Concentrated positions can be difficult to manage. The investment risk associated with them can be high, but so can the tax cost of trimming positions. However, a new tax-deferral method—the Qualified Opportunity Zones (QOZ) program—has emerged from the 2017 Tax Cuts and Jobs Act (TCJA), and it may help investors fortify both their earning potential and their social impact. This new law offers taxpayers who invest in Qualified Opportunity Funds (QOFs) the option to defer tax payments on realized gains and potentially reduce the associated tax liability.
Though QOZ properties draw the interest of curious investors, the program’s regulatory complexities may cause hesitation. Let’s take a look at the opportunities and risks associated with investing in the QOZ program as well as its impact on portfolios.
What is a Qualified Opportunity Zone?
A Qualified Opportunity Zone is an economically depressed urban or rural community with growth potential in areas such as residential and commercial real estate and employment. The TCJA encourages investment in the nearly 9,000 QOZs across the United States by offering a way for investors to reduce capital gains tax. There are certain investment and holding-period requirements to which investors must adhere to qualify for the tax deferral and reduction benefits offered by the QOZ program.
At a high level, a QOZ-eligible investment is identified as being a substantially improved property that lies within the boundaries of a government-approved opportunity zone. Professional asset managers familiar with the particulars of the requirements have started QOFs, which are investment vehicles that hold at least 90% of assets in QOZ property. These managers typically invest in QOZ real estate that’s subject to holding-period and several investment-related requirements.
Investors can defer tax payment on gains until December 31, 2026, if they invest in a Qualified Opportunity Fund—a partnership or corporation set up to invest in eligible property located in a QOZ—within 180 days of realizing the gain. If the QOF investment is held for at least five years, the investor’s taxable gain is reduced by 10%. If it’s held for seven years, the deferred taxable gain is reduced by 15%. In addition to the reduction of the originally deferred capital gain, an investor who holds a QOF for at least 10 years can get the associated QOF investment gain free of taxes.
What are the benefits of a Qualified Opportunity Fund?
For clients with concentrated portfolios that have been hanging on to investments for a long time, the capital gain discount, tax deferral, and potential tax-free reinvestment benefits may incentivize diversification into QOFs. In a Custom Core® portfolio, for example, the gain realization and subsequent reinvestment will reset the cost basis and create the potential for future enhanced tax-loss harvesting opportunities. Parametric’s portfolio managers will also use the opportunity to trim overweight positions that can significantly reduce tracking error.
Assessing the risks of Qualified Opportunity Funds
The tax benefits associated with Qualified Opportunity Funds may be compelling, but advisors must carefully evaluate the underlying fund investments, considering client suitability for the real estate asset class and performing careful due diligence of the fund manager to ensure the level of diversification matches the investor’s needs. Advisors should also consider the holding-period requirements and whether they align with the client’s liquidity needs. Finally, it’s worth mentioning that capital gains taxes associated with the initial sale of an asset are deferred, but payment is due on December 31, 2026, or when the investor sells their QOF holdings, whichever comes first.
The bottom line
The TCJA presents an opportunity for investors to both save on taxes and enhance portfolio diversification. Advisors should consider these benefits in addition to carefully examining the QOF investment to determine whether a fund’s objectives align with their clients’ goals. If all the boxes are checked, investing in a Qualified Opportunity Fund could be a great way to enhance after-tax returns and help develop communities in need of financial relief.
Rey Santodomingo, CFA, Managing Director of Investment Strategy
Rey is responsible for all aspects of Parametric’s tax-managed equity strategies. As one of the primary strategists for Custom Core®, he works closely with taxable clients and advisors to design, develop, and implement custom portfolio solutions. Prior to joining Parametric in 2008, Rey was a vice president in product management at MSCI Barra. He earned an MA in financial engineering from the University of California, Berkeley, and a BS in chemical engineering from the University of California, Santa Barbara. A CFA charterholder, Rey is a member of the CFA Society of Seattle and a prior board member of the CFA Society of Seattle. He has also served as an adjunct instructor at Seattle University's Albers School of Business and Economics.
The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss.