Much has been said and written about Opportunity Zones (OZs), the new federal tax program carved out by the 2017 Tax Cuts and Jobs Act. Amidst the buzz is a lively debate about whether these investments create good policy. But whatever the policy pundits say, OZs could prove an incredible proposition for investors. In short, they enable investors to defer some capital gains until December 31, 2026, (if re-invested according to OZ guidelines) and others (if held for ten years), to be waived entirely as the linked article to the New York Times points out. More on this later.
In over two decades of raising capital in commercial real estate, rarely have I seen a tax break introduced that is as advantageous as this one, with the double benefit of putting more investment into communities that need it. I do not say that lightly. Investors should move carefully and quickly to speak with their tax and legal advisors to learn more about how they could participate and maximize the potentially most powerful, ten-year benefit of the program.
In this first installment of our blog post series on OZs, we define what they are, describe how to invest in them, and suggest some initial criteria for choosing an investment partner that can help you make the most of this unprecedented opportunity.
A New Type of Alternative Investment, with U.S. Support
Many alternative investment programs are developed almost solely to attract investors, carving out various long-term monetary incentives. The potential power behind the new OZ program is that it adds altruistic motives to monetary ones, with the goal of bringing relief to economically-distressed communities.
Briefly, the 2017 Tax Cuts and Jobs Act, U.S. Tax Code (26 U.S. Code § 1400Z) aims to boost economic development and job growth in underserved U.S. communities. It does so by incentivizing investment in OZs through vehicles called Qualified Opportunity Funds (QOFs).
How Opportunity Zones Were Selected
This part is fairly straightforward, so far. To qualify as an OZ, communities were proposed which met or fell below either a 20% poverty rate or a median family income lower than 80% of the area median. State governments (e.g. the governor’s office) nominated the OZs in their jurisdiction, and these zones have been certified by the U.S. Treasury Department.
The word got out pretty quickly. Certified OZs now number over 8,700 across all 50 states, D.C., and five U.S. territories. Every state participated in order to attract investment to its underserved communities—and the infrastructure and jobs that come with them.
To see the list of designated opportunity zones by the Internal Revenue Service, take a look at the list at this IRS link.
The Big Idea—Unique Tax Benefits of QOFs
Here is the big picture idea: if you made a large capital gain from a prior investment, you can reinvest the capital gain proceeds into a QOF—and potentially receive all three of these benefits:
- Benefit #1: Defer the tax on all of your capital gain from that prior investment until as late as December 31, 2026.
- Benefit #2: Reduce your tax burden up to 10% in year 5 (after your re-investment of the gain in a QOF) and by an additional 5% in year 7*.
- Benefit #3: Any future capital gains, over and above your original QOF investment, can be waived entirely if held for a period of 10 years from your original QOF investment.
(Note: *this 15% in benefit #2 is the maximum amount that your original capital gain can be reduced (via a step-up in basis), and it must be realized eventually (in the year 2026 or when sold, whichever comes first.)
We will go into greater detail about the tax advantages in the next post of this series.
The upshot? You can reinvest your realized capital gains in a QOF to further defer taxes—while also simultaneously appreciating your money.
For their part, QOFs can be set up as either partnerships or corporations and their permissible investments can either be in a “property” or a “business,” both of which must exist or be operated within a qualified Opportunity Zone.
Barron’s summarizes the IRS requirements, saying when investing in a property, a QOF must invest at least 90% of its assets in properties (e.g. buildings or land tracts) that meet three qualifying criteria. They must 1) have been purchased after 2017, 2) be located in one or more designated OZs, and 3) be targeted for substantial improvement, like a new shopping mall or a transportation hub, or a significant renovation.
When investing in a “business,” a QOF must derive at least 50% of its gross income from local (in-area) income. The investment cannot be in what they call a “sin business,” such as country clubs, golf courses, liquor stores, massage parlors, racetracks, and gambling venues. (We won’t comment on the policy here, but it seems to us that golf courses are closer to virtue than to sin. But hey, they did not consult us on that.) Nor can it be a facility that furthers the use of hot tubs or tanning beds.
Other potential caveats include the provision that a “substantial portion” of intangible property must be used in the active conduct of the trade or business. The phrase “substantial portion” has not yet been defined (we are watching for upcoming updates on this). There is also this provision: less than 5% of the property of the business can be nonqualified financial property such as debt, stock, and partnership interests. Cash and short-term debt instruments are acceptable, within reason, since they can be employed as working capital.
