Qualified Opportunity Funds: How We’re Investing to Lower Risk

Perhaps you’re now sitting on a lot of unrealized capital gains — from an equity investment, stock grants, or real estate. A relatively new strategy for deferring and lowering capital gains taxes is to sell and reinvest the gains in a designated Opportunity Zone, one of thousands of low-income areas across the US, as established by the 2017 tax law.

This can be a win-win: lowering your tax bill while helping to revitalize a low-income neighborhood (there are 22 Opportunity Zones in King County alone). But there remain many pitfalls and misinformation out there about how to invest, so I thought I would share how we’re focusing our due diligence so our clients can make the most of this new opportunity.

To invest in Opportunity Zones, you must do so through what is known as a Qualified Opportunity Fund (QOF). Our position here at LNWM is that QOFs can work well for some clients. But certainly not all. A great deal depends on individual finances, time horizon (this should be money you can afford to lock up for at least 10 years), and the specific QOF through which you invest. We cannot emphasize that enough.

In many of the more promising Opportunity Zones close in to thriving cities, such as Seattle’s Pioneer Square, prices have already risen by what we estimate to be 10% or more to reflect increased demand. The QOF must be capable of investing wisely and making sure the numbers pencil out in terms of return and the risk involved, not just good at raising capital. Fees must be reasonable. And also meeting all the regulations and deadlines.

Below are the key things we are looking for in the management of QOFs we have already invested with, as well as future investments:

QOF Management: 5 Rules of Engagement

#1. Strong project development expertise

#2. High degree of knowledge/compliance about Opportunity Zone laws and regulations
— Has hired outside counsel, Big Four accounting firms to ensure compliance with regulations and understanding of current IRS guidance

#3. High level of personal investment in the QOF

#4. Promising demographics in the areas of investment
–No tertiary markets
–Focus on growing population centers (i.e. Austin, Seattle, Portland)

#5. Most Important: The investment must pencil out on a standalone basis (no tax savings included).

Other Options
Another thing we point out to clients is that there are other ways to defer capital gains taxes, such as a Section 1031 real estate exchange or establishing a trust. An easy option: simply hold on to the assets, so that your heirs can inherit them at market prices (a “step-up in cost basis”), significantly lowering their capital gains taxes when they sell. By contrast, deferred gains invested in a QOF do not get a step-up in cost basis should the investor pass away. His/her heirs will report the same gain as the investor would have reported.

For more, read our paper Opportunity Zones: The Promise and the Pitfalls.

One of the Opportunity Zone ventures we have invested in: Canton Lofts in Seattle’s Pioneer Square, recently featured in The Seattle Times.

Josh Hile
Josh Hile
Josh is a senior investment analyst at Laird Norton Wealth Management. An MBA and CFA, he is responsible for research and recommendations on global equities and for due diligence and monitoring of equity investments.