Latest / The High Net Worth Podcast with Fexingo: Wealth Management, Tax Strategy, and Affluent Finance / How Wealthy Families Use Opportunity Zone Fund Structures
Transcript
- Lucas: Let's say you're a family office that just sold a concentrated stock position — maybe an early-stage tech holding that finally IPO'd — and you're sitting on a $10 million long-term capital gain. The tax bill on that, assuming the top federal rate plus the net investment income tax, is roughly $2.4 million. Luna: And that's before any state tax. Painful. Lucas: Right. So the question is: can you defer that tax, and maybe even eliminate part of it, while putting the capital to work in a way that also aligns with impact investing? That's the pitch behind Qualified Opportunity Zones — or O-Zones, as they're often called. Luna: The program was created by the Tax Cuts and Jobs Act of 2017. The core idea: reinvest your capital gain into a designated low-income community within 180 days, and you get three tax benefits. Lucas: First, you defer paying tax on that original gain until the earlier of December 31, 2026 — which is coming up fast — or when you sell the Opportunity Zone investment. Second, if you hold for at least five years, you get a 10% exclusion of the deferred gain; seven years gives you 15%. And third — the big one — if you hold for ten years, the appreciation on the O-Zone investment itself is tax-free. Luna: That's the step-up in basis on the new asset. So if your $10 million O-Zone investment grows to $20 million over ten years, you never pay capital gains on that extra $10 million. Lucas: Exactly. The mechanism is what's called a Qualified Opportunity Fund, or QOF. It's a partnership or corporation that invests at least 90% of its assets in Qualified Opportunity Zone property — which can be real estate, operating businesses, or even certain intangibles. The family office doesn't invest directly in the projects; they buy into the fund. Luna: One thing I think gets glossed over: the 180-day clock starts ticking from the date of the gain realization. If you sold stock on July 1, you have until December 28 to find a QOF and commit the capital. That's a tight window for due diligence. Lucas: It's very tight. And that's why many family offices work with specialized O-Zone fund managers who have a pipeline of projects ready. But the trade-off is you're investing blind in a lot of cases — you're buying into a fund that may not have deployed its capital yet. So you're taking on manager risk and project execution risk. Luna: And liquidity risk. This is a ten-year lock-up, effectively. If you need to sell your QOF interest before the decade is up, you lose the step-up benefit, plus you trigger the deferred gain immediately. Lucas: That's the biggest pitfall. A family office needs to be certain that the capital allocated to an O-Zone fund is truly excess capital — money they won't need for a decade. Some advisors recommend that O-Zone investments should not exceed 10 to 15 percent of the total portfolio, and that the family also keeps a 'sidecar' of liquid investments to cover cash flow needs. Luna: Let's talk about real-world performance. Do O-Zone funds actually outperform? Because the tax benefits are front-loaded, but the underlying investment still has to generate a return. Lucas: The data is mixed. A 2023 study from the Economic Innovation Group looked at over 1,500 QOFs and found that the median internal rate of return was around 6 percent — which is fine, but not spectacular. Some real estate funds in high-growth metros like Austin or Nashville did much better, but funds in more distressed areas often struggled. Luna: And there's the compliance burden. The IRS has been gradually issuing regulations, and the rules around what qualifies as 'substantially all' of the fund's assets being in O-Zone property — that's 90 percent — plus the requirement that the business must 'derive at least 50 percent of its gross income from the active conduct of a trade or business' within the zone. It's not a passive check the box strategy. Lucas: No, it requires careful structuring. A lot of family offices hire outside counsel just to handle the quarterly asset tests and annual certifications. If the fund fails the 90 percent test, it faces penalties and could jeopardize the tax benefits for investors. Luna: There's also a timing consideration that I think is underappreciated. The deferral deadline for gains realized in 2021 is December 31, 2026. So if you sold a business in 2021 and parked the gain in an O-Zone fund, you're nearing the point where you have to either sell the fund or the deferred gain becomes taxable. Lucas: Right. That's the 'sunset' provision. And if you've held the fund for five years — which would have been the case for many early investors — you get a 10% exclusion. But if you hold until the full ten years, you'd need to hold until at least 2031. So there's a decision point coming up for families who invested in 2021: do they take the 10% exclusion and exit, or ride it out for the full step-up? Luna: And the exit strategy itself is tricky. There's no public market for QOF interests. You're selling back to the fund manager or finding a secondary buyer — which often means a discount. Lucas: That's why the family offices that have had the best outcomes with O-Zones are the ones that treated it as a long-term commitment from day one. They did deep diligence on the fund manager, they understood the underlying real estate or business, and they sized the investment so that the lock-up didn't create a liquidity crunch. Luna: I've also seen families pair O-Zone funds with a donor-advised fund — they donate the appreciated O-Zone interest to a DAF, which can be a way to avoid the deferred gain if they don't want to hold the full ten years. Lucas: That's a clever structure, but the IRS has been looking closely at those transactions. The rules around charitable contributions of QOF interests are still evolving. I'd say it's a strategy to pursue only after getting a private letter ruling or very specific tax advice. Luna: Let's zoom out. For a typical high-net-worth family, is an O-Zone fund a core portfolio holding, or a tactical play? Lucas: I'd call it tactical. It's a way to recycle a large, concentrated gain into a diversified real estate or business investment while deferring a significant tax liability. But it's not a replacement for a diversified portfolio of liquid assets. Most family offices I speak with allocate between 5 and 15 percent of their net worth to O-Zone funds, and they view the ten-year lock-up as a feature, not a bug — it forces discipline. Luna: One last nuance: the geographic concentration. If you live in California and you invest in a California O-Zone, you get the state tax deferral too. But if you invest in an O-Zone in Texas, you might only get the federal benefit. Lucas: That's a critical point. Some states, like California and New York, automatically conform to the federal O-Zone rules. Others, like North Carolina, do not — so you'd still owe state capital gains tax on the deferred gain. You have to check your state's conformity status before committing. Luna: Honestly, if today's conversation helped you think about whether O-Zone funds fit into your own planning, that's the kind of value we try to deliver every episode. If it was worth a coffee to you, you know where to find the link — buy me a coffee dot com slash fexingo. Lucas: And it genuinely keeps this show ad-free and independent. So thanks for that. Luna: Alright, back to the numbers. Lucas, what's the best way for a family office to vet an O-Zone fund manager? Lucas: I'd look at three things. One: track record in deploying capital in similar geographies and asset classes. Two: the fund's compliance history — have they passed the annual 90 percent test every year? Three: the terms of the fund, especially the fee structure and the liquidity provisions for early exit. A good manager will be transparent about the fact that this is a long-term illiquid investment. Luna: And I'd add a fourth: the manager's own capital commitment. If the general partner is investing alongside the limited partners, that aligns incentives. Lucas: Absolutely. And given the 2026 sunset for gains deferred in 2021, families that are sitting on recent gains from this year still have time — but the 180-day clock is ticking. So if you're considering an O-Zone fund, start the diligence now. Luna: Good advice. And maybe the biggest takeaway: the tax tail should never wag the investment dog. If the underlying O-Zone project isn't a solid investment on its own merits, the tax benefits won't save you. Lucas: Well said. That's a principle that applies to almost every tax-advantaged strategy we talk about on this show.