Investing In Opportunity Zones

What are Opportunity Zones (OZ) and Why Should We Care?

By now you have likely heard of the term, and you have heard of the great potential for making tax free returns for the foreseeable future. Some estimates calculate that over $100 billion in new investment capital will be flowing to OZs in the coming years. It almost sounds too good to be true, because it is. OZs can be fantastic investment opportunities under limited circumstances, but they are not the end all be all of investment opportunities as there are numerous restrictions and issues associated with these structures, and there may be better investment opportunities that are outside of OZs.

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‍Creation of Opportunity Zones

OZs were first created by the Tax Cuts and Jobs Act on December 22, 2017, and they are essentially a tool to promote new investments in economically distressed communities. The federal government tasked each state governor in the United States to designate distressed areas that would qualify as an OZ based on certain thresholds for resident income and poverty levels. Once the state has designated an area as an OZ, and an entity called a Qualified Opportunity Fund (QOF) acquires property in the OZ, the investors of the QOF are able to defer prior gains by investing gains in a QOF within 180 days after the end of the applicable tax year when the investor recognized the gains. Some of these gains may even be deferred indefinitely. By way of example, an investor that sells stock with a $1 million gain can acquire an interest in a QOF with the $1 million gain and avoid paying taxes on the gain. If the investor holds that interest in the QOF for at least five years, 10% of the investor’s gains will be permanently excluded, and the exclusion will be increased to 15% after seven years. After 10 years, all gains will be excluded from capital gains tax.

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Qualified Opportunity Fund Requirements

The structure is not as simple as it sounds as a QOF must meet certain criteria. First, it must self- certify by filing a separate IRS form, and must contain specific language in its operating documents both as to its designation and as to how it will invest. Second, 90% of the assets that the QOF owns as of specific measuring dates must be in an OZ or the entity will not be considered a QOF. Third, the QOF may only accept cash investments so investors that have other assets (e.g. an interest in real property) will be excluded. Finally, only those property interests that were acquired after December 31, 2017 would qualify so a property owner that owns an interest in an OZ cannot reclassify itself as a QOF to benefit from the tax treatment of a QOF. Note also that the QOF cannot purchase property from a related party and qualify so existing owners will not be able to participate in the QOF by restructuring its ownership in the property (with some limited exceptions).

Using the same example as above, the investor must acquire an interest in an entity (e.g. a LLC) that has designated itself as a QOF, and that has inserted required language in the LLC’s operating agreement. The QOF must be new (i.e. it cannot have owned the property previously) and must primarily identify and acquire property in an OZ. The property that the QOF purchases cannot be coming from anybody that is related to the investors in the QOF so our investor cannot sell his or her own property to the QOF.

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Types of Property

The type of property that the QOF may acquire is also limited. A QOF cannot purchase just any investment property and collect the income generated from the property. A QOF that acquires real estate must purchase real estate that it can “substantially improve” after it acquires the property as the whole purpose of this structure is to improve neglected neighborhoods by connecting investor capital with low income zones. The IRS has interpreted this language to mean that an investor must double its adjusted basis in the property in a 30-month period, and land is excluded from the calculation. For example, a QOF that purchases a $5 million property with land valued at $1 million must invest at least $4 million ($5 million less the $1 million land) within 30 months to qualify. Locating property in an OZ that would be suitable for a substantial improvement will be one of the most difficult aspects of these transactions and may create a scenario where the QOF is constructing improvements to the property that are not necessary or do not generate a very good return on investment.

Going back to our prior example, the QOF that our investor has identified will need to find real estate in a distressed area that has been designated an OZ. The QOF’s plans for the property must be such that it will substantially rehab, expand, or develop that property (e.g. purchasing a property with a rundown industrial building with plans to refurbish the existing building to create retail and construct an attached tower with multifamily units).

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State Requirements

Note also that OZs are created pursuant to a federal law so states are not restricted by them. If the applicable state has not adopted corresponding legislation, the investor will still be subject to any state taxes applicable to the gains. Many states (including Minnesota) have not yet adopted the required laws so an investor may have a rude awakening when he or she is assessed a substantial capital gains tax on a gain that the investor thought was tax free. An investor should consider this before investing in a QOF.

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Distressed Property

Another problem with OZs is that the property is still located in a distressed economic area and the property still needs to perform well after all improvements have been completed. If an investor acquires an interest in a QOF that invests in a mid-core property that provides its investors with a measly 5% annual return after the property is stabilized, and the investor could acquire an interest in an asset that provides a 15% return, any deferred capital gains benefit will be lost after only a couple of years and the investor would likely be locked into the property for 10 years or more. A better investment opportunity would be the property that provides the higher return despite that the investor is using post-tax dollars. Note also that the values of properties located in OZs have been increasing at a higher rate than in other areas so the assets are likely artificially inflated. This aspect will diminish the investor’s return further.

Using the example from above, imagine our investor has a choice between paying the capital gains taxes now and investing in a development that will have a 15% annual return, or deferring the gains and receiving a 5% annual return. Assuming that the investor would be subject to a 30% capital gains tax and would be investing $700,000 in the non-OZ investment, that $700,000 would be worth about $1,224,000 after five years, whereas the investment in the QOF would only be worth $1,216,000 after five years. Thereafter, the investment in the non-OZ property would greatly exceed the value of the investment in the QOF and it wouldn’t be restricted in the same way that an investment in a QOF would be. It’s easy to see very quickly the benefits of the no-OZ investment.

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Types of Gains

The type of gains that may be deferred is also limited. The general consensus is that short term capital gains will not be eligible for the tax free benefits. Depreciation recapture will also be ineligible so most gains from real estate investments will not have the same benefit as, for example, the sale of stock.

Considering all of these factors, an investor should compare any investment in a QOF with what the investor could reasonably receive from an investment made with post-tax dollars in a property located outside of an OZ. The investor may determine that the investment in the QOF is not worth the hassle or the potential return despite the tax savings. An investor should also consider how changes in the law may affect its investment and the gains that it may receive.

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Non-Real Estate Investments‍

There is, however, one category of assets that could be extremely beneficial for investors. Qualified investments are not limited to real estate. If an investor acquires business assets that will be located in an OZ and those business assets have a direct trade of business use for a business located in the OZ, and the assets themselves will be located in the OZ for the length of the investment, the gains from the business assets will be tax exempt. For example, if a QOF leases out space in a building located in the OZ, starts a business in the premises and invests substantial capital in the business, and the business takes off, the investor would have a very profitable tax exemption. Imagine if Facebook opened its headquarters in an OZ in the early days and kept a substantial portion of its assets in the OZ, the investors in Facebook would potentially be able to sell their stock without paying federal capital gains tax. Many tech start-ups are taking advantage of this treatment by opening up their businesses in an OZ.

An investment in a QOF could defer a substantial amount of taxes. The ultimate question that the investor should ask is if the underlying asset being acquired would still be purchased if it were not located in a OZ. If the answer is yes, the investment in a QOF would be icing on the cake for an otherwise profitable enterprise, and the project will likely attract far more capital than a non-OZ project. If the answer is no, the investor should consider its alternatives and determine if the benefit it receives by investing in a QOF is outweighed by the meager return, the overvalued asset, the length of time that the investor would need to hold the asset, and the hassle that the investor would need to deal with in connection with investing in a QOF.

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For more information, please see the following links:

Additional Description of Opportunity Zones from Minnesota DEED.

Summary from the U.S. Dept. of the Treasury.

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