Opportunity Zone (OZ) in commercial real estate is a topic of conversation that is trending these days. OZs were created as a part of the 2017 Tax Cuts and Jobs Act. It acts as a solution to stimulate economic growth and create jobs in some of the country’s most economically impoverished areas by incentivizing investors to redistribute their capital there through real estate investment and development. In return, the investors can maximize their profits with a hoard of tax benefits through 2026 from the scheme. Hence, opportunity zones in real estate are stockpiles of real potential for the investors. In this article, we outline the basics and advantages of investing in opportunity zones.
What is an Opportunity Zone (OZ)?
The Internal Revenue Service (IRS) defines Opportunity zone (OZs) as ‘an economically-distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment.” Low-income census tracts characterize these geographic areas.
The Tax Cuts and Jobs Act passed by Congress in December 2017, created the Qualified Opportunity Zone (QOZ) program. Governors nominated communities and defined areas that fall into the low-income census tracts. The idea was to redirect private capital investments and gains to such ‘economically distressed’ areas. The real estate investment projects would create jobs in these communities which in turn would ensure a healthy income flow. As a result, these economically backward areas would be a hotbed for transformation, employment as well as economic recovery.
QOZ investments in return subject real estate investors to several tax benefits and incentives. By investing realized capital gains in QOZ, real estate investors can defer or even eliminate tax liabilities on realized gains. Furthermore, investment tax incentives provide investors with high after-tax returns which are almost double the traditional real estate investments. However, time is of the essence if the investors want to avail every special tax treatment and incentive.
What qualifies as an Opportunity Zone?
After the Tax Cuts and Jobs Act was passed in 2017, the governors of U.S. states and territories (and the mayor of Washington, DC) were asked to nominate census tracts until April 2018. The Secretary of the U.S Treasury via the delegation of authority to the Internal Revenue Service must certify the nomination.
In order to qualify to become an Opportunity Zone, an area needs to meet the criteria for income set by IRS, including:
- A minimum poverty rate of 20%
- A median family income must be less than or equal to 80% of the statewide median family income in the metropolitan or non-metropolitan areas.
The governors can nominate no more than 25% of census tracts in each of these qualified states. For another 5% of the census tracts to be eligible to become an opportunity zone, it must comply with certain criteria. The particular area should be adjoining a current Opportunity zone. Furthermore, the median family income in the area is not more than 125% of the median family income in the surrounding opportunity zone.
Where are opportunity zones located?
Initially, in April 2018, there were just 18 states that were nominated for the program. However, since then the program has expanded and covered all 50 states. It also includes Washington D.C., and US territories like Puerto Rico, the Virgin Islands, the Northern Mariana Islands, Guam etc. Presently, there are 8766 opportunity zones in both rural and urban areas throughout the US. This adds up to approximately 12% of the census tracts in the country. Over 35 million reside in the opportunity zones with about 7.5 million living in poverty. Such opportunity zones are generally located within a county that has persistently been impoverished by at least 20% for 30 years.
Opportunity Zones are located throughout the country. In order to locate the designated qualified opportunity zones, investors can check the IRS notices 2018-48.
How to invest in an Opportunity Zone?
Investors must invest their qualified eligible capital gains in an opportunity zone via an Opportunity Fund on or before December 31, 2026 to qualify for the accompanying tax benefits.
A qualified opportunity fund is a partnership or a corporation that must be organized for the purpose of investing in a qualified opportunity zone. The corporation must invest 90% of its assets in the form of qualified capital gains in a qualified opportunity zone. The IRS describes it as an ‘investment vehicle’.
The treasury department in October 2018 stated that opportunity funds must self-certify that they will fulfill the 90% asset requirement. They must fill the form 8996 with their federal tax return. If the fund fails to meet the 90% asset criteria, it will be penalized. In the absence of an external agency to approve the fund, private market fund managers undertake the task of managing the opportunity funds.
Investors can extract eligible capital gains by selling assets such as stock, partnership interest, private business or real estate. Furthermore, investors should invest their gains into the qualified opportunity fund within 180 days from the sale of the asset. The investors can also put their non qualified gains into the opportunity funds. However, these capital will be treated a separate investments and will not be conferred similar tax incentives.
How do Opportunity funds operate?
The opportunity fund must deploy their capital in QOZ businesses that acquire, construct or redevelop tangible business property within the QOZ and derive 50% or more of income from the QOZ. These funds can also invest in real estate or other hard assets that are used as a trade or a business property within a qualified opportunity zone.
