What is the opportunity in Opportunity Zones?
In early 2018, few people outside of specialty economic development and real estate finance circles had heard of Opportunity Zones. Today, there is a national rush to raise money to invest in Opportunity Zones as the incentives are being cited as potentially the largest economic development initiative in our country’s history. But what exactly are Opportunity Zones, and how did they come to be the most talked-about topic in real estate in 2019?
Slipped inside the 2017 federal tax overhaul, the Opportunity Zones incentives were the brainchild of the Economic Innovation Group, a public policy-focused nonprofit. The intents of the incentives are to “free up” the estimated $2.3 trillion in capital that currently is subject to capital gains taxes and to nudge investors to invest that capital on a long-term basis in low-income communities.
The areas now designated as Opportunity Zones were nominated by individual state governors and designated by the Treasury in the first half of 2018. Each state could nominate up to 25% of its eligible low-income census tracts as Opportunity Zones. While each state could follow its own process in selecting the particular tracts to nominate, each tract had to be a low-income community as defined by the federal New Markets Tax Credit Program, which is a community with a poverty rate of at least 20% or that has a median family income that does not exceed 80% of the area median income.
The law offers three distinct benefits related to federal taxes. If an investor realizes a capital gain, they have 180 days from the date of the realization to invest the realized gains in a Qualified Opportunity Fund (QOF) and earn the following benefits:
Temporary deferral of tax on previously earned capital gains. Deferral of capital gains until the earlier of Dec. 31, 2026, or the sale of the investment.
Step-up in basis of previously earned capital gains invested. A portion of the deferred gain may be subject to permanent nonrecognition:
10% reduction in the gain if the investment held for 5 years and if investment is made by Dec. 31, 2021.
15% reduction in the gain if the investment held for 7 years and if investment is made by Dec. 31, 2019.
Permanent exclusion of taxable income on new gains. The subsequent gain from increases in the value of a qualified opportunity fund interest will be completely exempt from federal capital gains tax if the investor holds their interest for at least 10 years.
Independent assessments of the impact of Opportunity Zone incentives show the potential for it to improve the after-tax internal rate of return on a given investment by as much as 30%-40%.
There are a few factors to take into consideration. Opportunity Zone Funds are considered private alternative investments and share many risks with other private alternative strategies. For example, most Opportunity Zone investments will likely be in private real estate in noncore markets or in early-stage private companies, which are inherently speculative and illiquid. The requirement to remain invested for at least 10 years to achieve the maximum tax benefits means that investors are expected to have a very long time horizon when investing in QOFs.
There also are a number of investment considerations that are unique to Opportunity Zones. Opportunity Zones are low-income areas, which means areas of high poverty that are often located outside of major hubs of economic activity. Not only do these characteristics add to the speculative nature of the investments, but these investments also may be subject to highly localized and idiosyncratic risks. Opportunity Zone fund investments also have a higher regulatory or compliance risk. They are subject to a new and unique set of regulations that may be difficult for a developer or entrepreneur to meet, especially if they are somewhat inexperienced.
Before making an investment in Opportunity Zones, here are a few additional things to consider:
Know thyself! First, make sure you thoroughly understand your risk tolerance and tolerance for liquidity, and you are comfortable with the particulars of the law and their ramifications for your tax and overall liquidity position.
Seeking deal flow? Make some calls. Many investors have an interest in investing in Opportunity Zones but aren’t quite sure how to get connected with opportunities. Law firms and accounting firms are a great source of information, as they are often working directly with developers and entrepreneurs and can put you in touch with them.
Get some guidance! Finally, the Opportunity Zone incentive can make a good deal better, but it does not turn a bad deal into a good deal. In many cases, the expected financial benefit of the incentive may not outweigh the incremental risks of a given deal or the difficulty of investing in it. The quality of the deal, its benefits and its risks likely are difficult for a nonprofessional to discern, and guidance from advisers is a must.
Lucas Mansberger is an investment strategist and senior manager selection analyst for Greenleaf Trust.