January 2, 2019
Part One of a three-part series
By Dave Sorter
Opportunity Zones have been a hot-button topic in the real estate investment world for the past several months. The action has heated up even more since Oct. 19, when the U.S. Treasury Department provided some clarity on the rules by which Opportunity Zone investments can be made – one of which extracted a big sigh of relief among potential investors and developers.
“Other than interest rates, I can’t think of another topic I’ve been more frequently asked about,” said Darin Mellott, CBRE’s director of research-Americas.
The concept of Opportunity Zones was hatched in early 2017 by Sens. Tim Scott (R-SC) and Cory Booker (D-NJ) as a way to propel economic development in what the Internal Revenue Service calls “distressed areas.” Congress approved the legislation as part of the tax-reform bill last December. That was appropriate, since the investments in Opportunity Zones are “really tax-driven,” said Matt Ertman, a partner with the Allen Matkins law firm, which is working with several clients on Opportunity Zone issues.
Opportunity Zone investments are primarily a way for investors to defer capital gains taxes for a period of time.
The investor takes the proceeds from the sale of a property or security and re-invests them in a Qualified Opportunity Fund (QOF), which anyone can establish – investor, developer, etc. – though investors have started a smaller share of the funds than other groups The fund then finances the development or redevelopment of a property or properties within one or more Qualified Opportunity Zones (QOZ). The fund can be of any size, as long as the proper paperwork is fled by the tax deadline, according to a CNBC article. Healthcare organizations could create their own funds with the intent of building medical facilities in Opportunity Zones.
• QOF investors can defer paying taxes on the capital gains used to fund their QOF investments until Dec. 31, 2026 – meaning they have to pay the taxes in April 2027, or when they sell the investment, whichever comes first.
• Those investors who hold their investments for five years get a 10% break on those original capital gains.
• QOF investors who hold their investments for seven years get a 15% break on those original capital gains.
In other words, the real-estate investor does not invest directly in the property, but instead invests in the QOF, which determines the properties it will fund. Of course, the fund’s prospectus will tell potential investors where and what the investments will build or rebuild. This mechanism differs from, for example, 1031 exchanges, in which an investor can roll over gains from the sale of one property into investment into another – although both are geared toward capital-gains-tax deferral.
Qualified Opportunity Zones – recommended by the governors of each state and certified by the federal government – are mostly in urban areas, though about one-quarter are in rural locations. They are available in all 50 states, the District of Columbia, Puerto Rico and other U.S. territories. U.S. Rep. Mark Meadows (R-NC) introduced a bill on Dec. 14 that would allow governors to designate 5% of tracts within a disaster area as Opportunity Zones.
Another difference between QOZ investments and direct real estate investments is, as Allen Matkins partner Mike Pruter said, “two timing elements.”
“First, the investor must invest the capital gain (into a QOF) within 180 days of when the gain occurred,” said Pruter, who specializes in the tax aspects of real estate law. “This is unlike usual real estate funds, which lines up investors, calls capital and takes the time it needs to make the investment. Here, you have to structure the resources and get all the cash up front.”
Then, the investment itself needs to meet certain requirements. The funds are tested twice a year, Pruter said, and if the capital is not adequately deployed – primarily meaning that 90% of its assets are invested in a QOZ property – the fund is assessed a penalty of 5% per year. At some point, a non-complying fund could even be de-certified, “but the IRS hasn’t come up with a process to do that,” Pruter said.
The QOF also has 30 months from the time of initial investment to double the value of the development being funded. That means just the buildings, Treasury’s October guidance stated.
That’s what caused the sighs of relief among investors and developers, because many feared the value of the land would be included in the improvement requirements. But it’s not, which is piquing interest among more potential investors.
Even though the deferral on the original capital gains ends – for now – in 2026, those who keep their QOF investments for 10 years or more will not be assessed capital gains taxes on the improved value of the property invested in. For example, if a building was worth $50,000 when bought by the fund, and is worth $125,000 in 10 years’ time, the investor won’t have to pay capital gains tax on that additional $75,000.
And, even though Opportunity Zones’ designations are slated to expire at the end of 2028, investors can keep the investment with full tax breaks through 2047.
As with any investment, potential investors must research QOF’s background and the viability of the projects planned.
Though many QOFs have been established, the investment sector is still in its infancy. As with this, or any other investment, those interested should perform their due diligence.
Next: Opportunity Zones’ impact on Today’s Market
Tags: Opportunity Zones