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Smart Investing, Not Just Tax Should Drive Qualified Opportunity Zones - CAIS

Tom Burroughes, Group Editor , March 5, 2019

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This publication spoke recently to the alternative investments platform about these new Zones and how high net worth investors should consider them.

Launched more than a year ago as part of US President Donald Trump’s tax changes, Qualified Opportunity Zones have already caused plenty of discussion among wealth managers (see here). To some degree, they dovetail with the trend of “impact investing” by targeting disadvantaged communities. These are designed to put money and resources into poorer parts of the US and areas with particular challenges, whether they be lack of affordable housing, high crime, poverty or lack of opportunity. Qualifying investments in these zones carry exemptions – under certain limits – from capital gains tax, for example. Already, wealth management houses such as Cresset have gotten into the act, bringing out funds aimed at the QOZ opportunity. 

Family Wealth Report recently spoke to Nicholas Millikan, director of research for alternative investments at CAIS, a financial product platform for wealth managers, about these Zones and what they could bring to a client’s portfolio. If other wealth management practitioners want to talk to Family Wealth Report about this subject, please contact the editor at tom.burroughes@wealthbriefing.com

Now that the funds are officially here and investible advisors need to understand what questions to ask to ensure they’re choosing the opportunities with the best chance of success. Not all managers or properties are alike, CAIS argues. 

Millikan has been involved in sorting and vetting Zone fund managers and opportunities. CAIS argues that the timeline for investing is “tight” - investors hoping to make the most of the capital gains tax benefits must be invested by December 31 of this year.


What is your general view on how much capital QOZs could attract over the next few months/years? Has enough been done so far to publicize what they are and can do in terms of various tax incentives?
Millikan: Much has been made about the amount of capital gains that are eligible for investment into QOZ funds. While it will remain to be seen just how much of these gains are realized and invested into the space, the finite life for maximum benefit under the program should see a rush of flows at the end of 2019, and again in 2021 – for example, to receive the maximum step-up in basis on the deferred gain, investors need to be invested for seven years prior to December 31, 2026 when taxes are payable. 

This sense of urgency needs to be tempered by cautious engagement in the QOZ space since there could be a massive supply of capital chasing a home during these periods with the potential to push property prices higher than they otherwise would be. Developers may relax their underwriting standards to pencil otherwise unattractive deals and we could witness investments made into low-quality properties.

The tax incentives at this stage are well known and unlikely to change. There are, however, other aspects of the program's regulations that remain unknown such as the recycling of capital, which could cause managers who haven’t considered the structure of their portfolio some issues down the road.

People say that the tax tail should not wag the investment dog, and tax breaks can sometimes encourage sub-optimal investment ideas. What's your take on how well-crafted QOZs are in terms of the criteria used to set them up (given the usual political horse-trading that goes on with these matters)?
Millikan: The utilization of 2010 census data has created an opportunity for those locations that have experienced economic growth and revitalization since this time. This may have created a ‘zip code arbitrage’ situation. Places like the Bay Area and Long Island, NY have strong and vibrant economies already and now could see an additional tail- wind of the QOZ program. This isn’t to say their future success is all but guaranteed, but the QOZ initiative may initiate increased levels of capital flooding into these markets.

At the end of the day, a tax incentive can’t justify a bad investment. Yes, deals will be penciled under the program which otherwise wouldn’t have been, but a robust due diligence process around manager selection, as well as diversification of managers and geography has the potential to reduce such risks.

From a tax planning point of view, what do you see as the greatest benefit?
Millikan: Some unique tax benefits built into the new regulation include the fact that, unlike the 1031 Exchange, QOZ investments allow investors to only reinvest their capital gains, not the original principal and capital gain. Additionally, the tax incentives under QOZ are threefold. A deferral of the gain, a step-up in the basis of that gain and finally an avoidance of capital gains on the QOZ investment all together if the investment is held for 10 years or more.

What is the firm doing in this space? What is your own role?
Millikan: Over the past several months we have been working with our due diligence partner, Mercer, to identify a slate of high quality QOZ managers. They have sought managers who have considered the risks associated with the project, who have strong existing pipelines of properties and deals within the space, have deep experience in acquisition, development and management of properties, as well as local relationships they can leverage, and who have given fund structure and exit strategy heady consideration.

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