Opportunity Zones Investing
Opportunity Zones Investing
To find the latest information on this topic, read Relief Provided for Qualified Opportunity Funds and Investors.
Congress introduced the Opportunity Zone program as part of the 2017 tax reform, also known as the Tax Cuts and Jobs Act (P.L. 115-97). The goal of the program is to incentivize the private sector to invest in underserved communities. This is one of the most talked about provisions in the act and has created excitement in the investment community.
Nuts and Bolts of Opportunity Zones
Qualified opportunity zones are census tracts that were identified based on poverty and median income levels. The U.S. governors of each state were able to nominate up to 25 percent of the tracts in his or her state as an Opportunity Zone. A small number of tracts contiguous to a qualified census tract could also be nominated. The primary targeted areas are distressed urban communities and rural areas. Treasury approved over 8,700 Opportunity Zones, including tracts in all 50 states, the five territories and the District of Columbia. These tracts will remain throughout the program. Because much of the census data was from 2010 and 2011, there are tracts that have already started the revitalization process.
There is an estimated six trillion dollars of unrealized gain available for investment. Treasury Secretary Mnuchin estimates that over 100 billion dollars will be invested in the Opportunity Zone program. While we don’t know exact amounts, there is great interest in the program. So, how does an investor participate in the Opportunity Zone program?
An investor must have gain that is treated as capital gain for federal tax purposes to realize the tax incentives. The short-term or long-term capital gain may come from many sources, including the sale of stock, collectibles, a business, or real estate. Investors invest in Opportunity Zones through an investment vehicle called a Qualified Opportunity Fund (QOF) within 180 days of the date the capital gains are realized. An investor may elect to invest some or all of the eligible gain, and there is no limit on the amount of gain eligible for this deferral.
The QOF must hold 90% of its assets in the form of qualified Opportunity Zone property, which consists of qualified opportunity business property, stock or partnership interests. As such, the QOF may invest in real property or businesses. Currently, QOFs primarily focus on real estate as there are still many unanswered questions relating to businesses. We have typically seen ground up construction or the purchase of low-quality, class C commercial and vacant buildings. These types of properties are best suited for the substantial improvement requirement in the regulations and there is potential for an increase in appreciation. There is much interest in the gateway cities, but secondary markets like Portland, Seattle, Baltimore, Philadelphia, and Denver have had an increase in activity. Many of these secondary markets have prime properties in downtown areas that other major cities are lacking.
Once guidance is released, we expect to see an increase in private equity and venture capital investments in businesses. Allowing start-ups to have space in an Opportunity Zone property in exchange for an equity interest in the company may also be an investment strategy. The goal is to bring in jobs and mixed housing to the Opportunity Zones, and new businesses will play a vital role in reaching this goal.
Understanding Tax Incentives
The investor’s initial basis in the capital gain invested in the QOF is zero, and there are three tax incentives in the Opportunity Zone program. First, the tax on the capital gain will be deferred until December 31, 2026 (or the date of the sale of the QOF interest, if earlier). The capital gain rate in 2026 will be used to determine the tax. Second, if the QOF investment is held for five years, the investor can take a 10 percent step-up in basis. An additional 5 percent in basis is permitted if the investment is held for seven years. Third, if the QOF investment is held for 10 years, then the basis in the investment equals its fair market value on the date of sale; the gain on the investor’s appreciation on the original investment is permanently excluded.
The Opportunity Zone program ends on December 31, 2026. As such, 2019 is the optimal year for investing in a QOF so that the investment can be held for seven years for the 15 percent step-up in basis. The 10-year hold for the appreciation in value tax exclusion, however, can be made up until December 31, 2026. Some common concerns about a downturn in the real estate or other markets and the requirement to sell the QOF property. The proposed regulations provide that all sales of QOF property must be completed December 31, 2047, to be eligible for the gain deferral. This extended period of time for the sale was to accommodate the cyclical nature of these markets.
Consideration should also be given to other federal tax and state tax incentives. There are opportunities to stack these initiatives to make the tax savings even greater. For example, in Philadelphia there are over 50 parcels that qualify for both the Pennsylvania Keystone Opportunity Zone program and the federal Opportunity Zone program. Investing in one of these properties would allow benefits from both programs.
Benefits for Family Offices
An important source of funds for Opportunity Zone deals has been from family offices and high net worth individuals. The Opportunity Zone program works well with family office network investment strategies. The tax deferral, tax reduction, and tax exclusion incentives have created interest in the program. Second, many family offices want to participate in impact investments. Making long-term investments to help distressed communities may provide the investment opportunities that they are seeking. There are even QOFs specifically set up for impact investing that make job growth and other metrics as part of their objectives. Third, investment in a QOF is best for a patient investor. To reap the tax incentives, there is a 10-year holding period. Most family office capital is patient capital, so this program fits the investment model.
Estate planning issues should be considered before an investment is made. For example, a decedent’s investment in an Opportunity Zone will not receive a basis adjustment at death under IRC 1014. Instead, gains recognized will be treated as income in respect of a decedent. As such, a trust or other estate planning tool should be considered.
It is estimated that between 10 – 12 percent of all family office investments are made in the real estate market. Investing in Opportunity Zone real property may be a natural fit. There is a cash flow from rental activity with a tax-free strategy on the appreciation when exiting the QOF. As such, family offices with real estate experience may want to take on real estate projects themselves. However, even family offices with experience in real estate may not have experience in underserved communities. Seeking out developers with experience may be beneficial. Family offices may also consider investments in Opportunity Zone businesses – retail, manufacturing, and others. Further, investment in venture capital or start-ups may be advantageous as the appreciation on the investment may be more lucrative than real estate. The geographic location of the start-up is typically not a factor in its success. As such, Opportunity Zones may be a welcome opportunity to shield the tax liability.
Opportunity Zone investments are attractive to nontraditional real estate and business investors. As such, family offices and high net worth individuals may wish to use developers and operators for projects. The QOFs are self-certified and relatively easy to create, and there will likely be many inexperienced developers offering QOFs. It is important that investors do their due diligence on these projects.
Due Diligence and Risk Management
While the tax incentives are very attractive, it is important to remember that an Opportunity Zone investment must stand on its own. The Opportunity Zone properties are typically located in low-income communities where there is economic distress. Investment fundamentals are critical – the tax incentives will never make a bad investment good. If the investment depreciates in value, then the tax incentives are not helpful. As such, due diligence is key to mitigate the risks.
When looking at real estate investments in an Opportunity Zone, location, median household income, job growth, vacancy rates, transportation access, environmental issues, social issues, property type and other factors should be considered. Properties that are already in an area where there is growth or near that area are prime locations. The cost of property in Opportunity Zones has increased in certain urban markets. Investors also should obtain information about the developer. The developer’s track record and whether they have developed projects in distressed markets should be considered.
Further, finding a fund manager that understands how the program works is likewise critical. There are numerous ways to structure a fund (e.g., direct project investment, single purpose entity, and closed-end fund) and it will be important for the fund manager to understand what is optimal. There are also reporting and testing requirements for the QOF that must be met annually that a fund manager should be aware of.
While the provision was part of tax reform legislation over a year ago, little guidance has been provided. The first set of proposed regulations was released in October 2018. Treasury has indicated that there will be at least two additional sets of proposed regulations, the second of which was released in April 2019. While the tax incentives are promising, it is important to remain mindful of the investment fundamentals. The deal will only be as beneficial as the underlying investment, however, the tax incentives could make a good deal quite lucrative.
This article was originally issued in the Family Office Magazine in June, 2019.