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Author

Ryan Cotton

Director of Private Markets, BMO Family Office
Author
Author

Tina D. Milligan

Managing Director and Head of the Family Wealth Strategies and Family Enterprise Advisory Team with BMO Family Office
August 06, 2019
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August 06, 2019

There has been much discussion regarding the Qualified Opportunity Zone program established via the Tax Cuts and Jobs Act in 2017 because of potential tax advantages. This program aims to incent long-term private sector investment in low-income communities  nationwide while allowing investors to potentially defer and partially reduce capital gains tax by investing capital gain amounts (or a portion) in Qualified Opportunity Zone (“QOZ”) through a Qualified Opportunity Zone Fund. When considering a QOZ Fund, as with any investment, it is important to ensure that the investment is sound, prudent and addresses one’s financial objectives.

Types of investments in QOZ Funds

As background, the types of investments that will become QOZ Funds include properties and businesses located in Qualified Opportunity Zones:

  •  Real or personal property, including commercial real estate development and renovations

  •  New businesses established and operating,including manufacturing, wholesale, warehousing and distribution or retail businesses

  • Expansion of existing businesses or property

QOZ Fund applications and important considerations

This new program has several possible applications aside from the beneficial tax considerations:

  • Businesses can establish a QOZ Fund in order to raise capital and/or seek co-investment to expand their business, if 90% of their assets are in Opportunity Zone Properties

  •  Investors might consider a QOZ Fund as part of their philanthropic and/or community involvement goals as an impact investment

  •  Investors might consider a QOZ Fund as part of their private real estate and/or private equity strategy

The latter two applications may allow investors the opportunity to defer and partially reduce capital gains tax as noted above.
Although there may be tax benefits to investing capital gains in a QOZ Fund, investors must first address the following questions regarding their fundamental goals and objectives:

  • How does this investment fit into one’s tax, estate and financial planning objectives?

  • Taking into account asset allocation, risk tolerance and liquidity needs, how does this investment fit into the one’s big picture investment portfolio?

  •  Is there the possibility of meeting philanthropic and/or community involvement goals?

  •  What is the right QOZ Fund investment

Investment considerations of QOZ Funds

Remember that most QOZ Funds are structured as private investments. Private investments are intended for qualified purchasers and accredited investors who have a fundamental understanding of the inherent risk associated with these types of investments.

A QOZ Fund, like other private investments, is illiquid. To have the opportunity to take full advantage of the tax benefits, the investment of the capital gain amount may not be sold for a 10-year timeframe.Furthermore, interim liquidity may be limited given the requirement that QOZ Funds reinvest sale proceeds from the sale of QOZ property into new QOZ property in order to avoid penalties.

Investors considering a QOZ Fund must carefully assess their risk tolerance and overall asset allocation. Originally, the capital usage requirements set forth in the QOZ program language only allowed for the development of tangible property, therefore the funds initially forming have been predominantly geared toward new ground-up development and/or heavy reposition of expiring real estate assets. Newly issued proposed regulations have made it possible for the development of a trade or business as well, making it possible for operating companies to now consider forming a QOZ Fund. QOZ funds may present investors with risks that are typically not as pronounced in funds acquiring more stabilized, cash-flow oriented assets. This type of investment may have additional risk given the fund rules requiring cash to be deployed more quickly in comparison to other private investments.

Investors must also factor in that QOZ fund managers are currently raising billions to target QOZ investments, and the number is rising each day. All this fresh capital targeting an extremely limited set of attractive QOZ regions creates the potential for fierce competition and, in turn, robust pricing for QOZ assets, especially in the locales with the most favorable market dynamics. It is important for investors to work with fund managers and operators who are familiar with not only the language of the QOZ program, but with the local markets in which they will be investing. Doing so can help investors navigate pitfalls that may arise from elevated competition for assets.

It is imperative not to let the tax benefits overshadow investment-planning essentials in meeting broad
financial goals. As with any investment, sound due diligence is needed in conjunction with consideration of other basic portfolio construction elements when selecting an investment.

This is where a partner like BMO Family Office and our investment management, investment research as well as our tax and financial planning capabilities can help. We are carefully monitoring the QOZ fund landscape as to form and additional guidance becomes available. Our professionals can assist clients with questions regarding QOZ Funds, not only to address questions about which investments may be appropriate, but also to consider whether this type of investment makes sense as part of one’s overall planning objectives.

Important definitions

  • A Qualified Opportunity Zone is a state designated low income community.

  •  A Qualified Opportunity Zone Fund is a Treasury Department certified entity that holds 90% of the assets in Opportunity Zone Property.

The Tax Incentives Outlined

There are three potential tax incentives to investing in economically distressed communities:

  •  A temporary deferral: An investor can defer capital gains until 2026 by putting and keeping realized gains in an OZ Fund.

  •  A reduction in capital gains: the original amount of capital gains on which an investor has to pay deferred taxes is reduced by 10% if the OZ Fund investment is held for 5 years and another 5% if held for 7 years.

  • An exemption of capital gains on appreciation: any capital gains on investments made through the OZ Fund accrue tax-free as long as the investor holds them for at least 10 years.

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