It seems like you cannot swing a dead cat without hitting some sort of news article or so called real estate guru touting how the newly established Opportunity Zones (OZ) will lead to an explosion of capital coming into real estate investment and development (businesses too) throughout the country, especially into blighted areas that are much in need of investment.
Not so fast. Opportunity Zones are the “new shiny thing” that gives investors some pretty nice tax benefits. First, investors who have capital gains tax liability can invest those returns in designated so called “distressed” areas and receive some tax forgiveness on the original tax liability if held up to 7 years. Second, the biggest advantage is that any gains accumulated from the investment in these low income areas can be tax free if the investment is held for 10 years. In perusing some of the initial information out there on Opportunity Zones it is easy to be struck with lack of specifics on the structure to deal with to the multiple tax scenarios associated with such investments.
It is a bit of the Wild West initially with some very loose and undefined characteristics and guidelines that may lead to confusion, potential for deception and lots of questions in the early going, but overall even given these uncertainties, OZ investment mainly on the part of funds employing private equity or institutional funds have the potential to take on large transformational projects for certain cities and areas.
As one newly minted fund manager predicted in a recent Bloomberg article “Opportunity Zone Dollars coming from larger investors of both high net worth and institutional sources when pooled together and smartly employed by seasoned real estate people will have the ability to undertake some really impactful and innovative community beneficial projects that would not happen under current financing and equity environments”.
Opportunity Zones were part of the Trump inspired Tax Cuts and Jobs Act of 2017. The rationale behind this program was a response to what many believe and is a fairly well documented uneven recovery from the Great Recession of 2007-2009. While the overall economy has steadily rebounded in the ensuing years, it was felt that too many communities did not see that sort of economic recovery (jobs, wage growth, business formation etc.) that to a large degree was concentrated in urban areas. In many parts of the country the thought was rural areas and smaller towns and cities were left behind and are still suffering from lack of investment and economic resiliency in light of the one of the best economies in decades. In concept this all seems like a nifty market based vehicle to boldly incentivize much needed investment in communities that have not drank from the hose of economic recovery over the last 6-7 years. How these areas were chosen and are now in place is where the capitalistic altruism starts to wobble a bit and like all these type efforts gets a bit political.
OZs are low income community census tracts as established for the decennial US census and each state governor was able to nominate up to 25% of these census tracts to be included in the OZ program. Oregon has 834 census tracts and 300 low income eligible ones which resulted in Governor Brown getting 86 areas approved as Opportunity Zones in the spring as of 2018. Business Oregon, an Oregon State agency related a bit on the process, “Oregon’s Opportunity Zone selection process entailed extensive outreach to the public, federally recognized Indian Tribes, local governments and other parties over a 3 month period.” Find the link to the map of Opportunity Zones here.
When looking at the map you will see that in Portland there are some very “suspect” low income zones with much of northwest Portland, the Pearl, close in eastside and downtown and other areas that have experienced considerable investment, gentrification and development for years and many of us long time Portlanders know are by no means are low income or blighted… but hey who are we to complain? But there has been considerable push back that some of areas designated as Opportunity Zones do not need any incentives and would continue to attract considerable investment with or without an Opportunity Zone.
In talking with Stephen Brooks, my attorney friend who knows the Opportunity Zone world well, he related the thinking of how the zones were designated. 1. Most OZ money would go into larger scale commercial real estate projects, which meant, if Portland wanted to attract real money, it would have to have census tracts that could support that type of development. 2. Many downtown Portland tracts qualify because of the fairly large concentration of low income housing which is dedicated housing that cannot be redeveloped at market rate which would meant that even with lots of new development these units would not be displaced. 3. Extensive development in low income neighborhoods (Lentz, etc) would likely result in displacement in cheaper low density older multi-family properties were replaced by higher end developments.
Though OZ’s allow for investments in businesses and as well as properties, I will concentrate on some of the aspects of property investments.
Opportunity Zones Offer Three Basic Tax Benefits:
- A temporary deferral of capital gains that are reinvested in an Opportunity Fund not unlike a 1031 exchange
- A stepped up basis for the capital gain if invested in the Opportunity Fund. If the investment is held by the taxpayer in the fund for five years the capital gain amount is reduced by 10% and then another 5% if held for seven years for a total of 15%.
- Lastly the biggest benefit being that all gains that occur from the investment in the Opportunity Zone if held for 10 years are exempt from capital gains taxes.
A simplified example would be a taxpayer recognizes a $200,000 gain on the sale of a property. By investing in an Opportunity Fund that person can postpone capital gains until 2026 and if they hold the investment in the fund for five years that gain is reduced by 10% to $180,000 and for seven years, another 5 % to $170,000. Then after 10 years the person sells the investment in the fund for $300,000 that $100,000 would be exempt from any capital gains taxes (30% for long term gains with it being 20% federal and 10% State of Oregon).
A few other house- keeping items: The original capital gains deferral ends in 2026. The gain has to be invested in the Opportunity Fund 180 days after selling of the exchange property just like a 1031 and only that part of the gain realized needs to be invested. Opportunity Zones are only for capital gains taxed at the federal level and treatment by each state that taxes capital gains may or may not “dovetail” with the OZ program.
How to Invest in Opportunity Zones.
This is where it could get a bit sticky. In order to invest in an Opportunity Zone there has to be Fund established, and from my research it does not look to be very onerous or have much regulatory oversite as any corporation, partnership or LLC basically self-certifies by filling out an IRS Form for the purpose of investing in a “qualified opportunity fund property”.
- At least 90% of Qualified Opportunity Zone Fund’s assets must be invested in a qualified zone property.
- Capital Gains that are invested in an Opportunity Zone Fund money must constitute equity not debt.
- Properties in which the fund invests (directly or indirectly) generally must be substantially improved within 30 months or have their original use commence with the Fund in the Zone.
If the Fund intends to engage in ground up development or “substantially” improve an existing property by investing new money into a property in the amount of the original purchase price of the property allocable to the building(s) on the land. Other tidbits: There are not territorial stipulations so a Opportunity Fund established in Portland can invest in any of the 8700 Opportunity Zones throughout the Country. All Funds will have some of minimum investment from potentially as low as $25,000 into the millions depending on the Fund’s aspirations and size and of course there will be fees involved which at this early stage may vary considerably.
Clearly, tax benefits of Opportunity Zones can be substantial. It is still early in the process, with tons of Funds being started, many of which could encompass dozens if not hundreds of investors. Some things to consider.
- Buyer Beware: Opportunity Zone Funds though termed “qualified” should not be construed to mean they or their proposed investments have been thoroughly vetted or approved by any regulatory authority or that their on-going operations or management will be monitored. In fact, the ease and lack of scrutiny in setting of a Fund is pretty amazing. You neighbor just out of Club Fed for embezzlement with some beautiful graphics, less than verifiable glowing projections of returns and some great wordsmithing can put together a compelling case for an Opportunity Fund. As a result, investors need to make sure that the fund sponsors are reputable, have meaningful and well established experience, a focused plan and demonstrated success with the types of investments they are offering. Then even the gliterrati of real estate development and investment firms who may be behind a given Fund often have some real big failures on their resumes.
- Loss of control. Once you hand over this money especially to larger Funds with multiple investments you are part of a larger whole with little say or control over type, scale or location of the projects. You just have to kind of “trust” that those running the fund know what they are doing, are prudent and smart with the investments and can execute. If they elect to change direction, load up on debt, not keep to the timeframes for development or “reach” to buy assets or fund developments because they have to deploy the funds with the clock ticking you are “along for the ride” with little or no input.
- Once in, liquidly may be difficult. So if you perceive the Fund going down the unholy path that my warrant losing your investment and want out to just pay the tax and preserve you cash or your life and needs change and you need the dough: most likely you are at the whims of rules of the Fund that may lock you in. For most small to medium investors a fund for one or several focused and understandable projects may be much more manageable and flexible and less risky than trying to jump on some huge glitzy Fund that has multiple investors and some rather broad parameters.
Many attorneys, CPA’s and Financial Planners are already coming up with lots of scenarios and questions about Opportunity Zone investments and qualifications which will need to be answered by the IRS as the program works its way through the next couple of years. While the tax benefits look to be very advantageous if all goes well, the Opportunity Zone Investment forecast looks a bit cloudy initially and should be closely analyzed on tolerance of the investors personal risk and goals with the appropriate counsel and also vis-à-vis more established, but maybe less beneficial options such as 1031 exchanges.