Investing in Opportunity Zones allows real estate investors to defer or eliminate short-term and/or long-term gains on the sale of real property or other similar investments.
An important tax incentive provision for real estate investors, developers and professionals were included in the federal Tax Cuts and Jobs Act that was enacted in December 2017.
A little-known section in the $1.5 trillion federal tax cut, titled Opportunity Zones, allows states across the nation to have a new tool to incentivize growth in underdeveloped, poverty-stricken areas. While these incentives could become the nation’s largest economic development “program,” their potential for positive impact depends first on the decisions that America’s governors make.
The new tax law instructs governors in each state to designate areas as “opportunity zones” from a pool of low-income census tracts and certain contiguous areas between those tracts. Those areas would then be eligible to use new tax incentives to attract long-term development in poor areas that lack infrastructure and jobs.
The deadline for governors (and the mayor of the District of Columbia) to designate zone locations was March 21, but many states received a 30-day extension to April 20. As of this publication, 15 states and three Territories have submitted their zones, including American Samoa, Arizona, California, Colorado, Georgia, Idaho, Kentucky, Michigan, Mississippi, Nebraska, New Jersey, Oklahoma, Puerto Rico, South Carolina, South Dakota, Vermont, Virgin Islands and Wisconsin.
After designating the zones, the Secretary of the Treasury must certify and designate the Opportunity Zones within 30 days of the nomination. However, a 30-day extension can be awarded for the Secretary of the Treasury as well.
Click here to see which areas may be Qualified Opportunity Zones for the States that have submitted so far. As states identify their Opportunity Zones, the map will update. LICs will appear in brown and Eligible Non-LIC Contiguous Tracts will appear in red.
Of all the low-income population census tracts designated eligible for the program, governors get to designate 25 percent (or at least 25 tracts in states with fewer than 100 qualified tracts) of them as Opportunity Zones. The incentive provides three tax benefits for equity investing in Opportunity Zones. Investors could take advantage of one or more of the benefits.
- Permanent exclusion of taxable income on new gains. For investments held in an Opportunity Fund (the investment vehicle that makes investments in Opportunity Zones) for at least 10 years, investors pay no taxes on capital gains produced through their investment. Said another way, after 10 years, the taxpayer’s basis is equal to the fair market value of the fund investment as of the date it is sold or exchanged.
- Basis step-up of capital gains invested. For capital gains placed in Opportunity Funds for at least five years, investors’ basis on the original investment is increased 10 percent. If invested for at least seven years, investors’ basis on the original investment is increased 15 percent.
- Temporary deferral of taxes on capital gains. Investors can place existing assets with accumulated capital gains into Opportunity Funds. Those capital gains are not taxed until the end of 2026 or when the asset is disposed of.
Except for the exclusion of a few “sin” businesses, the activities and projects Opportunity Funds can finance are broad. Opportunity Funds can finance commercial and industrial real estate, multifamily properties, housing, infrastructure, and current or start-up businesses. At least 90 percent of an Opportunity Fund must be invested in a qualified Opportunity Zone.
For real estate projects to qualify for Opportunity Fund financing, the investment must result in the properties being “substantially improved,” such as upgrading existing properties or building on available land in a zone.
Potential for Tax-Free Treatment of Future Real Estate Appreciation
If an investment of existing capital gains is held for 10 or more years in an Opportunity Fund and eligible Opportunity Fund investments, at disposition or sale of the Opportunity Fund interest, the appreciation on the initial investment would not be subject to taxation.
For example, if a multifamily developer would invest $20 million in an Opportunity Fund that invests in eligible qualified Opportunity Zone property (i.e. new apartments in the zone and other commercial properties) and the investment appreciates to $35 million over a 10-year investment horizon, the $15 million of capital gain would be tax-free to the investor at disposition or sale of the interest in the Opportunity Fund.
This tax-advantaged treatment of long-term investments in qualified Opportunity Zones provides significant planning opportunities for real estate, project finance, and infrastructure projects.
Investors will benefit most in Opportunity Zone financing when the underlying assets, real property or business investments are subject to rapid 10-year appreciation. Because of this, utilization of Opportunity Zone financing with structured leveraged may result in substantial tax-advantaged appreciation vis-à-vis traditional real estate investment models.