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The Tax Cuts and Jobs Act of 2017 received a lot of attention when it was introduced and became law in late 2017. Most of the attention was focused on the debate about whether a significant cut in corporate taxes would spur economic growth, and each side of that argument generally fell along party lines. But hidden deep in the legislation was the creation of opportunity zones, a concept that had support from both parties in Congress. The basic idea is to encourage investment in low-income communities by offering tax breaks to investors making investments in these areas.

Welcome to the Land of OZ (Opportunity Zones)

The legislation paved the way for approximately 9,000 U.S. census tracts to be designated as opportunity zones. By taking advantage of this new provision in the tax code, individuals who invest in real estate or other projects within these opportunity zones can reduce and delay the capital gains taxes due from sales of other investments. Opportunity zone investors may defer the payment of capital gains taxes until December 31, 2026, and the amount of the taxable gain can be reduced by up to 15% if the investment is held for at least seven years. In addition, all gains on the opportunity zone investment itself are tax-free if the investment is held for more than 10 years.

If I Only Had a Brain

Many who learned of the tax breaks introduced by the new program thought investing in these zones was a no-brainer. Why not reduce and delay a taxable gain if possible? Particularly if the gain on the opportunity zone investment is also tax-free. The problem with this thinking is that it does not consider the actual investment or the associated fees. The opportunity zone investments currently available are typically private real estate funds that are somewhat concentrated. Many only hold a few properties and do not have a great deal of geographic diversification. There is also an increased level of risk associated with investing in low-income areas of the country. Losses incurred on a poor real estate investment in an opportunity zone fund could easily outweigh any tax benefit received. Opportunity zone funds also have high management fees (1.5%–2.5%) that can also cut into the after-tax benefit of owning the fund.

Another potential problem is that the tax on the original gain is due in 2026 but liquidity in opportunity zone funds is low to nonexistent. That means investors in opportunity zone funds need to make sure they will have enough cash available outside the investment to be able to pay the tax when it comes due.

If I Only Had a Heart

For many investors, the social element of the opportunity zone program is also an attractive feature. Social investing is increasing in popularity and the concept of investing in economically challenged areas is compelling to investors that want to invest in a socially responsible way. Socially motivated investors, however, need to make sure that the investments in an opportunity zone fund are accomplishing their social goals. Many of the early opportunity zone funds are buying properties that are in opportunity zones but are located very close to wealthy neighborhoods. This makes sense from an investment perspective as these properties may be less risky; however, it may be questionable to assume that this investment is providing an opportunity to disadvantaged populations. Also, some critics of the program say the concept of opportunity zones increases the amount of gentrification that can occur in cities as properties are built that current residents can’t afford.

It Takes Courage

Opportunity zones are a very new concept and some of the regulations surrounding them are still evolving. The state of California, for example, has not yet embraced the federal rules pertaining to opportunity zone investments so California residents still need to pay state taxes on the original realized capital gain. Also, the IRS is required to present findings on the success of the program to Congress, so rules may change depending on the findings. Given the relatively new status of the program, the potential for changes in the rules, and the illiquid nature of the underlying investments, it requires a bit of a leap of faith to be an investor in these funds. While the tax benefits may be tempting, it is best to evaluate an opportunity zone fund based on the planned investments of the fund before making the investment.

Filed under: Investing

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