This year has seen a flurry of coverage about Qualified Opportunity Zone (QOZ) real estate investment. Since the launch of this program and our QOZ Fund, our investor relations staff has received hundreds of calls. In some cases, investors are eager to get involved right away, while others are intrigued and want to learn more about the program before deciding whether or not it’s right for them.
It’s a mistake to avoid Opportunity Zone investing unless you know everything there is to know about it. According to our calculations, you can expect a 75% increase in after-tax profits from a QOZ investment than from a similar risk profile investment. For investors looking for high returns while minimizing risk in today’s market, QOZ investing may be worthwhile.
Investors, analysts, and journalists alike have bombarded us with questions and assumptions regarding QOZ investing over the past few months. These discussions led us to compile a list of the nine most common misconceptions regarding the QOZ initiative. This article can be a good introduction if you’ve never heard of Qualified Opportunity Zone investing.
- A QOZ site is not an investment opportunity for me.
It is fair that ninety-five percent of Qualified Opportunity Zones do not make for suitable locations to invest in real estate. However, there is a fine distinction between what the Census Bureau considers to be a “distressed economic area” and what we consider to be areas with significant investment potential. According to our estimation, only about 5 percent of QOZ locations meet the criteria for both categories, and real estate investors should be looking to invest in these places. After all, places that are being developed or are just on the outskirts of it have the potential to yield the highest investment returns.
Suppose you have been investing in real estate for a sufficient amount of time. In that case, there is a reasonable probability that you have invested in a QOZ region without being aware of it, and you have most definitely done so without obtaining a tax benefit. Even today, many real estates in Qualified Opportunity Zones are being purchased by investors who are not QOZs because of the excellent risk-adjusted returns that these properties offer.
The transaction comprises a piece of land currently undeveloped, and a multifamily building classified as Class A was completed and put on the market less than two years ago. They will develop the undeveloped land into a new building connected to the present building according to the plan. The current apartment building brings in direct revenue for our QOZ Fund. The new structure will bring an additional 105 units to the property and incorporate new amenities that will be of use to all residents, such as a pool, leasing office, and fitness center.
- The QOZ program deals will be overpriced.
Some investors are worried that the possible avalanche of QOZ funds would lead real estate prices to climb to the point where there will no longer be an opportunity to make a return on investment. The worries are that higher real estate prices will attract more buyers. Although someone will always be overpaying for a piece of real estate, this does not imply that everyone will do so.
Numerous announcements have been made regarding QOZ funds in the news; however, very few of these funds have succeeded in their attempts to raise capital. The rivalry that we observe for QOZ assets comes primarily from dollars not invested in QOZ, as opposed to funds invested in QOZ competing with one another. Over the past year, we have been entrusted with the underwriting of over a hundred different QOZ deals, we have bid on dozens of deals, and we have been awarded five deals. Every time there was an auction, numerous purchasers were competing against us, and the majority of the time, we were the only bidders utilizing QOZ money.
What you should take away from this is not to dismiss the possibility of investing in QOZ simply because you are scared that prices will increase. Make sure that whoever you invest with is treating QOZ opportunities with the same level of care and scrutiny as they would any other business transaction. Look for skilled managers who had already established themselves as successful real estate investors before the announcement of the QOZ initiative. You shouldn’t put your faith in just anybody who wants to start a QOZ fund to save money on taxes.
- They will discontinue the program.
The Jobs Act of 2017 and Tax Cuts was the vehicle via which they completed the plan, and it had support from both parties, including Republicans and Democrats. It is not impossible, but it is doubtful that this legislation will overturn. You or your real estate investment manager should not let the tax benefits granted by the QOZ program alter how you evaluate possible investments based on those investments. It would be best if you considered the tax benefits of a QOZ to be a bonus on top of a deal that you would pursue regardless of the taxes involved. You would continue to have an investment that provides the same benefits as private real estate, including tax efficiency, the generation of income, and high returns, even in the unlikely event that the legislation was to be unexpectedly reversed. The tax savings provided by QOZ are, in all honesty, an addition to an already excellent asset class.
- The tax advantages of a QOZ investment are available to investors with post-tax funds.
Only gains on the sale of capital assets are eligible for all three of the primary tax benefits offered by the QOZ program: deferral, reduction, and elimination. Investing the money that does not come from a QOZ into a QOZ fund is possible, but this money will not qualify for any tax benefits.
- The QOZ program has the potential to revitalize areas that were once desolate.
The Qualified Opportunity Zone program was designed to free up billions of dollars in capital gains held by affluent individuals and incentivize those persons to participate in Qualified Opportunity Zone funds, which would then invest in economically disadvantaged regions. In my opinion, I do not believe this will be the outcome. Possibilities for real estate investors need to be economically viable and create returns for investors. Low-income neighborhoods cannot pay the rent required to build new products. Therefore, one ought to steer clear of these opportunities. This rule will undoubtedly help speed up development in places already undergoing transition. Still, attracting capital into the neighborhoods that require it the most is improbable.
- The QOZ program will result in a catastrophic failure.
