Opportunity Zones Paint Bright Future for Commercial Real Estate

March 27, 2019

Even though the US has experienced a long run of overall growth and economic prosperity, economic inequality has worsened consistently since the 1970’s. Income and wealth gaps have widened sharply over this period.  The Tax Cuts and Jobs Act, enacted in December 2017, aims to address these inequalities by providing investors with new tax incentives designed to stimulate long-term private investment in distressed communities across the US known as Opportunity Zones (OZ). All of the underlying incentives relate to the tax treatment of capital gains and all are tied to the longevity of an investor’s stake in a qualified opportunity fund, providing the most upside to those who hold their investment for 10 years or more. Initially, investments will focus on real estate development with later-stage investments including private capital investments into operating businesses.

 

Recommendations for areas to be certified as Qualified Opportunity Zones (QOZ) were made by the governors of each state. Governors could designate up to 25% of census tracts in their state as “Opportunity Zones” as long as they met the following criteria: First, a census tract must have at least 20% poverty rate. Second, the median income must not exceed 80% of metro or state level and third, designation of OZ’s remains in effect through the end of 2028. Decision-making for the recommended areas were in many cases based on input from the general public and regional economic development organizations. There are over 8,700 QOZ’s throughout the United States. There are hundreds of these designated communities throughout California, more specifically, some of the more notable ones located in Orange County are in Santa Ana, Anaheim, Fullerton and Costa Mesa.

 

 

The program has drawn interest from investors across the country; policy experts and fund managers expect a flood of capital to flow into the space as soon as regulations are finalized. The original legislation was largely incomplete, and investors are awaiting the release of specific regulations and guidance on several key issues from the Treasury Department and IRS before they start deploying funds.

 

Key issues include how much money needs to be invested in order for a project to qualify, the time horizon in which improvements must be made, whether debt could be placed on properties, can individual partners make their own decisions rather than having to follow the partnership, and differences between “original use” and “substantial improvement”, among others. In general, responses to investor questions and continued updates to the legislation illustrate that the government really wants this program to work and they are going to create the practical flexibility needed to insure the program’s success. For real estate, the program is unquestionably positive and has the potential to be transformative for real estate investment in these designated low-income areas.

 

 There are two vehicles available when evaluating investments in QOZ’s: real estate or local businesses. Due to the legislation guidelines, real estate will more than likely focus on ground-up development rather than value-add projects. On the other hand, businesses must derive at least 50% of gross income from actively conducting business in the OZ. Most businesses qualify with the exception of country clubs, gambling establishments and other “sin” businesses.

 

This may sound good but how does it actually work and how can an investor benefit? Let’s assume in 2019 that an investor wants to roll over a capital gain from a previous investment (real estate or business) into a QOF. In 2024, the investor has held the investment for 5 years and therefore receives a 10% step-up in basis.  Fast forward to 2026, the investor receives a 15% step-up in basis for holding for 7 years. At the end of 2026, the original deferred gain is recognized and tax on gain is owed. Beyond the 5 and 7-year periods, gains become tax free after an investment period of at least 10 years and applies to assets held until 2047. The additional hold period was provided to avoid the potential of a flood of property investments hitting the market shortly after completing the 10-year holding period. Additionally, it is important to note that in order to take full advantage of the benefits, capital gains must be reinvested by the end of 2021.

 

Opportunity zones create a powerful incentive for long-term investment into distressed communities across the country. I am optimistic about the potential impact the program will have in the coming years. However, to insure the program is successful, policymakers, investors, fund sponsors and local stakeholders will all need to be proactive about articulating a comprehensive strategy, understanding and addressing unintended consequences of their investments, encouraging collaboration and consistently measuring and reporting on impact metrics. 

 

For more information or how to get involved please contact me directly at (949) 263-5303 or ChrisD@voitco.com 

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March 27, 2019

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