The Pros and Cons of Opportunity Zone Funds for the Passive Investor
With the 2017 Tax Cuts and Jobs Act, the United States government created a new wealth building vehicle for investors. This legislation established opportunity zone funds as a way for investors to improve struggling communities while receiving capital gains tax breaks. The investment vehicle offers a means for a passive investor to gain wealth while helping others.
What is an opportunity zone?
Throughout the 50 states and US territories, there are more than 8700 areas and projects that qualify as opportunity zones. These locations are often properties that have fallen into disuse and require extensive upgrades.
In cities, an opportunity zone project might be a warehouse or factory in a former manufacturing area. The opportunity zone fund will provide investment capital to renew the property for different use.
This program hopes that these initial investments will spur other investors to improve local properties. As a new housing project begins through the opportunity zone fund, investors will improve other properties to redevelop grocery stores and other commercial ventures. Soon, a whole region will see improvement because of the original investment.
How does an opportunity zone fund work?
Opportunity zone funds are a vehicle for passive investing. Individuals who contribute to the fund pool their resources so that the fund manager can invest in a real estate development project. At the end of the project, investors receive income from the sale or lease of the property.
An important difference from other real estate investments is that opportunity zone funds must improve the property as well as acquire it. The government is not looking for dilapidated properties to transfer between owners. The program intends to create a win-win project that benefits both the passive investor and the opportunity zone communities.
Who can invest in an opportunity zone fund?
A major overhaul of a building requires a large amount of capital. To meet the expectations of potential buyers, properties will need both basic repairs and new infrastructure. No company will want to open a branch in a building that does not have adequate resources for a wireless network.
For this reason, opportunity zone funds are not open to every potential investor. People who want to participate must be accredited investors who can meet specific guidelines. The investor must have a net worth of at least $1 million. Alternatively, investors must prove that they have had two consecutive years with an income of at least $200,000.
Also, this opportunity is for larger investments. Typically, fund managers are looking for a buy-in of at least $100,000. This amount increases the ability to make significant improvements to a property. However, it will put this program out of reach for the majority of investors.
The Benefits of Investing in an Opportunity Zone Fund
Without incentives, investing in financially-stressed communities might not be appealing. The legislation that creates opportunity zones also includes several financial benefits.
Deferred Capital Gains
Capital gains taxes are a frustrating reality of wealth building. The better the investments perform, the more the taxpayer must pay. However, opportunity zone investing provides a loophole that allows investors to defer capital gains taxes and use the money to generate passive income.
By making an opportunity zone investment within 180 days of incurring capital gains, the taxpayer can defer the tax on the invested amount until 2026. With positive performance, the taxed money can create more income before it goes to the government.
Reduced Capital Gains
Improving an opportunity zone is a long project. This program awards investors who keep their money in the fund for an extended time. A five-year investment reduces the original amount taxed for capital gains by 10%. By keeping the money in the fund for another two years, the capital gains reduction increases to 15%.
If investors keep money in the fund for 10 years, they are eligible for another tax benefit. The appreciation for the opportunity zone fund investment is not subject to capital gains. Investors must still pay the gains taxes on the original funds from a decade earlier, but there are no additional taxes on the profits derived from the opportunity zone project.
The Risks of an Opportunity Zone Fund Investment
Every financial investment comes with uncertainty. It is up to the investor to decide whether the passive income is worth the potential loss. While opportunity zone funds may benefit both the investor and the community, they are not without risk.
Untested Investment Model
Since this program has only been around since 2017, there is not an established track record to assess the risks of this investment. Improving a property in a struggling community is a laudable idea, but it does not guarantee a high return. Even a well-developed property may have trouble finding tenants in a depressed area.
Some investors will be nervous about the size of the initial investment. For many people, a six-figure investment represents the majority of their wealth available for passive investing. They may not be willing to tie up so much money in a long-term investment.
Uncertain Community Benefits
The goal of the opportunity zone program is to create an investment that benefits local communities while producing a financial return. As the legislation stands, community leader input is not a requirement of the development process. Unpopular projects could be stalled by legal challenges and protests. Without an understanding of the needs of local residents, investors might fund a project that raises the cost of living and gentrifies a low-income area.
Is an opportunity zone fund the right investment for you?
If you meet the criteria for participating in an opportunity zone fund, you want to do your homework. Potential investors should take some time to learn the details of the different projects seeking funds and the backgrounds of the managers and developers involved. While the tax benefits of this program are attractive, you do not want to lose money just to avoid paying some capital gains taxes.
After doing your research, you may find a project with great potential for success. An investment in the right opportunity zone fund offers fiscal benefits that will change a community for the better.
Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.