Opportunity zone (OZ) investments have been garnering a lot of attention recently because of potential savings from tax deferral and tax reduction, under the new tax code, through investing in developing and low-income areas.
We attempt to quantify the tax advantage of these investments to help you assess whether the tax savings are worth the costs, including illiquidity, manager fees, and opportunity costs relative to other investments.
What is an OZ investment?
The Opportunity Zones incentive is a new investment tool established with the 2017 tax cut to encourage long-term investment in low-income urban and rural communities, with the use of tax incentives. Each US state’s governor can designate up to 25% of their state as OZs meeting qualification thresholds around low income and other metrics. A map of all zones across the country is available at Economic Innovation Group.
What are the tax incentives?
The 2017 tax plan allows investors to defer paying taxes for many years and eliminate taxes entirely when investing in an OZ in a few different ways:
- Deferral: First, a capital gain realized today can be reinvested into a qualified opportunity zone fund (QOF) in which the tax payment due on this gain can be deferred up to 7 years.
- Reduction: Further, the tax on this gain is reduced based on the time the investment is held (by 10% if held 5 years, or 15% if held 7 or more years). After 7 years, the tax on the reduced capital gain is due no matter whether the QOF investment is sold yet or not.
- Elimination: In addition to the reduction in capital gain, any gains on a QOF held for at least 10 years become tax-free. Note if the investment is held less than 10 years, then the normal capital gains tax is due at that time.
How much is this tax break worth?
Through our analysis, we estimate the benefit to be up to 1.7% annualized, BUT this benefit comes with caveats and risks. Through analyzing a few scenarios below, we illustrate how these potential tax benefits are entirely dependent on the OZ investment returns, future tax rates, and of course fees paid, relative to public market benchmarks.
Because of these considerations, we’ve found that lawyers and experienced investors remain leery and seem to understand that investment considerations trump the tax considerations. So we review the risks that experienced investors are aware of first.
Risks: illiquidity, high fees, and complexity
With any investment, there will be uncertainty with future returns. The QOF return could end up lower or higher than public markets. Tax rates could also change in the future, affecting the benefit of the deferral.
Aside from the uncertainty about future returns and tax rates, illiquidity, higher fees, and complexity are important factors.
- Complexity: There are many criteria that must be satisfied by both the investor (e.g. roll capital gain into QOF within 181 days of realization) and the fund manager (e.g. capital must enter the project within 31 months, 90% of assets must be in the OZ, etc…) to qualify for the OZ tax break. If the criteria are not met or there are issues with execution, the fund and/or the investor can be penalized.
- Fees: Assuming the same return before fees as the relevant benchmark, the maximum fee one should pay for a QOF is the estimated value of the tax break, which we calculate in the next section. Most QOF’s will come with hedge fund-like fees ranging from 2–5% fixed. With high fee investments, one must also always be aware of the misalignment of incentives between investors chasing long-term returns through a quality investment versus managers seeking to maximize short-term revenues.
- Illiquidity: Investors should be compensated for giving up access to their capital for long periods of time. Some studies show that 2–3% is the minimum expected compensation (i.e. illiquidity premium) for taking this risk. Historically, the high fees on private equity and private real estate have eaten up this extra compensation.
How much is the tax incentive worth?
Below we analyze different investment scenarios and calculate the upper bound value of the tax incentive and then show what the tax savings may be in more realistic cases.
First, to invest we must have a sizeable capital gain. We assume $1 million (most likely to be on equities today after their performance over the past decade). We have the option of continuing to hold and defer the tax (which we analyze) or selling today and reinvesting. In the base case, we realize teh gain today and reinvest back into different equities.
The alternative is to invest in a QOF to capture the associated tax breaks. Today most of these funds will own real estate because it is easier for property to qualify. But equities tend to earn most of their returns via capital gains so, in theory, would be preferable. We analyze both asset classes.
