February 7, 2022

How to Invest Capital Gains in Qualified Opportunity Zone Funds

By Michael McKeown, CFA, CPA, Chief Investment Officer, Marcum Wealth

How to Invest Capital Gains in Qualified Opportunity Zone Funds Wealth Management

After a strong several years of up markets and asset prices, many investors are sitting on large capital gains. Valuations are high across stocks, real estate, and private equity. Where is a compelling place to invest capital?

Opportunity Zones (OZs), created by the Tax Cut and Jobs Act of 2017, may be part of the answer. The goal of OZs is to incentivize investment in economic areas that have not participated in the recovery since the Great Recession.

Governors from all 50 states, six territories, and the District of Columbia designated areas as OZs, which were certified by Treasury. This result was 8,766 individual OZ census tracts. Many of these areas are on the upswing already due to revitalization by local developers and businesses.

Investment Benefits

Investors who realize capital gains in Opportunity Zones will benefit first and foremost from the deferral of capital gain recognition until December 31, 2026. Think of this as an interest free loan.

In addition, there is no capital gains tax upon the sale of investments in Qualified Opportunity Zone (QOZ) funds if held for 10 years. There is also no depreciation recapture for real estate investments.

Comparing QOZ funds to investments with the same return expectations subject to capital gains tax, the net after-tax return increases by 3% to 5% per annum. This results in a potential cumulative return difference of 34% to 62%.

While the QOZ fund is invested in development and value-added real estate, there are benefits during the 10-year period.

First, accelerated depreciation schedules will allow a greater shield for passive income.

Second, much of the value will be realized in the first half of a QOZ fund’s life, as projects are built and then stabilized. At this point, refinancing a return of capital is possible. So long as it does not exceed the original investment, it will not be considered an inclusion event, and thus will not trigger a capital gain.

The How

We humans like stories, and anyone raising money for a project has one. These can mesmerize prospective investors to the extent that they forget to focus on the “how.” How can this be successful? How can this go wrong? How many similar projects has the developer/manager completed? How is the manager compensated and are the fees reasonable?

“Show me, don’t tell me.” Verify historical track record with third party reports. Perform background checks. This is the time to leave no stone unturned.

Sitting in the seat of a thriving investment advisory practice, hundreds of QOZ fund managers emailed and called on us, seeking investment. Investors should setup search criteria and a comprehensive due diligence process on the front end, before speaking with any potential developers or funds.

An investment process should have qualitative and quantitative factors, along with checklists to keep focus. We concentrated our efforts on multiple-asset funds, to maximize diversification benefits across multiple regions, sectors, developers, and managers.

We believe QOZs provide a great way to jumpstart a private real estate investment program. In addition, the capital deployed into these growing areas will provide a strong social impact.


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