Opportunity Zone Investments: Frequently Asked Questions

By: Jan B. Brzeski
January 2019

The Tax Cuts and Jobs Act of 2017 included a new incentive for investors who want to take capital gains and invest them in designated lower-income census tracts called Qualified Opportunity Zones. The program allows for investments in various types of operating businesses, but is particularly well suited for the development and operation of real estate.  This FAQ focuses on the rules covering Opportunity Zone investment from the perspective of a real estate investor, and includes practical considerations, key issues, risks and strategies for investors wanting to explore this attractive new option for reducing tax liabilities.

The Big Picture


What are Qualified Opportunity Zones?

The Opportunity Zone program is a provision within the 2017 tax legislation designed to incentivize investment in low-income/high poverty areas in the United States. It is hoped that these incentives will result in a wave of new construction and business formation creating jobs and spurring economic development in these distressed areas. The Qualified Opportunity Zones themselves are designated census tracts, which were nominated by the governors of every state and certified by the Treasury Department. Investors with capital gains in a particular tax year can invest their gains in Opportunity Zones through 2026, and receive favorable tax treatment as a result.

Why should investors pay attention to Qualified Opportunity Zones?

Opportunity Zones are a useful option for investors facing large capital gains taxes on any type of investment or asset. The program is designed to incentivize people to sell appreciated assets and productively deploy their capital in a manner that will significantly contribute to economic development. Instead of paying the tax on realized capital gains, investors may deploy their capital gains into Opportunity Zones, following IRS guidelines, and thereby achieve very substantial tax savings.

What types of tax benefits can Qualified Opportunity Zones offer?

There are three benefits: (1) deferring payment of capital gains taxes that would otherwise be due, until 2026; (2) reducing those taxes by up to 15%; and (3) avoiding capital gains taxes altogether, on gains achieved with the funds invested into an Opportunity Zone. The three of these benefits together create a once-in-a-generation or maybe even a once-in-a-lifetime incentive worth studying carefully.

How do Opportunity Zone investments work?

Instead of paying capital gains taxes, investors now have the option to invest in a Qualified Opportunity Fund (QOF), which in turn makes investments in Opportunity Zone Census Tracts. For example, in Los Angeles, many parts of Hollywood are in Qualified Opportunity Zones, as are areas near USC, West Adams, some parts of Silverlake, and many neighborhoods in Long Beach. Investors may set up their own QOFs and source and manage their own real estate projects, or they may choose a more passive approach, working with companies that have relevant investment management experience. In our view, most QOFs will be customized to meet the needs of a particular investor or groups of investors. For a variety of reasons, we do not see many large funds set up for the general public. The main challenge is that Opportunity Zone investments are subject to strict rules and timelines, which vary from one investor to the next. A large fund serving many unrelated investors, investing in a portfolio of various projects, will have trouble meeting everyone’s needs at once.

What types of investments will be available in Qualified Opportunity Zones?

Opportunity Zone investments can be in real estate projects or in operating businesses. However, our field of expertise is in real estate and therefore that is the focus of our analysis. The options available within the category of real estate are limited by the requirement that the property must be “substantially improved”. In practice this means most projects will involve ground up development of new buildings, or heavy renovation and repositioning of existing buildings.

Who are the key parties involved in Qualified Opportunity Zone investments?

Typically there are two or three different parties involved, though in some cases there may only be one party. The investor who has a capital gain to invest is always involved (the “Investor”). Typically there is a fund manager separate from the investors (the “Fund Manager”). This company or person should have substantial experience in real estate investment in order to curate and oversee investments for the investor. Frequently, there is a third party who actually redevelops the subject property (the “Developer”). While the Developer and Fund Manager may be one and the same, we are seeing more instances where there are two separate parties occupying these two roles. On the other hand, for sophisticated real estate investors, it is possible for all three roles to be played by the Investor. However, we anticipate for various reasons that most Investors will not be experienced real estate developers.

Why is it likely that many Opportunity Zone investors will not be experienced real estate developers?

