The Risks Of a Tax-Saving Opportunity

One of the more interesting—and least-discussed—investment opportunities on the financial landscape is also somewhat new. The Tax Cuts and Jobs Act of 2017 created something called Qualified Opportunity Funds, which invest in projects at newly-created Qualified Opportunity Zones. The idea is to provide tax incentives for people to invest in projects that spur growth or affordable housing in economically-disadvantaged parts of the U.S. landscape.

How does it work? Let’s say you own real estate or stocks that you purchased at a low price, and now they’re worth a lot more. In accountant-speak, you have a low basis, and when you sell the real estate or stocks, you’ll have a relatively high capital gains tax bill. Under the new tax law, you could sell your appreciated asset, and then reinvest the gains (not necessarily the entire proceeds) in a Qualified Opportunity Fund (QOF) within 180 days. If you do that, you can defer paying the capital gains tax on your sold investment, and if you hold the QOF as an investment for ten years, then the capital gains taxes are completely eliminated on the QOF investment.

The actual tax situation is more complicated than this; there are two step-ups in basis, at five and seven year holding periods, and since the law sunsets in 2026, there’s some complication about the deferral lapsing at that point. But the larger issue is that already a number of companies are actively marketing projects in over 8,700 zones established by the IRS (you can download a spreadsheet on zone locations from the Department of the Treasury website). An Opportunity Zone Fund Directory has been created, which mostly seems to focus on affordable workforce housing projects. Sizes range from a few million dollars to $10 billion, and of course every promoter and developer touts their marvelous track records.

Investment concepts that are primarily driven by tax opportunities can be a dangerous proposition. The attractive tax benefits tend to distract from the much more important economic potential of the investment, including the nature of the properties being developed, their potential gains, the costs associated with building, acquiring and operating the properties, and most basically whether the promoter of the investment can be trusted or not with your hard-earned dollars. There is a good possibility that, despite the tax benefits, unscrupulous promoters will help you generate tax losses rather than gains, meanwhile lining their own pockets. In retrospect, the whole QOF marketplace might turn out to be a great example of “buyer beware.”

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