The passage of the 2017 Tax Cuts and Jobs Act (TCJA) enacted some of the most substantial tax reform legislation since 1986. One aspect of the TCJA produced one of the greatest tax breaks I’ve ever seen: opportunity zones (OZs). The IRS defines an opportunity zone as “ an economically-distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment. ” OZs were designed to increase housing and job development in overlooked communities by incentivizing real estate investors through tax benefits. Quite frankly, opportunity zones represent one of the best tax forgiveness opportunities for investors in our lifetime.
Roughly 8,700 certified opportunity zones are spread across the country, including almost the entire island of Puerto Rico. While you may associate the designation criteria with more rural areas, the final designated OZs have an average poverty rate of nearly 31%, and these economic conditions can also exist in vibrant urban cores. Some of the more noteworthy designated areas include secondary markets such as Nashville, Tennessee; Oakland, California; and Portland, Oregon. According to the Urban Land Institute, these are markets with job and population growth rates that exceed the national average — two key ingredients that fuel the underlying demand driving new development. I suspect we’ll see additional spikes in development activity within these urban zones, given they are already growing markets.
How Opportunity Zones Work
To harness the financial potential of OZs, you must invest in them through a qualified opportunity fund (QOF), which is essentially an investment vehicle that owns at least 90% of its assets in the form of qualified opportunity zone property, using capital gains from the sale of stocks, a business or other real estate projects. And, while multiple forms of investments, such as investing in an existing business, are possible through a QOF, the tangibility of commercial real estate assets arguably makes them the best vehicle. My company has offered two commercial real estate QOFs so far in 2019, and in a recent investor survey, we found that over 65% of our active investor base is interested in investing in opportunity zones with real estate, and we put two more in our pipeline. Investing in private companies inserts a level of risk that may simply outweigh the potential tax benefit associated with QOFs, which is possibly why they are rare so far — a directory of 118 qualified opportunity funds published by the National Council of State Housing Agencies shows that only nine are not related to real estate.
QOFs offer essentially three separate tax benefits: temporary deferral, partial exclusion and total forgiveness. Hypothetically speaking, if you were to hold a real estate development within a QOF for 10 years and earn a 12% compounded annual return upon sale, you would retain roughly an additional 50 cents of every dollar invested into the QOF, rather than pay it to the government in the form of taxes.
Special Considerations For Opportunity Zones
For investors who are concerned over recent volatility in the stock market, the possibility of a recession next year and general uncertainty about the short-term future of their investments, the long-term nature of QOFs presents an opportunity to balance one’s portfolio to be more resilient in the face of short-term shocks. The downside is that the time frame to fund is relatively tight. Investors have only 180 days from the sale of their asset to invest in a QOF to defer their capital gains.
The other thing to know going into a QOF real estate investment is that to remain in compliance, the QOF must double its basis in the underlying asset in any 30-month period (excluding the value of the land). So if a vacant warehouse is purchased for $2 million, and $400,000 of value is attributable to the land, then the QOF must invest another $1.6 million into that warehouse within any 30-month period or else lose its tax benefits. This is referred to as the substantial improvement requirement.
Practically speaking, this means that almost every real estate investment in a QOF will constitute either a redevelopment or ground-up development of a property. It’s important for investors, especially those new to commercial real estate investing, to understand that redevelopment and ground-up development entails a higher level of execution risk in comparison to investing in existing assets — there can be unexpected cost overruns, time delays and uncertainty surrounding its eventual lease up.
Analyzing Your Opportunity
Just because a property is offered within a QOF, that doesn’t necessarily mean it’s a good investment – it simply means that it’s tax-efficient. So far, the best QOF investment opportunities we’ve seen are developments that were already in their planning stages prior to the announcement of opportunity zones. It makes sense when you think about it: Any viable development investment, regardless of its potential status as a QOF, should demonstrate sustainable demand for its product type, whether it be tourism and business travel for a hotel, job growth for an office building, or strong population growth for a multifamily property. Demand that outstrips supply in the designated opportunity zone is paramount for the long-term viability of any QOF investment.
Finally, because you are locking up your investment for at least 10 years, it’s critical to have a high level of confidence in the group with whom you are investing. Developers with long-term successful track records and with a specialization in the proposed asset class are critical prerequisites for investing in a QOF. However, once you identify an attractive QOF investment opportunity that is managed by a high-quality developer, whether it be from an online marketplace or a direct connection, you can proceed to liquidate your investment, contribute your deferred gain to a QOF, and potentially earn the best tax-adjusted returns of your lifetime.