Deferring capital gains taxes is the top benefit of the opportunity zone model—but it isn’t alone. In fact, 1031 exchanges are a far more familiar concept for most investors, and exchange transactions also allow investors to defer capital gains taxes. For that reason, many real estate owners will likely opt for a 1031 exchange to defer capital gains taxes rather than an opportunity zone—which has more regulations. However, opportunity zones make more sense for some investors.
First, investors should focus on an optimization strategy for investment into a QOZ fund. “This is best suited for an investor who has capital gains generated from an asset or securities sale, like stock market gains or the sale of a business, that are typically not eligible for a traditional like-kind 1031 exchange,” Braden Crockett, VP and director of opportunity zones at Matthews Real Estate Investment Services, tells GlobeSt.com. “Essentially, gains that would be otherwise subject to taxation unless committed to this OZ program.”
Some investors might not be familiar with real estate model, but that doesn’t mean the can’t invest in the space. “Most investors who prefer passivity also lack access to private OZ investment opportunities or don’t feel comfortable questioning their friend’s assumptions on this new development deal they are raising capital for,” adds Crockett. “Investing alongside a tried and true sponsor at scale optimizes the probability of success. It will take a little research to find funds that are currently actively fundraising funds, but NCSHA’s directory is a good starting point for research.”
Once an investor has decided to use the opportunity zone model, they should assess the return requirements to optimize the benefit. Or, as Crockett says, keep your eye on the prize. “Remember, the name of the game is to optimize returns on the appreciation of a substantially improved QOZ investment, specifically one that will produce the highest returns over the next 10 years, at least,” he says. “Finding the right investment is key, but remember that all pro formas are not made equal.”
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Even when investing through a fund, Crockett recommends that investors do the appropriate due diligence. “Ultimately investors should do their due diligence on the project, a sponsor’s assumptions, improvement/development plans, exit strategies, and, most importantly, a sponsor’s track record of experience,” he adds. “Some examples of institutional quality behemoth funds based locally in Los Angeles are Griffin Capital OZ Fund, which is working on developing thousands of multifamily units in some of the country’s highest growth markets, or CIM group, both of which have had a long consistent track record of success.”
Opportunity zones have a lot of benefits, including the ability for investors to participate in institutional-quality development projects, but Crockett says there are some cons as well. “Expected returns, while anticipated to be strong, are typically not as sexy as executing your development strategy,” he says. “Typically offers investors between 12-25% expected annual returns.”