What is an Opportunity Zone?
An Opportunity Zone is a new community development program established by Congress in the Tax Cuts and Jobs Act of 2017 to encourage long-term investments in low-income urban and rural communities nationwide.
Real estate investors will soon be able to defer or even eliminate capital gains tax through a new program introduced in the 2017 Tax Cuts and Jobs Act.
The program rewards reinvestment of profit into “Opportunity Zones” — low-income census tracts selected by state Governors and certified by the U.S. Treasury Department.
In the coming weeks, the Treasury Board and IRS will finalize the guidelines on how to set up “Opportunity Funds”—the investment vehicle that will raise and deploy private capital into the zones.
For real estate investors, this is massive news. The tax advantages offered will rival the 1031 exchange, both in tax deferral treatment and program flexibility. In this guide to Opportunity Zones, we cover everything you need to know about this this amazing new program.
A Quick Look at How Opportunity Zones Became a Reality
The idea originated from tech billionaire Sean Parker, the former President of Facebook and Creator of Napster. In 2013, Mr. Parker enlisted powerful allies and formed the Economic Innovation Group (EIG)—a Washington think tank to help him press the policy into law.
|Why Opportunity Zones?
– More than half of America’s most economically distressed communities contained both fewer jobs and businesses in 2015 than they did in 2000.
– New business formation is near a record low. The average distressed community saw a 6% decline in local businesses during the prime years of the national economic recovery.
– The U.S. economy is increasingly dependent on a handful of places for growth. Five metro areas produced as many new businesses as the rest of the country combined from 2010 – 2014. Now is the time to diversify.
EIG wants to tap into an estimated $3.8 trillion of unrealized capital gains sitting in U.S. households. The group estimates that there’s another $2.3 trillion when you account for U.S. corporations. Their hope is that the tax incentives being offered creates the “largest federal community development initiative in memory”.
State Governors had until March 22, 2018 to choose up to 25% of their state’s eligible low-income census tracts (same definition as for New Markets Tax Credits) to become Opportunity Zones. The designation stays in place for ten years and cannot be modified after initial designation.
There are now roughly 8,700 Opportunity Zones throughout the U.S.
|A Brief History of Economic Incentive Zones
A similar idea to Opportunity Zones was first introduced in the 1980s by Margaret Thatcher’s U.K. Government. The English called them “Enterprise Zones” but the idea was the same—Offer a range of tax breaks and regulatory relief to attract investments and private companies into the zones.
While the results of the program are still debated, a famous success story is the transformation of London’s dilapidated docks into the bustling Canary Wharf we know today.
In the U.S., President Reagan was among the first to support Enterprise Zones, declaring in his 1982 State of the Union address, “A broad range of special economic incentives in the zones will help attract new business, new jobs, new opportunity to America’s inner cities and rural towns.”
But despite his administration’s best efforts, a federal program was never passed by Congress during his time.
In 1993 however, the Clinton administration unveiled the “Empowerment Zones and Enterprise Communities” program. And for the first time in America, incentives and opportunities were offered to businesses who chose to operate in these zones, usually in the form of tax breaks or comparable incentives.
One important distinction between earlier programs and the 2018 Opportunity Zones is the creation of the Opportunity Fund, which allows equity shareholders to receive tax relief, as well as the business owners who set up shop.
The Triple Threat Tax Treatment
To better understand Opportunity Zones from a real estate perspective, we recently sat down with Derek Uldricks, President of Virtua Partners—a global private-equity real-estate investment firm. Uldricks recently created Virtua Opportunity Zone Fund I, the first Opportunity Fund that aims to raise $200 million to target investments in different Opportunity Zones.
Uldricks explains the tax benefits Opportunity Zones offer investors using this example:
“Assume you have a $1 million gain in Apple stocks and decide to sell,” he starts. “To keep it simple, let’s also assume you’re in a 20% tax bracket, totaling $200,000 in capital gains tax. But instead of paying, you reinvest the $1 million in an Opportunity Fund.”
Here’s what happens next:
- Deferment of gains: By investing those gains in the Opportunity Fund, the tax due on those gains is deferred until the earlier of selling your interest in the Fund, or December 31, 2026.
- If you hold the investment for 5 years: You completely defer that payment of $200,000 plus you get a 10% step up in basis on the original gain that you deferred. So you now pay $180,000, saving you $20,000 in capital gains taxes.
- If you hold for 7 years: You receive an additional step up in original basis of 5%, and your capital gains tax bill goes down to $170,000, saving you $30,000 on the taxes owed from your initial gain.
- You hold the Opportunity Fund investment for more than 10 years: You pay ZERO capital gains tax on the appreciation of that asset.
That’s right. Let’s break that last one down.
If you hold your $1 million investment for 10 years, any gains you make on that investment are tax-free. You pay ZERO capital gains tax on all of the appreciation above and beyond the $1 million.
“So even if your $1 million turned into $3 million, that $2 million in lift achieved through investing in the Opportunity Fund is tax free,” Uldricks says. “The Tax Reform Act of 1986 took all the goodies away from real estate, and this is like the opposite of what happened with that … all these great things got put back in.”