The Opportunity Zone program was designed to entice people to sell appreciated assets that they might otherwise not sell. However, for most experienced real estate investors, the main appreciated assets they own are real estate properties. If an investor sells a real estate property, the tax code already has a very attractive option to avoid triggering capital gains tax, called the 1031 Exchange (also known as a “like kind exchange” or sometimes a “Starker exchange”). The Opportunity Zone program really shines for investors who want more exposure to real estate, and have non-real estate appreciated assets that they would like to sell such as stocks, partnership interests or private businesses.

How do Opportunity Zone investments compare with a 1031 exchange?

Analyzing the differences between the Opportunity Zone program and the 1031 exchange mechanism and assessing whether one or the other is right for a particular investor requires a deep understanding of both programs and depends on an investor’s individual situation, investment goals, risk tolerances, and preferences. This is a complex issue that deserves a more thorough analysis than can be offered here. As such, a detailed analysis comparing the two programs is available in a separate white paper on our website.

Briefly, the basic premise of the Opportunity Zone program is that it encourages investors who otherwise might not sell appreciated assets, to put their gains to productive use by investing in real estate or businesses located in designated lower income census tracts. There are three tax benefits offered by the Opportunity Zone program: (1) deferral of paying capital gains tax; (2) reduction in amount of tax owed on gains; and (3) tax-free appreciation.

The traditional 1031 exchange allows investors with capital gains from appreciated real estate investments to sell those properties and reinvest the proceeds into other properties without triggering a taxable event. This provision allows investors to successively roll one real estate investment into another real estate investment, building a larger and larger portfolio, all the while deferring capital gains until such time the properties are sold for good.

The major difference between Opportunity Zone investments and 1031 Exchanges is that the Opportunity Zone program is not limited to real estate. The source of the capital gain can be from any appreciated asset, and the investment in the Opportunity Zone itself can be in any type of business, not just real estate (though in practice the authors expect almost all Opportunity Zone investments to be in real estate, given the way the rules are written). The 1031 Exchange, on the other hand, is limited to real estate - an investor sells one piece of real estate and reinvests in another. The non-real estate aspects of the Opportunity Zone program broaden the sources of capital as well as the investment opportunity set.

What is the role of the Fund Manager?

Let’s assume the Investor is not a real estate investment expert. The Fund Manager’s job is to source, recommend and oversee specific investments that will produce mutually agreeable returns. When things don’t go exactly according to plan--which is common in real estate development, the Fund Manager’s job is to do everything possible to ensure the success of the project in spite of the unexpected developments. The Fund Manager must also communicate regularly with the investor and provide timely reporting so that the Investor keeps realistic expectations at all times. While the Fund Manager may not necessarily be a fiduciary for the investor in technical sense, the role of the Fund Manager is similar--to keep the Investor’s savings as safe as possible and to deliver a return in line with what was originally projected, to the extent possible.

What is the role of the Developer?

The Developer selects a suitable property in the Opportunity Zone; gets control of the property via a purchase agreement; takes the lead on getting whatever approvals are needed for redevelopment; and oversees the redevelopment, lease-up and refinancing of the property. In some cases the Developer also performs property management which consists of leasing, maintenance and accounting functions. In other cases, a third party property manager performs these functions.

IRS Rules for Opportunity Investments


How do investors qualify for favorable Opportunity Zone tax treatment?

To get favorable tax treatment, investors must re-invest capital gains into a Qualified Opportunity Fund. This fund must then designate properties in Qualified Opportunity Zones, with specific addresses, which it plans to improve. Finally, the Fund must substantially improve the properties in Qualified Opportunity Zones and then hold these investments for 10 years in order to maximize the tax benefits.

What is a Qualified Opportunity Fund?

A Qualified Opportunity Fund (QOF) is an investment vehicle, either a partnership or corporation, established for the purpose of investing in qualified Opportunity Zone property. To participate in the Opportunity Zone program, investors cannot buy property in Qualified Opportunity Zones directly. They must invest through a Qualified Opportunity Fund. The QOF is self declared. It can be an existing entity or a newly created entity, and it must meet a 90% asset test - that is 90% of the assets of the fund must qualify as opportunity zone investments.

