early employees in businesses that have gone IPO. In these cases, the capital gain represents nearly all of the asset's value and so a QOF would not allow much cash to be retained in a tax-advantaged way.
Thus, QOFs may indirectly provide liquidity to investors in some cases, but certainly not all cases. The opportunity for tax-advantaged liquidity depends on the percentage gain that has been realized.
Given the above liquidity considerations, QOFs may or may not represent an opportunity for diversification. Most of the QOFs that we have looked at have been focused on real estate opportunities. Selling a stock position to invest in a QOF might diversify portfolio if the investor is underexposed to real estate, while re-investing real estate proceeds into a QOF is unlikely to materially increase diversification.Consider The Risks
While we are big fans of real estate investing, opportunity zone strategies are generally more aggressive strategies focused on ground-up construction and development projects or distressed and heavy rehab projects. While the tax benefits can be very attractive, the risks of QOFs need to be carefully evaluated as well. Great tax benefits will rarely redeem a bad investment.Conclusions
QOFs may makes sense for investors who are looking for higher-risk real estate investments with generous tax benefits. However, the opportunity for liquidity and diversification benefits should be evaluated on an individual basis and risks should be carefully considered as well. We encourage interested investors to consult with their accountant and attorney, as well as their financial advisor (or MFA!) before making a decision.