QOFs are especially attractive to high net-worth individuals (HNWIs) and family offices coming out of a 1031 exchange. But beyond HNWIs and family offices, we see an even larger audience for this program as there is interest among institutional investors. QOFs are a great fit for almost any qualified investor who is about to realize a sizeable capital gain—and who does not need the proceeds for years to come.
How Are QOFs Different From 1031 Exchanges?
If some of this sounds a bit similar to 1031 exchanges (or, Like-Kind Exchanges), you are right. As with 1031 exchanges, there is a time limit for reinvesting capital to qualify for the program. Investors must reinvest a capital gain in a QOF within 180 days of the sale or exchange that generated it.
The key differences? First, 1031 exchanges are limited to real estate gains. Second, with 1031 exchanges, the entire amount of the sale proceeds must be re-invested whereas with QOFs the cost basis portion of the sale proceeds does not have to be re-invested, and can be taken out. This allows for more liquidity, which is a big plus.
QOFs are broader since they can involve capital gains on assets beyond real estate, e.g. a partnership interest could just as well be in a multi-family residence, a medical facility, or a new highway.
In another sense, QOFs are much more narrowly defined than 1031 exchanges. For example, there are geographical limitations (the investment must sit in an OZ)—and structural limitations for how the investment is aggregated (within a fund). Finally, unlike 1031 exchanges where tax deferment is indefinite, with QOFs, investors can only defer amounts related to the QOF until December 2026, or when the asset is sold, whichever occurs earlier.
$6.1 Trillion in Capital Could be Mobilized to Boost Economically Distressed Areas
QOFs are intended to create new incentives to address economic need and create much-needed job opportunities. In exchange for providing equity investment in commercial and residential buildings and in local businesses, investors get to defer and reduce their federal capital gains tax burden.
For many investors, the tax benefits are sufficient incentive.
Of course, any investor might aspire to also improve people’s lives and communities with their investments. The social good that QOFs have the potential to do for communities is clearly compelling—and “impact investing” is indeed a noteworthy and growing investment trend.
As a result, the total addressable market could be massive. The Economic Innovation Group (EIG) estimates about $6.1 trillion may ultimately flow into OZs.
If that number seems astounding, bear in mind that this estimate is not a politician’s fly-by-night rhetoric or some passing sound bite for the media. The EIG is a bipartisan coalition, advocacy group, and well-respected think tank that built sufficient momentum to get the program into congress. Members are entrepreneurs, investors, economists, and policymakers.
A New Investment Vehicle Demands CRE Experience
With the impending firehose of QOF opportunities you may hear about, it may be hard to sort through and determine which opportunities to participate in. Out of the 8700+ zones, some zones could contain multitude (or zero) QOFs within them. And investors need to know that, while all investments carry risk — some OZs present more risk than others. In our examination of the OZ maps, guidelines, and documentation, we found that some OZs are in areas previously identified as attractive for development, including many central business districts. While some view this as a negative thing about the program, it is arguably a factor that also lends to the potential for success within a zone.
As with any investment opportunity, it is imperative to find a fund manager with proven experience at the head of the QOF/fund project. OZs can be met with both enthusiasm and protest (think of the controversy surrounding Amazon’s proposed new headquarters in Long Island City, NY), so it is very important for funds to work both with local teams and community leaders to make strong choices for the community, the QOF, and local businesses.
Applying strategic analysis and careful scrutiny to every investment opportunity, our deeply experienced team has over two decades and $3 billion in CRE investments in our track record. We are fully aligned to be at the forefront of a QOF. We are monitoring the legislation and guidelines around these OZ and QOFs, and are optimistic that they have the potential to dramatically turnaround certain struggling areas, deliver returns, and significantly reduce investors’ tax exposure, simultaneously.
It bears repeating that a program like this is a rare opportunity and that to get the most out of the potential tax benefits, investors should educate themselves by talking to tax and financial advisors first, to determine whether QOFs are the right fit for them and their individual needs.
In our next post, we will take a deeper dive into how QOFs work—and weigh the considerations of each as well as the specific tax advantages.
Resolute Capital Partners provides high net worth individuals and family offices access to beyond-Wall-Street assets, such as alternative investments in energy, commercial real estate projects, Qualified Opportunity Funds, and security-based opportunities. By connecting eligible investors with capital-seeking projects, we are revolutionizing how worthwhile projects get funded … and how smart investors invest.
Before making any investment, we recommend you consult your tax and financial advisors.
For more information, read the press release from the IRS about the creation of the Opportunity Zones here, the locations of OZs are listed in the IRS document here, and the EIG’s OZ reference page is here.
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