An Opportunity Zone Fund Checklist for Advisors

Opportunity zone investments are so hot that 150 people were turned away from an IRS hearing on OZ regulations on Valentine's Day; more than $18 billion worth of investment plans in these zones have been announced, according to the National Council of State Housing Agencies; and even the mayor of Erie, Pennsylvania, plans to discuss the topic with Chinese officials when he visits Erie's sister city Zibo, China, to attract Chinese investment.

"This is what everyone wants to talk about; should I invest in opportunity zones?" said Josh Brown, CEO of Ritholtz Wealth Management, in a recent video tweet. "Is it a good investment? Well maybe."

ThinkAdvisor spoke with a number of investment professionals who are considering investing in opportunity zone funds to develop a checklist that can help advisors answer that question, beyond the consideration of their tax benefits, which are attractive.

Investors who roll over capital gains into an opportunity zone fund within 180 days can defer those gains until their investment in the fund is sold or until Dec. 31, 2026, and they can receive a tax advantage of a stepped-up basis in the investment if it's held for at least five years. At 10 years, the basis is stepped up to the market prices.

Keep in mind that the IRS has not finalized regulations governing opportunity zone funds, and some of the current proposed regulations have been disputed by potential investors and others.

One key example: the requirement that 50% of revenues of a business in an opportunity zone come from local sales, which would deter businesses such as a local manufacturer who sells products outside that neighborhood. Another example: Can a fund that sells individual assets in one opportunity fund deploy those proceeds in another without losing the tax benefit?

"Everyone is lining up to put funds together, but they can't invest until final regs are out," says Andy Hart, managing director of Delegate Advisors, a multifamily office, who reports receiving no less than 10 emails a day about opportunity zone funds investments.

Know the Fund Manager

"Manager selection, along with due diligence, is most important," says Nicholas Millikan, director of research at CAIS Group, an alternative investments platform.

Does the manager have experience working in the local community and have a local partner? "Part of risk mitigation is working with local partners and local governments to identify deals," says Rachel Reilly, director of impact strategy at EIG, which is credited with developing the concept of opportunity zones.

A local partner can also help if and when complications arise, notes Reilly.

Is there an alignment of interests between the fund manager and investors? This is more likely if the fund manager is also an investor in the fund, has skin in the game, says Hart.

Is the manager as interested in the social impact of a fund as in the potential investment returns, if that is a priority for your client?

Can the manager deploy capital in time to satisfy IRS regulations and manage the investment long term without a cash injection? A highly leveraged investment won't have the ability to reduce leverage afterward, Millikan said.

Existing regulations give funds six months to deploy funds, but many would like more time and are hoping the IRS provides some wiggle room and require that fund "substantially improve" the property within 30 months of purchase.

Examine the Deal

Is the investment attractive enough that it would be done without the tax benefits of an opportunity zone? "Be wary of deals being done that otherwise wouldn't be done," says Millikan.

"You don't win unless the fund has a good return," says Hart. "First and foremost read through the documents. You need to be sure they comply with the regulations, not that the fund 'will comply' with the regs when they're finalized."

If the fund is investing in real estate, is it buying into a market that already has inflated prices, say, New York City instead of nearby Newark, New Jersey?

Even the growing hoopla about opportunity funds is already impacting asset prices within opportunity zones. Hart reports that the seller of a opportunity zone real estate club deal of interest to his client recently hiked its price by 20%.

Does the deal have processes and procedures in place for independent verification of compliance with regulations? "You don't want to rely on the manager for self-certification," says Hart, referring to the legislation that allows opportunity funds themselves to certify themselves by filing a form with their federal tax return. "Trust but verify."

Understand the exit terms of the deal and how investors are going to paid back. "What if at the end of 10 years the economy is in the midst of recession?" asks Millikan. 'You don't want to dump the property then." (Investors can still get the full basis step-up for investments held for 10 years up to Dec. 31, 2047.)

Be wary of excessive charges. "Charges to finance properties are not uncommon," Hart said. "People are trying to slip them in."

Know the Social Impact

This is important for clients who are interested in opportunity fund investments because of their economic and social impact. That was the idea behind the creation of these funds, but the 2017 tax cut legislation that provides their tax benefits does not require proof of a social or economic an impact.

It does require that 90% of opportunity zone fund assets be invested in an opportunity zone — there are over 8,700 across the U.S. — and that a business retain 70% of its tangible property in the opportunity zone.

"A lot of the strategies being proposed appear to be the tax tail wagging the dog and the vast majority don't mention impact," said Justina Lai, director of impact investing at Wetherby Asset Management.

For those investors who want to ensure that an opportunity zone fund aims to benefit the local community, those funds need to show they understand the local community, have some level of community engagement and a way of assessing community needs, says Lai.

Investors need to understand how the fund is ensuring that benefits accrue to the local community, including its commitment to monitoring progress and and the thesis behind the strategy. Is the focus on job creation or providing access to basic needs and services like affordable housing or educational training? "They need an articulation of the overarching strategy," says Lai.

To that end, a group of members and supporters of the U.S. Impact Investing Alliance and its partner, the Beeck Center for Social Impact and Innovation at Georgetown University, have developed an Opportunity Zones Reporting Framework. It consists of voluntary guidelines for best practices of opportunity zone fund managers to help achieve "positive economic and social outcomes in distressed communities."

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