How Investors Can Best Maximize Opportunity Fund Take-Home Returns
As someone with nearly two decades of experience acquiring, financing, and developing real estate, I’m used to being asked for advice on the most tax-efficient ways to invest in real estate. There are investment vehicles that offer ways to defer capital gains taxes, which can help real estate investors in no small way—but what if, in addition to tax deferment, an investment vehicle could also reduce your current capital gains taxes and eliminate future capital gains taxes upon your exit? These tax advantages are not theoretical. They’re now available to real estate investors through a new legislative change called Opportunity Funds. Thanks to a provision in the Tax Cuts and Jobs Act, real estate investors can now access unprecedented tax incentives over the course of the next decade—or longer.
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But what is the best way for real estate investors to access an Opportunity Fund? It may be instinctual to stick with the way you’re accustomed to investing in real estate—whether that means doing it yourself or using professional investment management. But in order to maximize earning potential, evaluation of a new investment option generally requires fresh examination. In this article, we’ll examine important considerations specific to real estate investors when considering operating your own Opportunity Fund or investing in a professionally-managed one—and ultimately how a real estate investor can maximize after-tax return potential through the Opportunity Fund.
What Are the Tax Incentives of Opportunity Funds?
Before we look at how to maximize the tax incentives of Opportunity Funds, let’s examine the tax incentives that Opportunity Funds offer.
An Opportunity Fund is a new investment vehicle made possible by the federal Opportunity Zone program, which was created under the 2017 Tax Cuts and Jobs Act. Opportunity Funds must invest at least 90% of their holdings in specific investments (including types of real estate investments) within one or more qualified Opportunity Zones. An Opportunity Fund can self-certify to the IRS, but it’s also responsible for ensuring that it abides by the guidelines of the Opportunity Program in order to be eligible to access tax incentives available under the program. If the Opportunity Fund meets qualification requirements, it has full access to each of the tax incentives available, including:
- Tax Deferment: If any investor invests realized capital gains into an Opportunity Fund (within 180 days of realization), they can defer tax payment until up to December 31, 2026, with those taxes becoming due in April 2027. If the investment is divested before then, the gain will be taxable the year that the investment is dispositioned.
- Tax Reduction: Taxes owed on the initial realized capital gain can be reduced by 10% if the Opportunity Fund investment is held for at least five years prior to the end of the deferment period (December 31, 2026). Taxes owed can be reduced even further to a total of 15% if the investment is held for at least seven years prior to the end of the deferment period.
- Tax Elimination: Earnings from Opportunity Fund investments held for at least ten years can qualify for permanent exclusion from capital gains taxes. There’s no limit on how long an Opportunity Fund investment can be held, so capital gains earned on a decade-old or older Opportunity Fund investment can be realized tax-free when an investor chooses.
Doing it Yourself
While Opportunity Funds offer an appealing set of tax incentives, they can be difficult to execute due to their complexity on several fronts. There are advantages and disadvantages to operating your own Opportunity Fund and personal considerations are key when determining which investment method fits best with your goals and resources.
As previously mentioned, Opportunity Funds can self-certify without the need for permission from the IRS. For those who possess all of the resources needed to operate an Opportunity Fund well, the DIY option offers investors the most control over the investment, which gives authority over the investments held by the fund. By handling all aspects of their investment internally, they can avoid having to pay a fee to an outside fund manager.
In return for control over the fund, you shoulder the responsibility for the execution of the property investment. An experienced investor may be accustomed to this dynamic, but the Opportunity Fund is a new investment structure, which means that it’s unlikely that they’re used to operating in compliance of the complex requirements of this specific program.
Real Estate Asset Restrictions
Firstly, the Opportunity Zone program places limits on the types and timing of real estate investments that can qualify for an Opportunity Fund. An Opportunity Fund can only invest in the construction of new buildings or in the substantial improvement of existing unused buildings. No other type of real estate can qualify.
If an Opportunity Fund invests in the improvement of an existing building, it is required to invest more into the improvement of the building than it paid to purchase the property. Arguably the biggest challenge in any city with arduous zoning and permitting process, whether the building is newly constructed or a heavy value-add, the development must be completed within 30 months of the initial purchase of the property.
These program requirements inherently restrict the DIY option to those who have the expertise and resources to manage full property redevelopments, conversions, and ground-up developments within a tight timeframe. For those more versed in stabilized assets, this is new territory that demands construction management expertise and extensive time commitment to run a development deal.