After purchasing the business property, the O fund must undertake substantial improvements to the property within the first 30 months. If an O fund undertakes the rehabilitation of a building, it must make sure that the cost of improvements exceeds the original cost of purchasing the property. In either case, O funds are subject to review on a half-yearly and annual basis. This is to ensure that the funds are actually revitalizing the low-income area in question.
There are approximately 927 opportunity funds that consistently invest in a broad spectrum of geographic locations and asset types including:
- Affordable housing
- Commercial real estate like office, retail, industrial and hospitality
- Workforce housing
- Sustainable agriculture
- Historic buildings
- Clean energy
The O funds must seek to define the ‘original use’ and purposes for the business properties that are vacant, abandoned or portable. In addition to this, the opportunity fund should provide the investors with an offering memorandum. This helps the investors to gauge the outlines and ramifications of the investment opportunity. The memorandum also provides the market summary of the opportunity zone in question along with the economic outlook and projected returns on investment. As a result the investors can verify the practicability of the investment beforehand. This way the opportunity funds also demonstrate the authenticity of their credentials and experience in the business.
Proposed changes in 2020
- To meet the requirement, at least 70% of a business property that is used for business or trade purposes must fall in a qualified opportunity zone.
- Apart from real estate, opportunity funds can invest in businesses operating within the qualified opportunity zones. These businesses must source half of the companies wages or employee hours in QOZ, to qualify for the 50% income requirement criteria.
- If a business invests 50% of the total amount the company pays for its services to undertaking various services in the QOZ, it qualifies for opportunity fund investment.
What are the tax incentives of investments in an Opportunity Zone?
Capital gain investments in qualified opportunity zones offer several tax benefits to the investors. These include tax deferral, step-up basis for capital gains, and capital gains exclusion.
- Tax deferral
Opportunity funds allow investors to defer taxes on their invested capital gain until December 31, 2026. They can also avoid taxation by reinvesting their capital gain proceeds into a qualified opportunity fund within 180 days of selling or exchanging their prior investments and achieving the gain.
- Step-up basis for capital gains
- If an investor invests money in an qualified opportunity fund on or before December 31, 2021 and lock the investment for over 5 years, he/she can reduce their capital gains tax liability by 10% for the original capital gain.
- If the investor invests on or before December 31, 2019 and holds the investment for 7 years by the end of 2026, he/she can reduce their tax liability by 15%.
- Investors seeking to eliminate capital tax gains completely must sustain the investment for a period of 10 years until December 31, 2047.
Several factors determine how much a qualified opportunity investment is entitled to tax benefits. These factors include:
- The amount of investment
- The time period for which the investment is held in
- Overall income from the investment
- Returns received from the opportunity fund
What are the benefits of opportunity zone investments?
Besides the reduction and elimination of taxes, there are several additional benefits to opportunity zone investments including:
- Investors can diversify their portfolio with real estate assets as well as local start-ups and businesses.
- Investing in a diversified multi-asset qualified opportunity fund provides a stable revenue stream to the investors.
- With opportunity funds, investors can now contribute to the social upliftment of economically undeserved areas and their communities.
What are the risks of opportunity zone investments?
- Opportunity zones lack the infrastructure to support large-scale business expansion. Hence, investors must conduct their due diligence regarding the location, market analysis, and community stability of the said area. An investment in an economically distressed area carries the risk of huge losses for the investors. Hence, investors should carefully study the success record of the investment manager in non-opportunity zones. This will mitigate the risk of partial or complete loss of investment principal.
- Opportunity funds require the investors to tie up a significant amount of capital for prolonged periods of time to gain the tax benefits. Such a lack of liquidity may not be feasible for investors who may face unforeseeable cash requirements.
- In the opportunity zones, business properties may have faced their ultimate appreciation prior to the opportunity fund investments. Furthermore, a real estate project may not be viable for the local community and their requirements. In such cases, there is little room for profits remaining for the investors after the high costs of investments that cancel out the tax benefits.
Real estate investments just got a lot better
Ultimately, opportunity zones can be highly lucrative for real estate investors to diversify their portfolio and incur valuable tax incentives while helping underprivileged communities to prosper. However, just like any investment, opportunity zone investments require proper research and risk tolerance on the part of the investors. Nonetheless, opportunity zone investment is a positive step towards revolutionizing the real estate industry.