Yesterday, a young tech worker from the West Coast signed up for my 2nd opinion review. He just had a very successful exit from an IPO, and is now sitting on $20mm worth of company stock, much of it capital gains. Morgan Stanley is pushing strongly for him to put his money into a QOF, and he wanted my view on that. 

I happened to have just written a paper on this topic for a Oxford Private Equity class assignment, so I have done some pretty in-depth research. Mindful that most people don’t have the patience to read a long essay like that, I will summarize my findings as succinctly as possible here. 

What is a Qualified Opportunity Zone (QOZ)?A QOZ is an economically depressed area that can’t attract investments on its own. The Tax Cut and Jobs Act of 2017 established this designation and certain tax benefits for investments into these areas.

What is a Qualified Opportunity Fund (QOF)?A QOZ is a private investment vehicle (in the form of a partnership or LLC) that invests in QOZs.

What are the purported benefits for investors in a QOF?Qualified capital gains that are invested into a QOZ can be deferred and may enjoy a 10% reduction when certain conditions are met. In addition, capital gains on the fund’s investments are tax-exempt if held for more than ten years. 

An Example: Suppose a Tesla employee sells $1.1mm of TSLA, but the cost basis of his shares is only $0.1mm. He will need to pay taxes on the $1mm capital gains at the current rate of 23.8%. That is $238k. Ouch! By putting this $1mm into a QOZ within 180 days, he can defer paying taxes. (If he does it before 1/1/2022 and holds the investment for more than five years, he will get a 10% tax cut as well.) Also, capital gains on any QOZ properties held for more than 10 years are exempt from capital gain taxation. 

What’s the catch? Here are ten.

1) Most QOZs are in inner cities with very high crime rates or in economically depressed rural areas. There are legitimate reasons why no investments are made there without incentives. 

2) The fees charged by these funds are exorbitant! Typically 2% management fees and 20% carry interest just to start. 

3) These funds are unregistered private placement investments outside of SEC oversight. There is just too much room for double or even triple dealing.

• For example, if the fund invests in trailer parks, there is no way to prevent the fund manager from having his relatives buy the parks and sell them to the fund at inflated prices. 
• As another example, the fund manager can charge advisor fees for providing “advice” to portfolio companies. The fund may also pay outside consultant fees that go to relatives/associates of the fund manager.
• You have no knowledge of or control over what is going on within the fund and inside the portfolio companies. These are called agency costs and asymmetric information risk.

4) You lose control of your money. When you do finally find out about these fishy dealings, you can’t take your money out. 

5) There is a very high likelihood that you will lose the principal. That renders all the tax benefits for capital gains moot.

6) It is a record-keeping and tax-filing hell. That’s always the case with any private investment, let alone one that claims tax benefits. 

7) While your money is tied up in trailer parks or inner-city shops, the S&P 500 could double. That’s called opportunity cost.

8) You will have to pay expensive lawyers and accountants. Oh yeah, you will have to pay the broker/financial advisor who pushed you into such a fund as well. You will make everybody happy except yourself. 

9) You thought you could benefit from tax deferral, but the future tax rate could go up.

10) Your spouse will hate you.

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