For all the above investments, we assume a 10% expected return. Many deals currently being pitched target 8–11% returns. Though we think most of these will fall short over the next 10 years, given that private equity and real estate returns over the last decade have barely achieved these levels (12% and 11% respectively) in the once-in-a-lifetime asset price inflation since the financial crisis of 2008.
With the equity QOF, we assume its annual return is in the form of capital gains, while with the real estate QOF, we assume half will be from capital gains and the remainder from income (of which half will be shielded by depreciation). Lastly, to start, we assume current tax rates of 20% for capital gains and 37% for income remain constant. We ignore the 3.8% investment surtax to keep things simple, but this would also apply.
With the QOF investments, taxes on the initial gain are deferred for 7 years and then reduced by 15%. But this is a tax liability that must be accounted for. So, we discount this liability to the present at the current 7-yr Treasury yield of 2.5% (i.e. hedge the liability by buying a 7-yr Treasury).
The table below compares these 4 scenarios: a) sell and reinvest into the market, b) do not sell, continue to hold for 10 years, c) sell and reinvest into equity QOF, and d) sell and reinvest into real estate QOF.
The base case shows a net return of 7.3% after paying the 20% tax in year 0, reinvesting the remaining $800k, and then paying another 20% tax after 10 years.
In the second scenario where we continue to hold and defer the tax, see an extra gain of $55k, or 0.3% additional annualized return. If one hadn’t already sold or wasn’t forced to sell the existing investment in year 0, then this could be considered the true hurdle rate that the QOF must surpass.
The third column shows the upper bound of the tax benefit. In this hypothetical 10% return case, with no fees to pay, the benefit of the tax structure is 1.7% annualized. Roughly half the benefit from the tax structure comes from the initial deferral and tax reduction, and the other half from the elimination of subsequent capital gains tax.
Of note, we’ve seen managers claim return benefits up to 3% in their marketing materials. They exclude the tax liability due in year 7. We are happy to provide more detail around our analysis upon request.
The final column shows how a hypothetical real estate QOF might perform. It shows almost no improvement over fully taxed equities. Since the OZ tax break is only on capital gains, not income, the real estate structure does not take advantage of the tax breaks to the fullest and hence why it benefits less. There would still be some advantage (~0.5% annualized using our hypothetical cash flows) compared to holding real estate without the OZ tax incentive.
With this as the framework, below we answer two follow-on questions.
Question: What happen if returns are lower than 10%?
Then the tax benefit will be even smaller.
The benefits of OZ investing are most dependent on what the returns of the QOF turn out to be, net of all fees and costs, relative to what you were already holding (i.e. opportunity cost). If the QOF underperforms an average public market investment, the tax benefits are likely wiped away. And the high fees embedded in most of these funds will have an even bigger drag in a low return environment.
Question: What happens if tax rates increase in the future?
It may not matter, depending on the timing of the rate increase.
Let’s assume that capital gains taxes increase to 30% in the future. The tax owed on the original gain that was deferred to year 7 is now higher than it would have been if you paid it upfront. However, this loss is offset by the increased benefit of the tax-free gain in year 10 (or beyond) on the QOF.
The net effect of the deferral (worse if rates rise) and elimination (better if rates rise) will depend on the how much tax rates increase and when.
Opportunity Zones will likely prove to be no special opportunity for most
All investing entails risks and opportunities. Our aim here was to highlight these trade-offs with OZ investments.
In summary, there are many risks with QOF’s and small tax advantages given realistic scenarios. To maximize the benefit, the QOF:
a) must meet the qualifying criteria over the investment period to maintain QOF status
b) must provide equal or higher returns, net of high fees, to alternative investment options
c) must be held for at least 10 years
There are still details with QOFs to be worked out by regulators. As with any new investment initiatives, there will be some big winners who deeply research the opportunity and take advantage of it to the fullest. But most will likely be disappointed, especially if working with agents charging high fees.
Some investors aim to avoid taxes at the expense of all else, but we believe investors should weigh the risk versus reward of an investment in its entirety. In other words, don’t let the tax tail wag the investment dog.