Advisors could soon offer clients access to opportunity zone funds, a hot new investment.
However, they need to make sure they do their due diligence first.
Qualified opportunity zone funds allow people to invest in economically distressed communities and receive an attractive tax advantage, provided they remain in the fund for at least five years.
Here's the catch: The zones and funds themselves are brand new, as the Tax Cuts and Jobs Act of 2017 created the program and the IRS is still hammering out details.
Further, the investments themselves are complex and illiquid, as they involve real estate. Even worse, scammers tend to follow in the wake of any new investment fad.
"From the tax perspective, you're like, 'Yeehaw! This is fantastic!'" said Lisa Featherngill, CPA and member of the American Institute of CPAs personal financial planning executive committee.
"But there is a level of due diligence required not just of the investment itself," she said.
To take advantage of this play, an investor needs to bring significant capital gains to the table, advisors explain.
"The ideal candidate might be someone who just sold a business, a retiring executive who wants to diversify company stock holdings, or it could be someone who just sold an apartment building or a rental," said Tim Steffen, CPA and director of advanced planning at Robert W. Baird & Co.
Once an investor has sold their business or property, they can defer taxes by rolling those capital gains into a qualified opportunity fund within 180 days.
These funds invest in property that's located within an opportunity zone.
Investors can defer taxes on the gains they invest in the fund either until they sell their holding or Dec. 31, 2026, whichever is earlier.
The longer an investor holds the fund, the sweeter the tax play.
Those who remain in the fund for more than five years can exclude 10% of their originally-deferred gain. Stay for more than seven years, and that number goes up to 15%.
If an investor holds the fund for at least 10 years, they won't owe taxes on the fund's appreciation once they sell their holding.
As attractive as these investments may sound, their availability has been limited.
For starters, the IRS is still fine-tuning the rules and just proposed additional regulation around them in April.
There's also the difficulty of finding established fund sponsors and vetting them.
"You have to know who you're investing with and their track record relative to turnarounds in areas that are less than sterling," said Michael Burwick, a partner at The Wagner Law Group in Boston.
Naturally, any up-and-coming investment is going to attract bad actors.
"You might see Ponzi schemes come into play to capitalize off the excitement around opportunity zone funds," said Ben Edwards, a law professor at the University of Nevada Las Vegas.
Advisors should make sure they aren't overselling the tax benefits of these funds, while also overlooking the liquidity lock-up and the cost.
"The challenge here is that the offering may have real tax benefits, but the danger is that those benefits may be outweighed if the arrangement is riddled with conflicts of interest," Edwards said.
Accredited investors must have a net worth of at least $1 million, excluding their residence, and income exceeding $200,000 in each of the last two years.
That threshold goes up to $300,000 if that person is married.
Baird partnered with CAIS, an alternative investment platform, and Mercer Investment Management to perform the due diligence on an opportunity zone fund it will make available through its platform in the next couple of weeks, according to Dayna Kleinman, senior product manager for alternative investments at Baird.
She did not name the fund manager, citing the upcoming launch date.
Eligible investors must meet the definition of "qualified purchaser," according to Kleinman. That is, they must have $5 million in investible net worth, excluding their primary residence.
Advisors will undergo training on this product.
The minimum investment into the fund is $250,000.
"The majority of funds are for qualified purchasers, and seeing how some of these risks play out, I think that's a better approach," Kleinman said. "They go into it understanding the life cycle of the product and the lack of liquidity."
Investors will be subject to a "hard lockup" for four years, meaning they won't be able to get any liquidity out in that time.
Finally, the fund will charge a 1.5% fee for assets under management, plus a 20% performance fee if the fund beats its hurdle rate (minimum required rate of return) of 6%.
Broker-dealers and advisors face a barrage of issues before they can successfully bring qualified opportunity funds to their retail investors.
Here are a few high-level issues for consideration:
Seek high-quality sponsors. "There are some players that don't have a real estate background and they love the tax play, or they have a real estate background, but it has nothing to do with property in depressed areas," said Burwick.
Sponsors should have a strong track record in real estate and specialize in undervalued areas and successful turnarounds, he said.
Look for legitimacy. Funds must meet certain requirements to maintain their qualified status. For instance, a fund must hold at least 90% of its assets in qualified opportunity zone property.
Scammers will also be out in full force, so advisors must be on their guard.
"The last thing you want to do is invest in something that calls itself an opportunity zone fund and it isn't qualified," Edwards said.
Know liquidity. How much of an investor's wealth is being redirected into this investment? Can they afford to have that much money locked up for 10 years?
"If you're not prepared to be illiquid with the gain money invested for a decade, then don't play," Burwick said.
Be tax savvy. Your client should have a good CPA to get them familiar with the tax implications of the fund.
"You would be getting a K-1 from this partnership," Steffen said, referring to the tax form that details a partner's share of income and deductions.
Other opportunity zone funds that are structured as real estate investment trusts, or REITs, will likely have a Form 1099 during tax time.
"Your accountant will want to make sure they're treating it right on your return, including making sure you aren't paying taxes on the gains," he said. "This isn't for the Turbo Tax crowd."