Experts on panels at practically every QOZ event remark that “the QOZ program will end in disaster,” and the media have indeed repeated that sentiment. Because they know that nothing sells more than fear, the so-called experts who propagate these anxieties usually have no real insight or experience to back up their claims. Likewise, journalists are only interested in garnering clicks and views.
Given the historical significance of government tax incentives for real estate investing, there is no reason to be surprised that many investors feel strongly about this idea. The real estate bubble burst in the late 1980s and early 1990s due to tax laws passed by the federal government during that decade. Investors in the 1980s rushed to real estate because of the depreciation benefit, which allowed them to avoid paying income taxes at the top federal rate of 70%. Because of this, investors grew more interested in real estate’s possible losses than its prospective profits. On the other hand, investors in the QOZ scheme will only receive a tax cut on their gains. We can’t get away with paying more for land or accepting a lesser rate of return on our investment because of this scheme. There is no tax advantage if there are no profits.
After the ten-year hold period mandated by the government, many people are concerned about how this process may affect the real estate market. However, just a tiny portion of the real estate market is represented by QOZ assets and funds. Ten years ago, many people predicted the market would crash because of the hundreds of billions of dollars in pre-crisis loans that were coming due. That period passed without a crash, and investors who kept their money in the bank missed out on one of the most excellent bull markets in modern history. Most QOZ managers can sell or hold assets at their discretion, and some managers can hold properties well until 2040 if it is in the best interests of their shareholders. A gradual depletion of QOZ properties is expected, although it will be insignificant in the context of the broader real estate market in terms of pricing or liquidity.
- Real estate values are too high to invest in a QOZ fund.
Over the past nine years, real estate values have risen, and expected returns have decreased. Even today’s risk-based investments have this in common: This doesn’t imply you’ll lose money during the following ten years, but it does mean that returns won’t be as high as they were in the preceding decade.
Make sure you invest in high-quality assets on a reasonable basis, diversify regionally, and invest with a manager who has experience with leverage and uses it wisely to avoid a loss. In a recession, you should be looking to invest in cash-flowing assets with a steady revenue stream, such as real estate. All investments, regardless of asset class, are subject to cyclicality, and investors must take precautions to avoid losing money. Prices paid at the market’s peak look like a bargain now, notwithstanding how severe the tremendous real estate recession was. You have a decent possibility of making a profit from institutional real estate because it has never lost money in ten years and because QOZ investors must invest for ten years to gain complete. QOZ’s risk-adjusted returns are the best of any investment opportunity, and there’s no better way to assess investment options than to analyze them on an after-tax basis.
In addition, many investors believe that diversifying their cash over several different sponsors lowers their risk, but in reality, this multiplies their risk tremendously. If you want to be successful in the private real estate market, you have to bet on the people behind the deal, and spreading your wealth around increases the likelihood that you will invest with a poor manager. Because the risk is in real estate investment management, it is essential to spend as much time as possible getting to know the manager. Because a QOZ investment is a commitment that lasts for more than ten years, you need to make sure that the manager you invest with is highly qualified to make the most of your money from the moment you put it in until the moment you take it out.
- After signing the paperwork, I am entitled to QOZ tax benefits.
The QOZ fund must take your money for you to be eligible for the tax benefits. Signing the forms to fulfill the QOZ program’s requirements is not enough. In addition, the money needs to be invested within the first 180 days of the gain being realized; therefore, you need to ensure that you have a comprehensive understanding of the tax regulations; otherwise, you may miss your window.
- My rate of tax deferral is set in stone.
Tax rates may be significantly higher in 2026 than they are today is one of the dangers associated with tax deferral. Due to this method, the investor will receive a “step-up in basis” rather than a tax reduction. If tax rates are allowed to remain the same, the result will be a tax cut; however, if tax rates are allowed to increase, the investor may pay more in 2027. For instance, if $1 million worth of capital gains are invested in the 2019 QOZ fund, the tax payment of about $220,000 will be deferred until 2026 and due in 2027. This instance will allow the payment to be spread out over two years. Because they put the money into the business in 2019, the investor is eligible for a 15% step-up. The investment means that the investor will only be taxed on $850,000 rather than the total $1 million. However, if the rate on capital gains is increased to 35% in 2026, the investor would owe almost $300,000 in taxes, which is more than what their tax due would be for this year if it were calculated using the current rate.
Investing in QOZ carries some dangers, and this is just one of them; the question is whether or not it is worthwhile. To answer your question, yes. It is projected that the profit from investing the tax deferral money from 2019 to 2027 will be between $300,000 and $500,000. This profit depends on how well the QOZ fund performs. Between 2019 and 2027, this revenue stream is expected to materialize. The option to invest the money tax-deferred for seven years more than offsets the possibility of a future increase in tax rates, and the step-up in basis further mitigates the risk associated with this scenario. In addition, the cash flow generated from the refinancing of assets and day-to-day operations should be more than enough to cover the cost of this liability when it becomes due.
******************************
Come join us! Email me at mark@dolphinpi.us to find out more about our next real estate investment.