Operational and Geographical Limitations
Unlike other real estate investment options, the Opportunity Zone program restricts investment options to designated census tracts (i.e., Opportunity Zones), which limits the geographic focus for acquisition. There are more than 8,700 qualified Opportunity Zones in the United States currently, which constitutes roughly 12% of all census tracts in the country and its territories. Some Opportunity Zones offer more promising near-term growth potential than others and the ability to transact with the sellers of the most promising investments is crucial.
Geographic limitations add more complexity beyond connections to acquisition prospects. Because Opportunity Fund investments are limited by geography, they require investors to be knowledgeable not only of trends of the overall area, but also of specific neighborhoods and census tracts within those neighborhoods. On top of that, investors also need the ability to operate locally.
If you have previous experience within a submarket, such as Shaker Heights in Cleveland (which doesn’t fall into any Opportunity Zones) and desire to acquire in a less familiar neighborhood now designated as Opportunity Zone, such as Ohio City in Cleveland, there will likely be challenges in finding and closing on a property where you have less of a network, reputation, and local knowledge. So, unless you’re located in or near promising Opportunity Zones where you already have a deep background, you’ll need to find a way to get boots on the ground at the Opportunity Zone investment that you’re considering.
The Complexity of Compliance
Lastly, and possibly most importantly, on top of these limitations, there’s a complex compliance structure that Opportunity Funds are required to operate within. As mentioned previously, an Opportunity Fund is required to invest at least 90% of its holdings in Opportunity Zone-qualified investments, and the burden of certifying and reporting falls on the Opportunity Fund managers.
The complexity of compliance that is innate to Opportunity Funds and the Opportunity Zone program is likely challenging for a small team or a single operator. Maintaining the required investment ratio while developing within a competitive environment and ensuring proper reporting throughout the lifetime of the fund requires specialized legal and accounting knowledge to navigate. Otherwise, you bear risks that could very possibly outweigh any possible tax advantages.
It’s nowhere near impossible to operate and Opportunity Fund alone, but the complexities of this investment vehicle restrict the DIY option to a small group of experienced and capable managers, who are able to make the investment worthwhile through their own efforts.
You can also take some of the weight off your shoulders by enlisting the help of real estate operators, an accountant, and legal counsel. But these services also add expenses, which reduce return potential and also add new relationships to manage. If you employ the help of a team of experts, you very well may end up paying expenses and fees that are comparable to what a professionally managed fund would charge in addition to the time and effort of self-managing a complex, new fund.
Investing a Professionally Managed Fund
A professionally managed fund removes direct control from individual investors, which may be undesirable for some hands-on investors. But with that, it also removes the burden of operating within a tight and complex program from investors’ shoulders while still offering access to tax incentives of the Opportunity Zone program.
Volume and Diversification of Assets
By pooling funds under a professionally managed fund, investors receive the ability to invest in assets that would otherwise be out of reach of many individually. There’s no legal limit on the number of assets in which an Opportunity Fund can invest in, so by pooling funds this way, you can access dozens of property investments across both residential and commercial real estate.
In addition to the practicality of accessing a larger volume of real estate investments, a professionally managed fund can offer greater geographical reach. Because Opportunity Zones are based on geography, some of the most desirable and fastest growing Opportunity Zones may or may not be local to you.
Through a professionally managed fund, an investor based in Cleveland can realistically access Opportunity Zone investments in Dallas or San Diego or where the most promising Opportunity Zone investments may be at a given time. Additionally, the success of each investment isn’t dependent upon an investor understanding the interdynamics and underlying elements impacting growth potential of individual census tracts.
Speed and Ability to Develop
As previously discussed, there’s more to investing in qualified Opportunity Zone properties than simply buying a cash-flowing asset and improving it through minor renovations. The ability to develop a property from the ground up, convert an existing building to a new use, or substantially rehabilitate an asset within 30 months of purchase requires a greater time commitment, deep resources, points of contact and the ability to operate with speed in a competitive environment.
Understanding local demand, community dynamics, zoning barriers, and other complexities will be critical in successfully executing on real estate developments in the limited number of promising neighborhoods. Additionally, in developing properties in a manner that improves the community, as the Opportunity Zone program is intended to do, requires taking into account the local vested interests at stake. If a real estate investor fails to operate properly in any regard here, they can risk opposition from many fronts.
