Hedge Funds and Opportunity Zones
Opportunity Zones have recently been cited in the news as new opportunities for investors looking for tax-deferred long-term gains. What is an Opportunity Zone? According to the IRS, an Opportunity Zone is an economically-distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment. Localities qualify as Opportunity Zones if they have been nominated for that designation by the state and that nomination has been certified by the Secretary of the U.S. Treasury via his delegation of authority to the Internal Revenue Service. In order to be eligible for this program, specific state census tracts must have a 20% poverty rate or have a median family income of less than 80% of the surrounding area. Governors then selected 25% of the eligible tracts for the program.
These Zones were added by the Tax Cuts and Jobs Act in 2017 as a way of spurring investment in economically distressed cities. As a result of this new law, many asset managers have been raising new funds to invest in these Zones. The value proposition in these Zones is such that taxes can be deferred on any gains invested in these Funds as late as the end of 2026. In addition, if the investment is held for longer than 5 years, an additional 10% is excluded on the gain. If the investment is held for longer than 7 years, the exclusion becomes 15%. Furthermore, if the investment is held for at least 10 years, the investor is able to be exempt from all capital gains taxes.
Not surprisingly, many funds have been eager to defer capital gains by selling investments that have appreciated and reinvesting the gains in the new funds within six months. According to the rules, the sale of stocks, real estate or businesses can be sold and their proceeds can be reinvested in these Funds. The principal and capital gains can both be invested, but only the capital gains portion is exempt from taxes. There is also no requirement to invest in a like-kind asset in order to defer the gain (which is a requirement in a 1031-exchange).
Funds Investing in Opportunity Zones
One of the more famous (infamous?) funds that has started an Opportunity Fund is Skybridge Capital, whose Co-Founder is Anthony Scaramucci, the former White House communications director for President Trump. Skybridge intends to raise $3 billion for their Opportunity Fund. Another is EJF Capital. They manage almost $7 billion in assets and recently started fundraising for a $500M fund in September 2018.
Skybridge and EJF Capital had announced plans for a joint $3 billion fund, but recently ended the venture after there were concerns about EJF’s experience in managing real estate funds.
While the traditional hedge funds are open to individual investors (many have minimums of $50K to $100K, and in many cases, substantially higher), there are other opportunities for individual investors.
These include crowdsourced investment vehicles like Fundrise, which allow retail investors to invest as little as $500 into a pooled investment vehicle, which then invests in an Opportunity Zone fund.
Benefits of Opportunity Zones
The benefits of these Opportunity Zones are multi-faceted. One is tax deferral for investors. Another is the hope of rebuilding depressed American cities.
From an investor point of view, the tax deferred benefits of such a program are the biggest benefit. The ability to take capital gains from a current investment and invest it in a new one that can defer taxes for up to 10 years can be attractive to long-term investors. In addition to the tax benefits, by increasing the benefits to an investor the longer they invest their money, it ensures that the investor is financially aligned with the Opportunity Zone and ensures they have skin in the game.
The largest social benefit is spurring economic investment. Recall the old saying ‘a rising tide lifts all boats.’ This program has the potential to revive smaller cities and towns that historically, have not had much outside investment. By providing incentives and access to private money, this new law can turn around once-forgotten cities in the Midwest and Rust Belt that have not been able to attract development and investment like the coastal cities of San Francisco and New York.
Risks and Downsides of Opportunity Zones
Like any speculative investments, the potential risks are not suited for the faint of heart. Aside from the lock-up period needed to realize the potential tax benefits, there is no lengthy track record by which an investor can gauge performance. In addition, one needs to question why some of the depressed areas have not had organic investments on their own and rather, require the specter of deferred tax benefits to attract investors.
There is also the risk that many Funds have raced to start up these Funds since the 2017 law came into effect and they themselves have not carefully performed their due diligence on asset quality. There is also some belief that investment firms and property developers would take advantage of the new laws by moving money around to avoid taxes rather than increase overall investment.
Another is the risk appetite of the investor. Many of the Funds have targeted areas that may be deemed too depressed to actually deliver positive returns. This is one situation where the early adopter may have gotten the best deals or opportunities have been picked over, while these Funds are left to scrounge for the dregs.
The detractors of this new law are concerned about the social aspects – namely, increasing wealth inequality and negative gentrification effects. There are some who think this will lead to the continuing wealth gap in the country. Those in the most depressed census tracts will fail to attract investors, while those that are on the cusp of becoming thriving towns will attract the lion’s share of investments. Broadly advertised as a new law that can attract investments in depressed cities, suburbs and rural areas, the law has also had its’ detractors who think it is just another handout to the rich.
The other potential downside is that these Funds will speed up gentrification. In fact, the recently touted Amazon HQ2 land in Long Island City, NY was located in a designated Opportunity Zone census tract. Before the deal fell through, there had been concerns from local officials and residents that it would further push out long-time residents who would no longer be able to afford to live there.
Opportunity Zone Events
Listed below are a few recent and upcoming conferences/seminars on Opportunity Zones.
If your hedge fund has started an Opportunity Zone fund and is looking to implement performance improvement systems or client relationship management tools around your new fund, please reach out to FinServ. To further continue the conversation or to discuss more of FinServ’s capabilities, please contact FinServ at firstname.lastname@example.org or give us a call at (646) 603-3799.
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