Opportunity is knocking with Opportunity Zones
Opportunity Zones (OZ), created by the Tax Cuts and Jobs Act of 2017, were designed to spur private investment in distressed communities by providing significant tax benefits to investors with large capital gains or longtime horizons.
An OZ is an economically distressed community nominated by the state governor and designated by the Department of Treasury where new investments, under certain conditions, may be eligible for preferential tax treatment. They are generally census tracts in communities experiencing economic distress, using the same definition used in the New Markets Tax Credit (NMTC) program.
However, unlike existing programs that were designed to boost investment in low-income areas through tax advantages, OZs function a little differently. They are governed by the revenue tax code by the treatment of capital gains. This removes many investment limitations that impact the existing programs, because there is no reliance on government funding to function and creates more of a free market.
According to the U.S. tax code, the following governmental requirements must be met before a census tract can qualify for nomination as an OZ:
• A poverty rate of at least 20 percent; or
• A median family income of no more than 80 percent of the state-wide median family income within non-metropolitan areas and no more than 80 percent of the greater state-wide median family income or the overall metropolitan median family income for census tracts within metropolitan areas.
Over 8,700 census tracts located in the U.S. have been designated an Opportunity Zone by the U.S. Department of Treasury. This represents 11 percent of the country by census tract, including 100 percent of Puerto Rico.
How does OZ investing work?
The program incentivizes investment in OZs by deferring and partially avoiding capital gains tax for those who invest in a Qualified Opportunity Fund (QOF), a U.S. partnership or corporation that intends to invest at least 90% of its holdings in one or more qualified OZs.
Any individual, corporation or trust can defer gains from the sale or exchange of property by investing an amount equal to such gains in a QOF within 180 days of such gain.
1. Taxation on the original gain is deferred until the earlier of disposition of the QOF interest or Dec. 31, 2026.
2. Reduction of those deferred taxes by 10 percent if property is held for 5 years and by 15 percent if property is held for 7 years.
3. No taxes due on any additional gain generated by the QOF upon sale or exchange of the investment if a QOF is held for 10 or more years.
The benefits from the federal level may be combined with local incentives, such as tax increment financing incentives or other project entitlements.
Example: A corporation originally invested $1,000 into an asset, and then sold that asset for $1,100 in 2019. Subsequently, it invested $100 (gain on sale equal to $1,100 - $1,000 of basis) in a QOF within 180 days and that QOF invested in a property in a QOZ. In this scenario, the corporation does not need to pay the $21 ($100 * 21 percent) of taxes on the $100 gain in 2019, and it can defer the tax until as late as 2026. If the investment is held in the QOF for 5 years and then sold in 2024, taxes owed are $18.90 ($21 * 90 percent). If the investment is held for 7 years and sold in 2026, taxes owed are $17.85 ($21 * 85 percent). Even if the investment is held in the QOF beyond 2026, taxes equal to $17.85 are still owed as of 12/31/2026.
However, if the investment is held in the QOF for 10 years or more, the corporation may elect to step up the basis of its investment to the fair market value, which may result in no capital gains being recognized and thus no further tax paid upon its sale of the asset.
Sounds great, but where are they?
In addition to gaining clarification from the Department of Treasury and the IRS, there are other practical hurdles to clear before a deal can really take off. OZs are typically areas that have chronically low employment rates and incomes, which are in turn areas that are not appealing to traditional investors. Although the program was designed to encourage the flow of capital into and development of these areas, thereby creating jobs and raising incomes, the practical side of finding real estate deals given the economics is a struggle.
One solution would be to combine other sources to the capital stack. Public-private partnerships could help facilitate deals. As aforementioned, projects could benefit by receiving a TIF or PILOT designation, reducing property taxes, and LIHTC and NMTC projects are a good match given the term of the respective programs align well with the benefit period of projects in OZs.
Additionally, real estate facilities that serve public and private uses may prove to be a good fit, such as new K-12 or charter schools, higher education teaching, research facilities, government office buildings or sports facilities. The opportunity zone program provides tax advantages that may allow private capital to be more willing to accept lower returns on a long-term lease or a build to suite for a government use, given the enhanced return provided by the tax advantages.
Finally, the Opportunity Zone Program is in its infant stage. People are trying to figure it out, and further guidance is needed. However, in terms of tax reform it is exciting, as the most recent overhaul to compare it to happened more than three decades ago with the Tax Reform Act of 1986 when public housing moved out of governments' hands and over to private developers. The reasons for tax reform in both of these cases are similar. There was then and is today, an extreme lack of development and capital going into lower income areas, and the government and America is realizing it is a bigger issue than they can fix alone. They are realizing that we need to do it together, through private/public partnerships - and if it proves to be as successful as the Tax Reform Act of 1986, it will be truly wonderful to see what new development is built over the course of the next couple decades.