What types of investments qualify for the Opportunity Zone program?

A Qualified Opportunity Fund must invest in Qualified Opportunity Zone Property. Qualified Opportunity Zone Property can be stock or partnership interests in a company or tangible property located in an Opportunity Zone that is used in a business. If an investment is made in a company, a substantial portion of the assets of that company, defined as 70%, must be tangible property located in an Opportunity Zone. The company can be an operating business or more likely it will be an entity established to purchase, develop, and operate real estate. To qualify for the program, either the use of the tangible property must begin with the QOF investment (does not pertain to real estate) or the property must be substantially improved. In practice this means most real estate investments will involve ground up development of new buildings, or heavy renovation and repositioning of existing buildings.

What is the significance of the requirement that investments be “substantially improved”?

To ensure that meaningful new capital and economic activity are taking place, Opportunity Zone properties must be “substantially improved” to qualify for favorable tax treatment under the Opportunity Zone rules. Substantially improved is defined as follows. Suppose a property is purchased for X dollars in an Opportunity Zone. Of this total, the land value (as determined by an appraisal) is Y dollars and the value of the improvements (buildings) is Z dollars. The Opportunity Zone investors must spend at least Z dollars improving the property. In other words, they must at least double the value of the improvements on the property. This ensures that the Opportunity Zone rules are not abused by simply buying properties in Qualified Opportunity Zones, without spending much money on them after purchase.

What are the key timelines to keep in mind?

(The following timeline is simplified. Taxpayers must contact a tax adviser to get more precise guidance.) Upon realizing a capital gain, the taxpayer has 180 days to invest in a Qualified Opportunity Fund (QOF). The QOF then has up to 180 days (or the end of the taxpayer’s tax year, whichever is sooner) to designate specific real estate projects in which the QOF will invest its assets. Thereafter, each project must be “substantially improved” within an approximately 30 month period.

The Opportunity Zone investment incentives were designed to create incremental economic activity in selected lower income neighborhoods. If a real estate investor already owns a property in an Opportunity Zone, that investor can retain at most a 20% interest in the redevelopment of that property, to qualify for Opportunity Zone tax treatment. In other words an investor cannot use capital gains to purchase a property from himself, but he can use capital gains to purchase a 20% interest in a property he already owns. This is to make sure that new capital and economic activity are flowing into the neighborhood, rather than simply giving a tax break to activity that would have happened regardless.

How much of an Opportunity Zone investment can fall outside the guidelines without destroying the tax benefits?

90% of the assets of a Qualified Opportunity Fund must be invested in qualified opportunity zone property. Qualified opportunity zone property is either improved real estate assets, or ownership interest in an entity that owns improved real estate assets. If the QOF invests in an entity that owns improved real estate assets, 70% of the assets of that entity must be improved real estate. This is a little confusing, but if the QOF owns real estate directly, 90% of the assets of the fund must be improved real estate. If the QOF owns real estate indirectly, through another entity, 63% (90% x 70%) of the assets must be improved real estate. This rule was written to allow for operating businesses to hold reasonable amounts of non-qualifying working capital. Given that 37% of the assets of a fund can be non-qualifying, it may seem that real estate investors could use this provision to make investments outside of Qualified Opportunity Zones. It is our opinion, however, that the IRS would view such activity as abusive and investors would jeopardize their preferential tax treatment.

What are the most important rules that have yet to be clarified?

There are still some areas that are not fully defined in the Opportunity Zone rules. For example, if an Opportunity Zone fund chooses to refinance a project in the future, and there is net cash available, what is the exact tax treatment if that cash is returned to the fund investors? Also, if an Opportunity Zone project is sold, can the proceeds be reinvested by the fund into another Opportunity Zone project while retaining all the tax benefits? Many experts expect favorable answers on these topics, but even without clear answers the program has great merit for certain taxpayers.

Investing Basics


How can I compare investments on an “apples to apples” basis?