Managing Compliance With a Team
The complexity of compliance is easier to bear with legal and accounting experts to navigate project requirements, manage the Opportunity Fund and more. A dedicated team available under a professionally managed fund structure enables the fund to move quickly while meeting all requirements. A do-it-yourself (DIY) operator will likely concentrate compliance risk to one Opportunity Zone property with a single 30-month development timeline and other program testing, which could have much larger economic consequences if there are unexpected project delays or unforeseen compliance errors.
However, in terms of accessing the greatest number and quality of deals within the parameters of the Opportunity Zone program, you’re limited by the expertise and reach of the fund manager. Although the burden operating the fund won’t fall on you under this structure, the lack of direct control makes it that much more imperative to choose the right Opportunity Fund manager with expertise of, and ideally, experience investing in neighborhoods in or adjacent to now-designated Opportunity Zones.
Costs Justified by the Value of the Service?
The difference in costs between operating an Opportunity Fund yourself and following the professionally managed fund path is one of the most crucial considerations when choosing how to invest in an Opportunity Fund. A fund charges its investors fees and expenses directly where a DIY investor can directly and indirectly pay their own sets of fees and expenses throughout the lifetime of management of an investment.
There is considerably more time and effort needed to manage the permitting, construction, and leasing required under an Opportunity Zone than the asset management involved in another investment structure, such as a 1031 exchange. With the DIY option, you can forgo fees that you would otherwise be charged by a professionally managed fund. However, if they end up relying on outside expertise and use services from real estate, accounting, and/or legal experts along the way, you will end up being subject to other fees and expenses that you were trying to avoid by investing in a professionally managed fund—the extent of which may be greater or lesser than what a fund would charge.
The fees and expenses charged by a professionally managed fund can vary widely from fund to fund. Because the Opportunity Fund is a relatively new investment vehicle, there is no standard cost structure. This makes it imperative for an investor to be able to understand and compare cost structures of competing Opportunity Funds and the DIY model.
In general, however, in terms of expenses, one main differentiator between the DIY option and professional management option is the ability of a professionally managed fund to benefit from economies of scale. A professionally managed fund pursuing a greater volume of investments can have greater leverage to manage Opportunity Fund legal and accounting setup.
For example, this can include standing up the opportunity zone fund in terms of legal, tax, and accounting, maintaining the ongoing code and regulatory compliance as it is released over the coming months and years, as well as the normal economies of scale of acquisition, financing, construction, and leasing in emerging neighborhoods.
Choosing Which Path is Right for You
Operating your own Opportunity Fund may be worthwhile if you have the expertise, resources, and geographic advantage to enable you to oversee this complex investment vehicle for at least the next decade. Managing the complexity of this investment vehicle alone can be a full-time job in and of itself. If you enlist outside help or if you’re unable to gain specialized Opportunity Zone knowledge necessary to form and operate an Opportunity Fund and source a shovel-ready development within your 180-day rollover window, you may lose the possible benefits of the DIY option.
On the other hand, because a professionally managed Opportunity Fund generally comes with several teams of experts, it has the capacity to execute more deals more quickly and possibly nationwide (depending on its strategy and geographical focus). Depending on its deal volume, a professionally managed Opportunity Fund may also benefit from economies of scale, which could allow it to lower management and development costs. However, under this path, investors will pay expenses incurred by, and fees for services provided by, the fund. Depending on which aspects of the DIY option and the professionally managed fund matter most to you, as well as your goals and resources, a cost-benefit analysis may be key in determining which method of investing in an Opportunity Fund is right for you.
We created the Fundrise Opportunity Fund to offer investors an effortless way to access high-quality real estate properties located in the most promising Opportunity Zones with strong long-term growth potential across the US. In Los Angeles alone, Fundrise has invested or committed approximately $100 million in neighborhoods in and along the areas now designated as Opportunity Zones. Our technology-enabled investment approach coupled with our partnerships with leading expert teams devoted to Opportunity Fund management enable us to take a nimble, and cost-effective approach to investing in Opportunity Zones nationwide.
Regardless of how you choose to invest, Opportunity Zones now offer one of the most tax-advantaged ways to invest in real estate. Opportunity Zones not only offer investors a way to substantially diversify their real estate portfolios and the ability to potentially double their after-tax returns over the course of the next decade.
Are you curious what your after-tax returns might look like if you invest in an Opportunity Fund?
Use this calculator to estimate how much money you could potentially save.