Real Estate Opportunity Zones
When the Tax Cuts & Jobs Act was passed by Congress in 2017, it opened up tax incentives potentially worth billions - or even trillions - of dollars for real estate investors in the 8,700 designated opportunity zones across the country. The goal behind the incentives is the revitalization of communities in those opportunity zones - depressed areas in desperate need of investment. But whether the investors currently looking to take advantage of these new tax breaks and the communities they're centered around ever reap the benefits of the new legislation is yet to be seen. There is no doubt that the potential rewards are immense, but the long-term commitment expected to maximize them has cooled some investors on actually diving in.
Opportunity Zones - Benefits & Flaws
The Incredible Long-Term Benefits, and Serious Flaws, of this New Tax Incentive
The idea of offering tax incentives to spur investment in economically depressed areas is nothing new. Opportunity Zones as they exist today were originally proposed by Tim Scott and Corey Booker in a bipartisan effort that eventually become law as part of the Trump administration's signature tax legislation.
Opportunity Zones are "low-income census tracts nominated by Governors and certified by the U.S. Department of the Treasury." Investment in Opportunity Zones is facilitated through Opportunity Funds, which are specially created funds that are required to invest a minimum of 90% of their capital in qualified real estate investments in one of the thousands of Opportunity Zones nationwide.
Triple-Tiered Tax Incentive
There are three primary levels of tax incentives investors can tap into through investments in Qualified Opportunity Funds (QOF) - an initial temporary deferral in capital gains, an increased basis benefit at the five and seven-year marks, and a permanent tax exclusion on capital gains after the ten-year mark.
The initial deferral allows investors to defer taxes on any capital gains they reinvest in a QOF until December 31st, 2026, or until the investment is sold, whichever comes first. To be eligible for the deferment, the reinvestment must take place within 180 days of the realization of the capital gains.
After five years of holding the investment, investors can exclude 10% of their reinvested capital gains from taxation. After seven years, tax exemption on another 5% is unlocked, bringing the total exclusion to 15% for investors that stay in a qualified opportunity fund.
Those tax incentives are attractive, but it's the ten-year mark when the real carrot emerges. After ten years in a QOF, an investor receives a permanent tax exemption on any capital gains realized from the sale of their investment in the opportunity zone. That permanent tax exemption represents a potentially enormous upside for investors...if, that is, they're willing to hold on long enough.
Long-Term Commitment Leaves Some Investors Skeptical
The basic idea behind Opportunity Zones is that the tax incentives offered will push marginal real estate investments into profitability, generating a major inflow of capital into qualified projects in the targeted areas. It's definitely a good idea in theory, but the length of the term required to unlock the full tax incentives has left some investors uncertain about the real value of Opportunity Zones.
Reducing the tax impact certainly reduces risk - music to the ears of most investors - but the requirement to hold the investment for ten years not only reintroduces some risk but also reduces the attractiveness for investors who are looking for quicker turnaround or need liquidity in their assets. The major question surrounding the Opportunity Zone initiative is whether or not the tax benefits provided are deep enough to motivate large-scale investment that requires a ten-year commitment.
The Economic Innovation Group (EIC) - the primary non-governmental backer of the Opportunity Zone initiative - certainly believes the capital is out there. They quote the pool of potential capital available for reinvestment in Opportunity Zones at 6.3 trillion dollars in unrealized consumer and corporate capital gains.
But whether or not that money makes its way into the QOFs is a major question, especially with the December 31st, 2019 deadline looming for investors that want to maximize their 15% deferral from the second tier of the incentive.
Another major question is whether the communities represented in the Opportunity Zones will ever see the intended benefits, even if the money does show up. For one thing, the rules aren't incredibly well defined. The Tax Policy Center has noted that while a fund could use their investment to rehabilitate abandoned homes into affordable housing, they could also buy a parking lot and refurbish the attendant shed. In both cases, they'd receive the tax benefits, despite the impact on the community being vastly different.
Some investors have also questioned whether certain Opportunity Zones' proximity to major centers will result in an uneven flow of capital, leaving some zones completely frozen out while others enjoy enthusiastic investment based on the promise of higher returns.
Fortunately, Treasury has the authority to take steps to ensure those kinds of abuse don't happen. Currently, the rules around the program are still in a state of flux, but the statute does require that significant improvements be made in Opportunity Fund projects so that investors can't simply park money and wait. There are also limits on what kinds of properties are eligible - for instance, "sin list" properties like casinos are ineligible, as are investments in companies that primarily offer financial services.
The sentiment behind the legislation around Opportunity Zones is certainly positive, and as the EIC correctly points out, there are potentially trillions of dollars out there that could be poured into the communities the zones represent. For investors willing and able to accept the long-term nature of Opportunity Zone investment, the tax incentives - particularly at the ten-year mark - are significant. The flaws in the program are real, but no program is perfect, and there is no doubt that the tax deferments and permanent exemptions offered will enable investment in many real estate projects that would otherwise have been marginal or slightly unprofitable. With any luck, that'll not only mean healthy long-term returns for real estate investors; it will also mean the reinvigoration of communities-in-need all over the country as well.
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michael@mulcahycapital.com
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