There are two main drivers to any real estate development project: (1) what is the capitalization rate (or “cap rate”) on cost at stabilization; and (2) what is the expected growth in income over time? The capitalization rate is the cash flow of a property (before servicing any loans), divided by the cost. In the commercial real estate industry, the term “net operating income” or NOI is used frequently. NOI is essentially the cash flow before paying interest on any loans and we will use the two terms interchangeably here. Stabilization refers to the point at which a property has been built and fully rented out, and is now generating its full potential cash flow.

What’s an example of how a capitalization rate is calculated?

Suppose a project costs $5 million to buy and $5 million in construction costs, and its cash flow upon stabilization is $600,000 per year. In this case the cap rate on cost upon stabilization is $600,000/$10 million, or 6%. Note that the cap rate on cost is different from the market cap rate. In our prior example, the developer’s cost was $10 million. Hopefully in return for doing all the work to develop the property, the developer could sell the property for more than his or her cost, in order to generate a reasonable profit. Suppose the developer could sell this property for $12 million. Given the same $600,000 of NOI, and the market value of $12 million, this project would trade an a cap rate of $600,000/$12 million = 5%. The difference between the 5% market cap rate that an investor would pay for a brand new stabilized property, and the 6% cap rate that developers require to undertake a project is the compensation that developers require to take on the risk and the work of a real estate development.

What is the significance of the expected growth rate in NOI of a property?

Suppose one property is in an area that is gentrifying rapidly (for example, Inglewood or Highland Park in the Los Angeles area), and another is in an area that is losing population (such as many parts of Cleveland, Ohio or Detroit, Michigan). Investors will pay more for the same amount of current income in Los Angeles, if they expect that income to grow more rapidly over time. The total return of a real estate investment is highly dependent on how quickly income grows. As relates to Qualified Opportunity Zones, the best returns will be on projects in areas that do transform during the next ten years or so, resulting in higher rents over time, and increasing interest in those neighborhood by investors.

What should I prioritize when considering Opportunity Zone investments?

The top priority should be the reputation, trustworthiness and relevant experience of the people involved in developing and managing the investment. Additional considerations include the investor’s personal risk tolerance and comfort with the property type and location of the project.

Is there a trade-off between current income and appreciation potential?

Typically there is such a trade-off. Investors require an equal or higher return to go to markets where overall market dynamics are flat. Because rent growth in such markets is not expected to be high, they absolutely require higher current income at the time of purchase (or a higher “going-in cap rate”). For example, if one buys a shopping center in a Midwestern city with stable or declining population, the cap rate (current yield, before loan payments) might be 8%. The same shopping center in a market where the economy and population are growing, especially in an urban market where there is little vacant land available for building more shopping centers, might be 6% or even lower.

How can I pick a solid investment and avoid the bad ones?

One way to mitigate risk is to find a trusted adviser who has relevant experience, to help evaluate possible investments. Spending time understanding all the ways that similar investments can get into trouble is very valuable, to be able to test all the assumptions of a proposed Opportunity Zone project.

What are the main ways real estate investments can get into trouble?

For an Opportunity Zone project in particular, potential problems include the following. (1) One of the partners is not performing, is difficult to deal with and/or is not forthright with other partners and investors. This is the most troubling scenario. (2) Not getting required local government approvals to proceed with the project, or getting those approvals and being held up by lawsuits, etc. This risk is heightened when the project has affluent homeowners located nearby. (3) Project goes over budget and/or takes longer than expected to deliver into service. This is quite common in real estate development. For example, in Los Angeles at times the City of LA and the local utility company have failed to communicate effectively, resulting in delays outside of developers’ control. (4) Project does not achieve the projected level of income. In some cities where approvals are easy to obtain and land is plentiful, a glut of new supply of any product type can result in reduced occupancy and/or rental income. This risk is greatly reduced in infill urban locations such as coastal California.

How should Opportunity Zone investors think about fees?

In general, developers and fund managers are not one and the same, and each charges their own separate fees. Development requires extremely deep knowledge of local politics (as related to gaining approval for projects) and market conditions. Fund management requires a whole different set of skills such as a fiduciary mindset, and always seeing “the bigger picture” as it impacts the ultimate investor. Opportunity Zone investors who face two layers of fees may find that their net annualized returns are not as high as expected, particularly because Opportunity Zone investments have a natural 10-year or longer time horizon, and annualized returns tend to go down as the holding period increases.

