Opportunity Zones (OZs) have been a widely discussed topic in 2019 as part of a new tax law intended to harness the $6.1 trillion of available unrealized capital gain monies and encourage economic development in over 8,700 designated low-income areas nationwide in real estate and business investments. To get the maximum tax benefit from an OZ investment, investors must invest by the end of 2019—ever nearing.
The law allows investors who recognize capital gains, for instance, from a stock sale to invest those capital gains into a qualified opportunity fund (QOF) and to defer paying capital gains tax for several years. Additionally, investors get a 10% step-up in tax basis on the original capital gains if they hold the investment for five years and a 15% step-up in basis on the original capital gains if held for seven years. Also, an investor has only 180 days from the sale of the original security to invest in an opportunity fund and access the tax break.
The deferred tax, however, is due by Dec. 31, 2026, which is seven years from the end of 2019. So, investors who are late to enter the game and invest in an OZ after the end of this year won’t be able to get the maximum 15% tax reduction on the original capital gains.
What are investors doing to take advantage of the little time left in 2019 to maximize the incentives? According to Novogradac, a national accounting, consulting and valuation firm that’s heavily involved in the OZ tax incentive, there are more than 230 opportunity funds currently available with more than $62 billion in investment capacity.
Real Estate Projects
When the first tranche of OZ regulations was released last October, those regulations dealt with open issues helpful primarily to real estate developers and investors. The result was the start of an OZ marketplace for real estate development projects. On the fund side, the experienced real estate funds launched OZ-targeted funds, because they could more easily adapt their business models to take advantage of the OZ tax incentive. Expert developers of institutionally sized real estate projects became attractive to those OZ real estate funds. According to some, “an estimated $20+ billion is currently being raised by funds nationally, for the purpose of investing in Opportunity Zone product” and groups of investors range from “traditional institutional investors such as Normandy Real Estate Partners and RXR Realty, to specialty investment managers and private equity such as EJF Capital and Virtua Partners.”
What is more is the “favored product for Opportunity Zone investors is unused or underdeveloped land, vacant buildings, and low-quality Class C commercial and multifamily properties.” For those who were early investors in OZ land projects, land values in OZs have increased by 20%, on average.
Following the second set of regulations, interest in investing in operating businesses using the OZ tax incentive started to take shape. Investors in OZ businesses may have the potential to generate better investor returns than OZ real estate investments by the nature of venture or private equity investing compared with real estate investing. As with venture investing, the target returns for OZ business investing should be at least 10 times the investment. In contrast, the average real estate investments target returns of two to three times the investment. The optionality and possibilities for business investments are vast. Tech startups, small businesses and workforce training programs are all examples of business investments; however, there are some limitations, such as liquor stores, casinos, golf courses and country clubs, which don’t qualify. Locating an operating business in an OZ can make a good investment into a great investment, but it will never make a bad investment into a good investment. Investors should work with experts and get sound advice as they navigate their options. These professionals should also have expertise in OZs and understand the specific type of investment being considered. But what can be done before Dec. 31, 2019?
Many OZ professionals believe there is and will continue to be a rush to get capital invested before the end of this year to get the maximum benefit. Moreover, many professionals think losing the additional 5% step-up in basis isn’t worth the possible risk of investing in suboptimal deals. Quite simply, the OZ incentive shouldn’t drive an investment decision. Moreover, it’s worth reminding nervous investors that the OZ tax incentive doesn’t end on Dec. 31, 2019. This date simply means that some investors can’t get the full 15% benefit, and the 10% benefit will be available for another two years.
OZ experts rightly caution that while a 10-year tax strategy might be enticing, it would all be for naught if the underlying investment doesn't perform well. Investing $1 million in capital gains in a QOF that loses money over the 10-year period is simply a loss. Even a fund that breaks even is a loss, considering the opportunity cost of keeping one’s money tied up for a decade shouldn’t be a reason for the tax tail to wag the dog. As with any investment, an OZ deal, be it real estate or a business, should produce returns without the added tax benefits. The tax benefits are a bonus to a deal with strong partners and excellent returns.
Meg E. Dodge is a principal and co-founder of Indigo 8 Advisors, which works with clients to develop and manage a customized Opportunity Zone investment strategy aligned to their financial and values-based objectives.