Investing In Opportunity Zone Funds? Experts Warn Of Hidden Financial Risk
Investors who fail to select the right opportunity zone funds could face unexpected financial headwinds.
Investors welcomed the second set of opportunity zone rules in April, which allows exits from qualified funds with a chance to take advantage of eligible tax benefits via asset sales in addition to the previously allowed equity sales.
If you do an equity sale, everything in the fund is required to go with the sale, while asset sales allow a purchaser to acquire individual fund assets, McGinnis Lochridge attorney and partner Douglas Jones said.
While asset sales give investors and funds another exit strategy, it isn't always the best choice.
“Even though the asset sales are allowable and you can do them, it’s a good idea in some situations to be able to preserve the ability to do an equity sale even though we have these asset rules,” Jones said.
It comes down to the blend of qualifying and non-qualifying properties within a fund.
“The reason the asset sales can be sort of not optimal in some situations is because the way the second set of regs reads is that only capital gains from the sale of qualifying properties [are] eligible for people to take advantage of the 10-year-hold benefit, and these funds are not going to have 100% qualifying properties,” Jones said.
“They have up to 10% or sometimes up to 30% non-qualifying properties, so if you’re doing an asset sale, you’re not getting tax benefit for potentially 30% of the assets in the fund. Whereas if you did an equity sale, you would get the tax benefit related to non-qualifying assets.”
Jones also is surprised many remain unaware 2026 is a do-or-die deadline for paying taxes regardless of whether any asset or equity sales have taken place at that point.
“One thing which I think is important for people to remember is those gains people are rolling over that they get a [tax] deferral on, that deferral ends in 2026 regardless of whether or not there is some sort of liquidity or exit,” he said. “So investors going into a fund have to be sure that they are in a position to pay those taxes in 2026 when the bill comes due.”
Womble Bond Dickinson tax attorney and partner Mike Cashin said the best practice may be to invest in real estate and then hold the assets and interest for 10 years. However, even with the updated rules, there is substantial risk of a taxable event surprising unprepared investors without the right structures in place and attention paid early on, he explained.
This is particularly true in asset sales that occur earlier than an investor in a fund expected.
“You could invest $1M into a building for example and sell it for $3M, and you have $2M in gains that’s taxable now unless you find some other way to defer it," Cashin said.
Hedging against these taxable events also can be difficult if investors join a fund where they have no control over the underlying assets or the fund managers.
“The funds that we are working on from a multi-asset fund perspective, just in terms of documentation, often do not give the investors any control over what is going on with the underlying assets that the funds directly or indirectly invest in,” Womble Bond Dickinson attorney and partner Pam Rothenberg said. “So, I think my comment on this is it depends on the spectrum of risk tolerance that the investor has as to the way the investor wants to put the money in real estate.”
Rothenberg suggested investors do a gut check early on and assess how much they are willing to gamble on a particular multi-asset fund before investing their capital gains.
“If you are super risk intolerant, then you really want to think about putting it in a single-asset fund with a tried, tested and true real estate player as sort of the sponsor, so the person that you’re giving your money to knows what they’re doing and you also have some kind of governance level control over what is going on with the underlying asset.”
Investors in multi-asset funds without the right structures and organizational documents in play become nothing more than passive investors, which is precarious considering the tax risk associated with early exits, particularly when the investor has no control over the real estate assets, she said.
What makes this scenario so troublesome is that the investor may not have control over what the fund does after it sells an asset, Cashin added.
The best way to mitigate the risk is to ensure investors know the fund's structure and sign the right governing documents at the front end of the deal.
“They should go straight to real estate players that are looking to raise equity either on a platform basis or on a one-off basis,” Rothenberg said. “For each asset have that real estate guy establish a fund, have the investor put the money in the fund, and then negotiate the documents to give that investor more input and decision-making control over what’s happening with that asset.”