What are typical developer fees?

Developers often charge a development fee which is a percentage of the project budget. They may also own a captive general contractor company which charges its own fees. Finally, developers who find and approve good projects typically aim to earn an incentive fee, if the project returns exceed a minimum threshold called a “preferred return”.

What is a preferred return?

The preferred return is the minimum target net return received by an investor in a project or fund. Incentive fees often apply only if a project exceeds the preferred return. For example, a developer might earn 20% of any profits, over and above an 8% preferred return. This means that once the investor has received more than an 8% cumulative annualized return, the developer starts to earn 20% of any profits above that threshold. The intent of a preferred return is that the investor will also receive all of his or her principal back, in addition to the preferred return, before the developer gets paid incentive fees. If in the end the investor does not receive a return of all principal, incentive fees are “clawed back” from the developer. This means the developer must forego future fees, or return fees already collected, until the investor is made whole on the original investment, and on the mutually-agreed upon preferred return.

What are typical fund manager fees?

Real estate fund managers usually charge a base annual management fee, plus an incentive fee which is subject to a preferred return. For example, some funds charge a 1.5% base management fee (charged on assets under management, or AUM) plus 20% of profits, subordinated to an 8% preferred return. Note the importance of this last phrase. It means that the fund manager in this case earns a “catch up” once the investor has received the preferred return.

What is a “catch up”?

A catch up refers to incentive fees earned by a developer or fund manager. In a “full catch” up, all profits flow to the investors, up until the preferred return hurdle has been cleared. Thereafter, all profits flow to the developer or fund manager, until a set split of profits has been achieved. Thereafter, profits are split according to a formula. In the prior example of an 8% preferred return and 20% incentive fee with a full catch up, this means that all returns above an 8% go to the developer or fund manager, until the fund manager has received 20% of the total profits. In practice this means the developer or fund manager will have received $2 of incentive fee, for every $8 received by the investor (because $2 is 20% of $10, which is the total amount of profits, namely, $8 + $2). Another form of catch-up features a sharing of profits between the parties, after clearing the preferred return. The details of how the catch-up is calculated make a large difference in the amount of fees earned by the developer or fund manager, in most cases.

How can I determine whether the fees are reasonable?

The best approach is always to source a variety of investment options, and then to compare the fees and likely net returns. Paying a lower fee is generally better, but not always. If one project is very profitable it can generate higher returns than others, even if the fees are a bit higher.

The Risks


How can I perform due diligence on the key parties involved?

There are many options for performing due diligence on business partners and the best approach is to do as many of the following as possible: (1) Google search, focusing on any news or litigation. (2) LinkedIn. Try to find someone that you know who also knows that person. If you can’t find information about the key people involved, proceed with extreme caution. Fund managers should be transparent about their backgrounds. Those who claim to be “under the radar” and a well-kept secret, or those who only accept investors by referral, may be brilliant but they may also be attempting a psychological trick to lure unsuspecting investors.

What are the top risks to be aware of?

The risks for investors in real estate projects can be divided into three categories: people risks; project risks; and other risks.

From the author’s experience, by far the largest risk is working with someone who is not forthright or who may not always reveal important information. Being a partner with someone who knowingly misrepresents key information will be disastrous. However, in real estate there are many shades of gray on the continuum of honesty vs. dishonesty. Some developers may mistakenly believe they are helping the investor by not burdening him or her with negative news. Others may be blind to conflicts of interest and may enter into side agreements with other parties that create a conflict with his or her partners on the real estate investment.

Run a background check on the person in question. Perform a search via Google and follow all the threads of information that come up. Use Linkedin to research a person’s contacts, and try to find a mutual contact between yourself and the person you are researching, to get a character reference from someone who is impartial and has an incentive to provide balanced information.

