If you’re an advisor with clients in need of a capital gains tax break over the long term, the federal government’s Opportunity Zone program still may be a good fit.

When the Tax Cuts and Jobs Act of 2017 was signed into law two years ago, it included the Investing in Opportunity Act establishing “qualified opportunity zones” (QOZs)—census tracts made up of communities designated as economically distressed—as well as qualified opportunity zone funds (QOFs), which can be either a U.S. partnership or corporation that has invested at least 90% of its holdings in one or more of the opportunity zones.

To stimulate private investment in these distressed communities, lawmakers provided program participants with a capital gains tax incentive. While there has been sharp criticism that the programs extend far beyond what most people consider distressed communities, the laws remain in effect. Program participants who invest their realized capital gains in a qualified opportunity zone fund can within 180 days of realizing them defer payment of taxes until April 2027 on investments held through December 31, 2026.

Program participants who hold their investments for at least five years before December 31, 2026, can reduce their liability on the deferred capital gain principal invested in the opportunity zone fund by 10% through a step-up. However, program participants who invested in a fund before the December 31, 2019, deadline and hold their investments for a minimum of seven years before December 31, 2026, can reduce their liability by a 15% step-up. Investors who can hold onto a QOF investment for at least a decade can expect to pay no capital gains taxes on any appreciation of it because they qualify for permanent exclusion under the program’s benefits.

Although the December 31, 2019, deadline has elapsed for a 5% step-up after seven years, Andy Kapyrin, a partner and research director at RegentAtlantic in Morristown, N.J., asserts that qualified opportunity zone funds are still a good investment in 2020.

“The three primary benefits will still apply and continue to make QOZ funds an opportunity worth considering for anyone with a substantial capital gain,” he said in an e-mail last week.

For some investors, however, the length of time required to realize a tax benefit may not make sense, Kapyrin cautioned would-be program participants.

“QOZ regulations are not well-suited for older investors,” he said. “Anyone with a shorter life expectancy may not benefit from a QOZ investment.”

For those investors comfortable with the prospect of a long-term investment, however, Kapyrin said the Opportunity Zone program provided incentives, but also unseen pitfalls.

“One of the most important things to keep in mind is that your tax break depends on the manager following [government] regulations,” he said. “It’s important that they have the regulation/tax compliance down to a ‘t.’”

He stressed the importance of screening fund managers for experience and competency before investing in any fund.

“By investing with a less-established emerging manager, you give someone the chance to learn to shave on your face,” he said.

“There are a shocking number of first-time fund managers in this space looking to do just that,” said Michael Pappachristou, a RegentAtlantic wealth advisor. “These managers may have real estate development expertise, but not necessarily the knowledge to run an investment fund. That is a risk to investors.”

Kapyrin said that in order to manage the risk of real estate development, investors and their advisors should identify a fund with a solid track record; good discipline about making investments; and, most importantly, a diversified portfolio of multiple assets.

Not only is an experienced fund manager key to a successful investment in a qualified opportunity zone fund, so is the oversight of the U.S. Treasury Department. Since 2018, the department has clarified the program’s parameters through the release of new regulations that serve as a guide for investors and their advisors, as well as for fund managers. Two years ago, the department released the first round of new regulations, and last year it released two more rounds.

The second round, released in early 2019, included one that may have profound implications for investors' estates, Pappachristou said.

“The 2019 regulations state that heirs will no longer be penalized in the event the investor dies," he said. "In other words, they will receive the benefits from the original qualified opportunity fund investment.”

He said another clarification in the second round affected qualifying businesses, which socially responsible investors in particular might appreciate. The new regulations require funds to have meaningful roots in the communities they develop or redevelop by requiring fund personnel to physically work in the zone at least 50% of the hours they are employed there.

Kapyrin said the most recent round of Treasury Department Opportunity Zone regulations, released last month, expanded the definition of vacant property in qualified opportunity zones that include unused or brownfield urban spaces.

“The changes ... enhance this program as a way to increase investment in blighted and underutilized urban areas,” he said.

For example, Kapyrin said, investors may now use gross gains to report a Section 1231 gain from the sale of property, even if they have Section 1231 losses for the year.

When not applied to an Opportunity Zone investment, a Section 1231 gain from the sale of property is taxed at the lower capital gains tax rate, as opposed to the rate for ordinary income. If the sold property was held for less than one year, the 1231 gain would not apply at all.

“This increases the potential pool of investors that would be interested in QOZ investing,” Kapyrin said.

He believes such clarification in the program may even push more socially conscious investors into becoming opportunity zone participants, another side benefit of the latest regulations.

“Impact investing … can be done profitably, [and] QOFs are one way to do it,” Kapyrin said.

But Pappachristou maintained that just because somebody is a socially responsible or impact investor, that does not mean investing in a qualified opportunity zone fund is necessarily right for them.

“There are several factors that need to be considered, such as net worth, the need for liquidity and regulatory or investment risk,” he said.

Both men emphasized how important due diligence is for anyone contemplating an investment in a qualified opportunity zone fund, whether they seek to do good or do well.

“We recommend that an investor discuss whether a qualified opportunity zone investment is appropriate for them with their financial advisor and tax professional,” Pappachristou said. “Depending on the scenario, there may be other tax planning strategies that make more sense for a particular client.”