The highlights of the Tax Cut and Jobs Act of 2017, better know as the Trump tax cuts, are somewhat well known: a 20% deduction for small businesses, a change in the federal tax brackets that gave many workers more take home pay, a higher standard deduction and a cap on deductions for state and local taxes.

However there was a fascinating article I stumbled upon the other day about a part of the bill that many may have missed: The Qualified Opportunity Fund, or QOF, which invests in Qualified Opportunity Zones.

The Intention: The intention of this provision is to spur economic development and long term investment in “distressed communities” nationwide. Over 8700 communities have been designated as Opportunity Zones and approximately 35 million Americans live in these areas. The median family income in these areas is 37% below the area or state median and unemployment is 1.6 times higher than the national average. These zones were proposed by each state and submitted to the Treasury Department, which is in charge of providing the guidelines for the program. A map of the 8,700 areas is below and can be found in more detail here.

Source: eig.org

The Opportunity: So what? You may say, the government is always trying to spur development in some way, but this one is different. To encourage the long term investment, the funds invested in these zones are to be from capital gains. Investors who fund businesses or develops real estate in these areas are able to defer capital gains taxes and completely eliminate them for new investments in these zones. After almost 10 years of stock market gains, this represents a lucrative shelter for those who have already been winning for the past decade.

As with everything though, the devil is in the details. I initially was excited at this prospect as I got to know it in more detail though the Treasury Department’s updated guidelines which are outlined in this 70 page document here. The document states that the investments cannot be direct, they have to be to a fund that sets itself up as a Qualified Opportunity Fund (QOF) for the purpose of investing in these areas. The fund can then invest in property or a business however there are restrictions to maintain the tax advantage on each type of investment.

To qualify, the capital gains used for funding must be invested in a QOF no later than 180 days after being sold for a gain. The gains can be from any investment, be it stocks, bonds, real estate or partnership interests.

If invested in a business, the business must derive at least 50% of its income within the zone. For a property, the land or property must be built on or upgraded with an investment that is equal to 100% of the initial basis for the property. For example if you buy a $50,000 home, you would have to invest another $50,000 in improvements to the home for the total investment of $100,000 to qualify.

The Benefits:

• Gain Deferral – Any capital gains invested in a QOF within 180 days of the sale can be deferred for that year.

• Permanent Tax Exclusion of 10% – Investments held at least 5 years will receive a basis increase equal to 10%, so a 100,000 deferred capital gain would then only be a $90,000 capital gain after 5 years.

• Permanent Tax Exclusion of 15% – Investments held at least 7 years will receive a basis increase equal to 15%, so a 100,000 deferred capital gain would then only be a $85,000 capital gain after 7 years.

• Permanent Tax Exclusion of 100% – This is for any gain on the sale or exchange of an investment in a QOF held for at least 10 years.

Note that this expires on December 31, 2026 so no gain deferrals will be available after this date. If the investment is sold before, then the capital gains taxes will be triggered at that time.

Best Case Scenario – Given the above, the optimal scenario in this case is to invest a large capital gain in an investment expected to appreciate handsomely after being held for 10 years. In 2027, 85% of the original capital gain would be recognized and taxes would have to be paid. After 2029, no taxes would be paid on any capital gain for the sale of the property. The overview of the flow of funds in this scenario is visualized below.

Source: treasury.gov and Cash Chronicles

The Reality: Given that the businesses will be local (where these areas are poorer on average) and the property requires a significant investment in relation to its original purchase price, the easiest win in with these funds is to buy raw land and develop it.

Not coincidentally, in New York City, many of these QOZ’s happen to be in areas that are up and coming for developers. Such as Long Island City and the Brooklyn waterfront. This includes the land where Amazon plans to build its “HQ2”.

In fact, as a recent Capital Analytics report points out, sales of development sites have surged by 60% year over year and a number of national developers have stepped in by setting up their own funds to put to work in these areas.

The large cities that already have high rents and a skilled work force should expect to see significant development in a number of areas over the next few years. How this will play out in the more struggling cities and towns in the interior of the country remains to be seen. As has been the case for much of the past 25 years, the winners may end up being the Big coastal cities.

A quick search engine check also shows that financial advisors and banks are dedicating whole departments and resources towards this opportunity to offer funds to their clients. The corporate machine backing these ventures seems to be moving at full pace, however I am also curious if there are ways the little guy can benefit from these funds.

The Investment Universe: An investigation of the investment universe for these funds had me asking things like how many funds were out there, how much they have already collected from investors and how small investors participate.

My search brought me to the National Counsel for State Housing Agencies (NCSHA), which collects descriptions and basic info submitted by QOFs here. Looking through the funds, their objectives and their size I noticed that funds range in size from $3 billion at SkyBridge Capital II LLC to $975k for Grey Holdings Group Inc. which is actually investing in a defense technology product. There are about 60 funds listed in total with various geographical focuses.

Conclusion: Just like any investment, each project within a fund should be evaluated for its risk and return, not just from its tax advantages. I am sure there are a number of these funds that will make some bum investments.

However on a good investment for those looking to defer payment on their capital gains and also looking for some potential tax free upside, these funds are a potential once in a lifetime opportunity.

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