Some of these risks include: (1) problems getting all local government approvals or entitlements required to pursue the proposed development; (2) going over budget for any number of reasons; (3) rents being lower than expected (for example, if there is a flood of new projects coming on line competing for the same tenants); and (4) operating expenses being higher than expected.

How can investors mitigate the project risks?

The best way to do this is, if possible, to engage a developer who has worked on similar projects as an advisor or consultant. To do this, try to get referrals through your own network of trusted advisors. Experienced developers can help assess how realistic the assumptions are for a specific project.

What are the top other risks?

Apart from people and project-specific risks, the main risks include: (1) The overall economy. Almost any investment made during the year before the Great Financial Crisis encountered stress during the crisis. For example, in some cases the construction lender bank failed, even though a project had plenty of equity and strong sponsors. (2) Regional and local market conditions and possible shocks. In the early 1990s, Southern California experienced a combination of racial unrest and riots, a fairly large earthquake, and the departure of many aerospace companies. These factors depressed the market for some time (but today the same region is viewed as one of the healthiest for real estate investment in the U.S.). For a long-term investment such as most Opportunity Zone investments that are properly capitalized, there should be time to recover from any temporary downturns. (3) Excessive leverage. Projects that are otherwise strong can run into trouble if they are too highly leveraged with debt. High debt service means that the project sponsors have less room to maneuver in case of unexpected setbacks. Most Opportunity Zone investments should have plenty of equity--30-35% or more of the total project cost is a good rule of thumb.

How can investors mitigate these other risks?

Nobody can control global and national economic shocks. The best defense is to understand the local economy where you are investing as well as possible; to ensure that all parties involved in a project are experienced; and that the project has plenty of equity to withstand unexpected setbacks.

Getting Educated


What research and resources can help me to maximize my chance of success as an investor?

Each investment can be categorized based on three criteria: (1) its local market/geography; (2) the asset type; and (3) the asset size. There are many resources to research an investment with experts in one or more of these three criteria. For example, there are real estate brokers who know a great deal about small apartment properties in Los Angeles, including typical market rents, values, and the pipeline new supply/construction trends. Some brokerage firms publish research. For example, CBRE has reports specifically about the Los Angeles area apartment market. In addition, there are associations for every property type. The best source of information is an experienced investor who has made similar investments in the past. Investors can maximize their chance of success by gathering a large amount of relevant information from every source available, prior to making an investment.

What industry associations should I research or join?

Industry trade associations include local and statewide apartment owners’ associations, the International Council of Shopping Centers (ICSC), the Urban Land Institute (ULI) and the National Association of Industrial and Office Properties (NAIOP).

How do I find events that are valuable to attend?

There are many real estate events in every major city. Universities are a good place to start, particularly business schools with real estate courses and alumni groups. For example, in Los Angeles UCLA has the Ziman Center for Real Estate and USC has the Lusk Center. Both centers maintain an active calendar of events for alumni and professionals in the local real estate community. Social media sites such as LinkedIn also feature groups for those who work or invest in real estate, and these groups can be a good place to learn about educational events. Finally, all the trade associations mentioned previously offer their own schedule of events and many of regional events throughout the U.S.

Who offers classes for investors who want to learn?

All of the associations listed previously offer educational opportunities and many offer classes online. In Los Angeles, UCLA Extension offers a wide variety of classes related to real estate investment.

What’s one joke about real estate developers that contains an important kernel of truth?

(Credit is hereby given to my first real estate boss and mentor Samuel K. Freshman for sharing this joke with me). Two developers go to Alaska to hunt for moose. They hire a pontoon plane to take them to a remote lake. The pilot tells them “I’ll be back in a week and remember, we can only handle the two of you, and one moose, if we want to take off safely again.” When the pilot returns, he sees the developers with two moose. “We’ll pay you an extra $1,000 if you can just take us back with both moose.” The pilot reluctantly agrees. On take off, he backs up the plane as far as possible, guns the engine and slowly lifts off the water but he clips the top of the trees and the plane crashes down into the forest on the far side of the lake. The developers both slowly crawl out of the wrecked plane and one asks the other “where are we?” The other developer answers, “about 100 yards from where we crashed last time.”