To recap, the triple threat tax advantages include:
- Capital gains tax deferral
- Step up in basis
- Capital gains tax elimination
PLUS you also still get the benefit of all the depreciation. “All of those other expensing options are still available to real estate investors,” Uldricks says. “It’s essentially a free loan from the government.”
“Under normal circumstances, cashing out of an investment, you would take that $200,000 and give it to the federal government. Instead, they’re letting you keep it at 0% interest – and use those funds to invest in one of these Opportunity Zone projects for 10 years.”
“It’s like the best of both worlds,” Uldricks says. “Pay no taxes on any gains [earned in the Fund], all the deferral, all the step up, and you still get to take depreciation to offset income in the rest of your portfolio. It’s an amazing tax benefit for investors and it hasn’t really been widely reported on yet.”
|Investment Length||Benefits Received|
|Fewer than 5 years||Deferred payment of existing capital gains until the date that the Opportunity Fund investment is sold or exchanged.|
|5-7 years||Benefits listed above + 10% of tax on existing capital gain is canceled|
|7-10 years||Deferred payment of existing capital gains until December 31, 2026 or the date that the Opportunity Fund investment is sold or exchanged (whichever comes first) + 15% of tax on existing capital gain is canceled|
|Greater than 10 years||Benefits of 7-10 year investment + investors pay no capital gains tax on the Opportunity Fund investment (investments are exempt from any capital gains beyond those which were previously deferred).|
Note: All capital gains realized by an investor in the 180 days before an Opportunity Fund investment are eligible for the tax benefits of investment in Opportunity Funds
Does it Beat a 1031?
Some have called the 1031 “a perpetual deferral until the ultimate exit”. Which means, if at any point you sell an asset, you’re on the hook for the gains. This leaves most investors holding their real estate until death—or the ultimate exit—so that at least their heirs get the step up in basis.
But with Opportunity Zones, you don’t have to die to eliminate the capital gains tax burden. “There’s three key words,” Uldricks says. “Automatic step up.” Which means, after the 10 years, it automatically steps up. You don’t have to jump through hoops to get it.
“The other really interesting part is that the legislation says ‘all of the basis steps up’” Uldricks says. “That includes saving taxes on any depreciation you take, unlike the 1031, where you may have to pay what’s called ‘depreciation recapture’ if you decide to exit the 1031 early.”
In essence, you can use depreciation to offset income in the rest of your portfolio. You can take those passive losses, and shield income in other parts of your portfolio.
Unlock Your Capital
Due to the nature of the investment vehicle, Opportunity Zone investments allow more creative use of capital. With a 1031, it’s all or nothing. Your initial investment is locked in along with the capital gains accrued over the life of the investment. And it all goes into the rollover asset you choose next.
Not when investing in Opportunity Zones. Going back to the Apple stock example, there was a theoretical gain of $1M. But that’s just the gain. You may have had another $200,000 in there that was your initial investment or “initial basis” – investment principal that can be taken out without penalty.
This is another huge advantage of Opportunity Zones. You can take your initial basis out, in this case $200,000, to do with it what you want. Spend or invest it guilt-free knowing that your gains have been invested in a fund that will receive the triple-threat tax advantages we discussed above.
Breaking Down the Investment Vehicle: The Opportunity Fund
We’ve now explained how Opportunity Zones came into being and what the tax advantages are. But how exactly do you go about investing in these zones? The answer is “Opportunity Funds”.
Here’s an explanation from EIG:
“Opportunity Funds are private sector investment vehicles that invest at least 90% of their capital in Opportunity Zones. The fund model will enable a broad array of investors to pool their resources in Opportunity Zones, increasing the scale of investments going to underserved areas.”
So, you can’t just purchase a property in an Opportunity Zone and expect the tax advantages. Nor can you team up with a Sponsor or Fund Manager who doesn’t abide by the guidelines for Opportunity Funds that will be set forth by the Treasury Board and IRS later this year.
The tax incentive is for investors to re-invest their unrealized capital gains into Opportunity Funds within 180 days. And these funds must be dedicated to investing into Opportunity Zones designated by the Governors of every U.S. state and territory.
This new investment vehicle will be organized as a corporation or a partnership and can be any array of equity investments in a variety of different sectors. EIG explains this last point.
“This is critical, because low-income communities have a wide range of needs, and Opportunity Zones at their best will recruit investments in a variety of mutually enforcing enterprises that together improve the equilibrium of the local community.”
EIG provides a few examples of potential Opportunity Funds:
- A $100 million national private equity fund that provides growth capital to lower middle market operating businesses located in Opportunity Zones.
- A $20 million local fund that provides the equity capital for the $100 million redevelopment of a closed shopping mall into a mixed-use development that includes new neighborhood retail and workforce housing.
- A $50 million disaster area fund that develops and leases new affordable housing for residents displaced by the 2017 hurricanes and forest fires.
There are certain rules that are still being fleshed out. But here’s what we know so far in terms of guidelines for Opportunity Funds:
– Must be certified by the U.S. Treasury Department.
