New Guidelines Make Opportunity Zone Investment Rules Clearer, More Attractive

Regular readers of this space are already aware of opportunity zones — the specific tracts of land throughout the United States in which the federal government offers tax incentives to invest. But it’s worth taking another moment to understand exactly where these tracts are, which benefits the tax man is offering and what the potential downside could be.

As for where they are, they’re all over. They’re urban and rural, in states and territories. There are more than 8,700 separate opportunity zones, and they comprise roughly 11% of the U.S. land mass.

Opportunity zones were created as part of the Tax Cuts and Jobs Act of 2017, and their establishment was the one part of the tax reform package which garnered the most bipartisan support.

By definition OZs are, according to the Internal Revenue Service, “economically-distressed”. But there’s distressed and there’s distressed. You’ll find blighted inner-city neighborhoods as well as underdeveloped swaths of isolated Rustbelt towns. You’ll also find plenty of Indian reservations, which are among the poorest ZIP codes in America. But you’ll also find a slice of midtown Manhattan. It’s in the 50s west of 10th Avenue. Sure, that area is still referred to as “Hell’s Kitchen,” but now it’s more well known as the neighborhood southwest of the Trump International Hotel and Tower. I don’t know how many other opportunity zones have both BMW and Mercedes-Benz dealerships, but that one has them both — plus Audi. But regardless of what legislative alchemy went into defining “economically-distressed,” the Community Development Financial Institutions Fund now administers the Opportunity zone program as a fully constituted agency of the U.S. Treasury Department, and savvy investors are looking for ways to leverage the tax breaks afforded by this new initiative.

Pluses and Minuses

To start with, all investments must be made through a qualified opportunity fund — you can’t just pour money into a project located in an opportunity zone and expect to realize any tax advantage. Also, the tax benefit isn’t for everyone, but rather it’s geared to those reporting capital gains. You have 180 days from the time you realize those gains to find a QOF in which to invest. While individuals and businesses realize capital gains every day of the year, in some cases you don’t know if you’re reporting a net capital gain or net capital loss until you do your taxes. In those cases, you have 180 days from December 31 of the filing year, so don’t be surprised if there’s a gold rush to park money in QOFs in June.

There are three main benefits of deploying your capital gains toward QOFs. The first is that you can defer paying those taxes for seven years. Next, there’s an opportunity to reduce the taxable amount of the capital gain. Say you came into a net $100,000 from the sale of stock and you funnel it into a QOF. If you keep it there for those seven years, then you won’t be taxed on 15% of the gain. So, when the tax bill finally comes due, you’ll have to pay taxes on $85,000 rather than $100,000. If you can only keep your money there for five years, then the taxable amount is reduced by just 10% and you’ll be taxed on the other $90,000.

Lastly, as an incentive to lock your money into the project, any gains you make from selling your interest in the QOF are tax-exempt providing you stay in it for at least 10 years. But there are potential downsides. First, there is the opportunity cost. Money invested in QOFs is money that could be invested in other tax shields, such as the New Markets Tax Credit, which might sunset at the end of this year — or be renewed indefinitely; nobody really knows.

And let’s be real: Tax treatment is only one element of what constitutes a good investment, and it’s usually not the only one. Presuming you would still want to invest your capital gains in multifamily real estate, you might prefer to go with some Class A high-rise that doesn’t need tax incentives to make it an attractive project.

Another consideration to weigh is liquidity. You can’t, generally speaking, have both the tax deferral and periodic cash distributions. The QOF can get around this by refinancing the underlying investment and sending that freed-up cash the investors’ way, but it might be best to only put in money that you don’t need to see for 10 years.

New Rules

Some investors might have been sitting on the sidelines the past few months, wondering which would come first: Treasury’s long-awaited update to its guidance governing OZ investing, or the 180th day after December 31, 2018, when the window will close for finding homes for a lot of net capital gains. The guidelines won the race April 17, so we’ll see what happens now.

It specifies that a QOF could own multiple assets and sell off individual properties in its portfolio.  Additionally, “the guidance makes it easier for funds to ensure compliance with the requirement that a fund has 90 percent of its assets invested in Opportunity Zones and expands the working capital safe harbors,” according to a Treasury press release. “The proposed regulations also provide clarity on treatment of gains on long-term investments, ownership and operation of the business, and what constitutes Qualified Opportunity Zone Business Property.”

Facts About the new Opportunity Zone Guidelines

  • Investments can only be made via qualified opportunity funds, partnerships or corporations set up specifically for investing in eligible properties located in OZs. LLCs are permitted.
  • The bar to establishing a QOF is not high. It involves self-certifying by filing Form 8996 with the IRS.
  • A taxpayer can transfer property other than cash as an investment to a QOF, but might not be able to take advantage of all tax incentives.
  • A list of qualified opportunity zones can be found here.
  • A map of qualified OZs can be found here. (Go to the Layers icon on the menu along the right side of the screen, select “Qualified Opportunity Zone Tract,” deselect all other options and zoom in to your region of interest. Opportunity zones will be shaded in blue.)

Source: IRS, CDFI

[Caption Opportunity zones in greater New York. Credit: U.S. Treasury Department]
[Caption Opportunity zones in greater New York. Credit: U.S. Treasury Department]
[Caption Opportunity zones in the Deep South. Credit: U.S. Treasury Department]
[Caption Opportunity zones in the Deep South. Credit: U.S. Treasury Department]
[Caption Opportunity zones in Puerto Rico and the U.S. Virgin Islands. Credit: U.S. Treasury Department]
[Caption Opportunity zones in Puerto Rico and the U.S. Virgin Islands. Credit: U.S. Treasury Department]