What You Should Know About Opportunity Zone Investing

Updated: Sep 23



"Jerry, all these big companies, they write off everything," Kramer explains.


Jerry responds: "You don't even know what a write off is."


Kramer counters: "Do you?"


Jerry adamantly admits, "No, I don't."


Kramer continues: "But they do, and they're the ones writing it off."


This banter between a witty comedian and his wayward neighbor is a humorous, yet accurate demonstration of buzzword mania exemplified.


In the world of Wall Street, endless waves of buzzwords have come and gone faster than Hanson's music career. In the 2000s, "clicks and mortar" was used to describe internet companies like pets.com, whose complex business models and outrageous valuations helped form, and deflate the dotcom bubble.


In 2017, the term "blockchain" began to emerge as a result of increased speculation over cryptocurrency and its potential effect on the global monetary system. To this day, I think there may be nine people on the planet who can accurately describe what blockchain means in under an hour. And as of this publishing, the jury is still out on bitcoin.

More recently, Opportunity Zones have risen in popularity since the Tax Cuts and Jobs Act was passed in late 2017 and have become the latest buzzworthy trend in the world of finance.

And that trend appears to be warranted given the considerable tax advantages and high growth potential with investing in Opportunity Zones.


But if history is any guide, it would tell us to proceed with caution and eyes wide open before employing a herd mentality towards investing in them.


Opportunity Zones are, for the most part, an investment just like a stock or bond or mutual fund. You invest money today with the expectation of receiving more in the future.

The big difference, however, is that Opportunity Zones are not publicly traded. They represent distressed areas across the country where, under certain conditions, investments may qualify for special tax treatment. They were designed to help spur economic growth among struggling communities throughout the United States and in return, offer investors significant tax benefits.


Currently, there are around 8,700 Opportunity Zones on the market today, and I suspect more will follow provided the need for economic revitalization continues to align with investors' appetite for alternative investing and tax avoidance.

The underlying assets within the designated Opportunity Zones consist primarily of land, real estate or privately held businesses. However, it's important to consider these assets are located in distressed areas and can only be accessed through privately managed funds that may harbor significantly more risk than say an S&P 500 index fund.


But with greater risk comes potentially greater reward. Opportunity Zones offer investors the benefit of deferring, or possibly eliminating capital gains taxes on the sale of investments that have appreciated in value, not to mention the future growth potential of investing in a distressed asset.

For example, let's say you purchased $1,000 worth of Amazon stock back when it IPO'd in 1997 and it's now worth $1.2 million leaving you with an unrealized gain of $1.199 million. Instead of selling the stock, collecting cash and paying taxes on the gain, you could elect to defer the gain and use the proceeds to invest in an Opportunity Zone fund. And depending on how long you elect to defer and hold your investment, your original capital gain can be reduced by 10% (if held 5 years), 15% (if held 7 years) or 100% (if held 10 years). In the words of Cosmo Kramer, "Giddyup!"


Yet the allure of exotic alternative investments, tax efficiency and trendy financial lingo should never cloud a prudent investor's judgement, nor make her lose sight of the investment objectives at hand. Whether you're investing in a publicly traded stock or an Opportunity Zone fund holding underdeveloped land in the mid-west, here are 6 Rules to Help You Assess a Prospective Investment Opportunity.


1. Intention

The first step is by far the simplest, yet most people neglect to consider what they're investing for and get too caught up in the minutia.

Having a clearly defined purpose for your hard-earned money is a critical component to making any intelligent, well-informed investment decision. Your purpose will help guide the entirety of your investment strategy going forward and make it easier for you to achieve your goals.


For example, assume you've recently retired, have $1.2 million in Amazon stock with a massive unrealized gain and are looking to replace your salary with investment income. In this case, an Opportunity Zone fund would help you significantly reduce your tax bill, however, it does little to solve the problem at hand which is to create immediate income to cover living expenses.

2. Risk

Once you've determined what you're investing for, your next step should be to understand the risks associated with said investment. How much money would I stand to make? What are the chances my investment declines in value, and how much would I stand to lose? Answers to basic questions such as these are at the heart of any risk assessment and ones investors should ascertain before putting their money on the line.