– Must be organized as a corporation or partnership for the purpose of investing in Qualified Opportunity Zone Property
– Must hold at least 90% of their assets in Qualified Opportunity Zone Property.
– Qualified Opportunity Zone property includes newly issued stock, partnership interests, or business property in a Qualified Opportunity Zone business
– Opportunity Fund investments are limited to equity investments in businesses, real estate, and business assets that are located in a Qualified Opportunity Zone. Loans are not eligible for the tax incentives. Opportunity Fund investments in real estate are subject to a substantial rehabilitation requirement.
What Does a Real Estate Opportunity Fund Look Like?
From the real estate perspective, Uldricks expects the landscape for opportunity funds to be shaped primarily by the substantial improvement requirement.
“The way the law is written, Developers are expected to make significant upgrades to a property—at least equal to the cost of the initial purchase,” Uldricks says.
“So while the funds will be nimble in responding to market interest and opportunity, the real estate firms and Developers who participate are limited by their ability to execute these types of large-scale construction projects.”
Uldricks himself, plans on focusing Virtua’s efforts on the following core strategies:
Residential real estate. Generally, both multi-family and single-family residential rentals as well as hospitality. “Regionally, we’re primarily focusing on the Southwest and the Southeast – the Sunbelt region,” Uldricks says.
“We like markets where demographics are improving, those areas are also generally good places for business. So when you’re doing residential real estate, you want to be in a place that has jobs because where there are jobs, there are people, and where there are people, there are renters.”
Uldricks has his eyes set on Phoenix, San Antonio, Austin, and Dallas. “We’re in those markets pretty deeply right now. We’re looking at Opportunity Zone assets and vetting through the possibilities,” Uldricks says.
“There’s also Atlanta, Georgia—a big hub for business and improving demographics. It’s a great place to invest. And in North Carolina, we’re looking at Charlotte and Raleigh, because we like markets where it’s easy to develop.”
Because most of the investments in an Opportunity Fund will likely be development projects, one of the key things every Developer and Sponsor must do is make sure that projects are completed on time.
“If you’re developing a project in California, it may take five years for you to actually complete the project, or just substantially improve it over that period of time. Well, that’s not going to work for the Opportunity Fund, right? Because we are required to substantially improve it over 30 months,” Uldricks says.
“So we need to be in markets that are pro-development, and are helpful in getting us the approvals we need to complete the projects on time and stay within those regulations.”
Like any investment, there are always risks to consider. Uldricks doesn’t shy away from this topic. “Of course you’re going to have to look at market risk,” he starts. The same rules apply when assessing opportunity zone investments as would exist in normal real estate investments in this case.
“There is also leverage risk,” Uldricks says. “Because we think most of these Opportunity Zone investments will be vertical development, they’re going to be leveraged. So pretty much every deal that is built has some form of financing.”
Investors should look at levels of leverage and guarantees. Ask, how credible is the Sponsor? Do they have a strong balance sheet? Are they able to work through the construction?
Which brings us to execution risk. Can Sponsors do what they say they’re going to do? An investor can perform the same due diligence to evaluate Sponsors they would normally undertake. That includes checking PPMs if available.
“There will also be construction risk,” Uldricks says. “Prices of construction costs have been going up, both labor and materials, so that’s something to pay close attention to. I think the first movers are going to have an advantage there.”
“There’s also the concern that you’re going to have a lot of people bidding up the values of properties that are in opportunity zones, right? So you have valuation risk. You may be overpaying for assets.” Pay close attention to what Sponsors are paying for the land.
At RealCrowd, we always suggest partnering with a Sponsor you feel comfortable with. And the only way to get comfortable is to do your homework. Ask all the right questions. That includes going over all the offering documents and making sure the deal structure makes sense.
Next Steps for Opportunity Zones
Now that the Opportunity Zone map is set, Treasury and IRS will release guidance to create opportunity funds for raising and deploying the capital into these communities.
John Lettieri, Co-Founder and President of EIG, in an interview with the Financial Post in June, discussed next steps:
“States are figuring out their recruitment strategies to bring in investors, while investors are looking at how they can raise funds. But before any capital gets deployed, investors want to see the guidance for establishing these funds.”
The guidance is expected in the coming weeks but until then, investors can start zeroing in on fund managers and syndicators to partner with.
There are many moving parts and most of the risks relate to abiding to the regulations. Because these are projects that will require substantial improvement under a short deadline, failure to comply will result in penalties and other fees that investors may potentially be liable for.
Opportunity Zones are a game changer. We’ve talked a lot about the benefits for investors. But the reality is, this program is so much more than that.
Supported by a broad range of professionals – from developers who will improve buildings, to venture capitalists who will fund entrepreneurs, to community groups who will ensure everyone benefits – the big vision is to revitalize America’s depressed communities.
*If you liked The Real Estate Investor’s Guide to Opportunity Zones be sure to enroll in RealCrowd University for more great content on the Fundamentals of Real Estate Investing.
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Adam Hooper is Co-Founder & CEO at RealCrowd. All opinions expressed by Adam and interviewees are solely their own opinions and do not reflect the opinion of RealCrowd. This article is for informational purposes only and should not be relied upon as a basis for investment decisions.