Consider the $400 million dollar Allagash Opportunity Zone CRE Fund I which invests in affordable housing, commercial real estate and multi-family residential housing located in Virginia, North Carolina and Maryland. Would you be comfortable putting a substantial amount of your wealth into something like this? Maybe. Maybe not. In order to better assess the risk and determine if this is a viable investment option, you will need a clear and unbiased understanding of what you're investing in, which leads to Rule 3.


3. Clarity



To quote Albert Einstein, "If you can't explain it simply, you don't understand it well enough." While Einstein may have been referring to the theory of relativity, this rule applies as much to investing as it does to quantum physics. Understanding the nuts and bolts of a potential investment is an imperative part of the process and will help in analyzing the risk and return of your investment.

Continuing with the example above, you may want to gain a better understanding of the managers running the Allagash Opportunity Zone fund. What is their track record? What qualifications do they have? What are their projected returns over the next 5-10 years and what assumptions were used to calculate their figures? If there's real estate involved, and in this case there is, how much debt is expected to be issued and is the interest fixed or variable? Will cash dividends be paid annually or in 5, 7 or 10 years out?


The list can go on and on depending on the nature and complexity of the investment, so it's important to take your time and do your due diligence to understand exactly what you're investing in.


4. Liquidity

Another key element in the process is knowing how quickly you'll be able to access cash from your investment, otherwise known as liquidity. If you're entering retirement and looking to replace your salary, understanding the liquidity of your investments is crucial.

Generally speaking cash and cash equivalents (i.e. money markets) are by far the most liquid types of investments given the speed in which cash can be made available to you. Mutual funds fall next in line in order of liquidity ranking as it takes one day after a sale for cash to settle in your account, followed by stocks and ETFs which can take a day or two.


Considering Opportunity Zones require a minimum 5-year holding period in order to earn a tax reduction, this may not be the best option if you need easy access to cash.

5. Alternatives

Have you ever thought about the alternatives to investing in an Opportunity Zone? Often when presented with an investment proposal, we rarely consider anything other than the proposal in question and take a linear approach toward our decision-making process when a more comprehensive style may be better suited.

Take the Amazon stock scenario discussed earlier, a perfect example of when Opportunity Zone investing could be advantageous. Rather than going through the cumbersome process of electing to defer your gain, filing the appropriate documents and selecting an Opportunity Zone fund you feel comfortable with, you may decide to sell your stock over a 10-year period, thereby spreading out the capital gains tax and using the cash to help cover living expenses in retirement with any excess being invested in a globally diversified portfolio of stocks and bonds.


You may also consider transferring your stock to a Charitable Remainder Trust which offers greater flexibility with your investment strategy and can help mitigate your tax burden. Or you might decide to sell all your Amazon stock at once, pay the tax and use the proceeds to buy rental property, start a business or invest in a start-up.


Whatever you decide, it's important to remember that more options exist in the marketplace than you may think.

6. Cost

Last but certainly not least is cost. In the world of investing, there's no such thing as a free lunch so you'll want to know upfront what the investment is going to cost you.


For most Opportunity Zone funds, there's an internal cost to operate the fund that can range anywhere from 1-2% of your investment, plus a percentage of any profits the fund generates. That means investing $1.2 million in one of these funds could cost you upwards of $24,000 each year, plus a percentage of the fund's profits which depending on the amount, could be substantial and significantly erode the growth of your investment.

On the other hand, the fund may perform well and shield thousands of tax dollars which in-turn, would help offset the cost of investing in the fund. (Refer to Rule 3 for how best to evaluate the potential success of an Opportunity Zone.) Either way, you'll want to understand the fee structure before making any investment.

Final Thoughts

Opportunity Zones represent a positive step forward in the realm of emerging alternative investments, offering investors a unique opportunity to contribute to the gentrification of local economies while benefiting from a reduction in taxes, and the potential for significant returns.

However, they are still relatively new, highly complex and have yet to prove themselves as a sustainable, long-term consideration for most individuals and seem best suited for qualified investors with both substantial wealth, and experience in making these types of investments.


So be sure to arm yourself with the right knowledge, tools and resources necessary to make the best decision possible when assessing a prospective investment. Be open to self-reflecting on what you're investing for and make sure to have a strong grasp on how the investment works, the ease of accessing cash and the costs involved without letting tantalizing buzzwords and complicated fund models disrupt your thought process.

26 views
Image by Aaron Burden

BOOK YOUR FREE RETIREMENT REVIEW

Want to know how we can help you increase income, reduce taxes and invest smarter in retirement?