The opportunity is striking for real estate investors, thanks to the Tax Cuts and Jobs Act of 2017. A provision in the law allows investors to benefit from preferential tax treatment when investing in communities in economic difficulty.
âThe basic idea is that the governors of each state designate specific geographic areas as areas of opportunity, based on economic needs and desired growth paths,â said Derek Uldricks, president of Virtua Capital Management in San Diego. He says the program is designed to encourage investors to inject capital into these areas of opportunity, potentially stimulating economic growth.
Blake Christian, a certified public accountant in Long Beach, Calif., Said investors would pour hundreds of billions of dollars into the more than 8,700 economically troubled communities identified by the census in the United States. In return, they could reap generous tax rewards.
“The Opportunity Zone program allows individuals and businesses to liquidate a wide variety of valued fixed assets and reinvest all or part of the gain in qualified opportunity funds within 180 days of triggering the gain,” Christian said. “The gain can then be deferred until December 31, 2026.”
In addition to deferring gains, taxpayers can reduce their recognized gain by 10% after holding the asset for five years, and an additional 5% after holding it for seven years, says Christian. The biggest benefit comes at the 10 year mark.
âAt this point and in the future, the investor will be exempt from any gain accrued after the initial reinvestment,â he says.
Christian offers an example of what this benefit is worth. Under these guidelines, an investor who invests $ 1 million in an opportunity fund in 2018 and sees their investment appreciate to $ 1.8 million by 2028 could sell at any time thereafter without pay federal income tax on product greater than $ 1 million.
“Ultimately, the tax benefits act like grants,” Uldricks says, “turning projects that were not economically feasible into projects that are now feasible, while also speeding up the inflow of capital for real estate development.”
Opportunity zones are new territory for investors. Here’s what you need to know if you’re thinking of getting started.
The investment structure is important. To benefit from the tax incentives, investments in Opportunity Zones must be made through a Qualified Opportunity Fund, which can be established as a partnership or corporation.
After the sale or exchange of an asset, “the taxpayer renews cash equal to his gain against a stake in the fund,” says Erik Loomis, tax partner at Cox, Castle & Nicholson in Los Angeles. “The fund must then own qualifying opportunity zone property, which is either another company or a tax partnership that operates a qualifying opportunity zone business, or the fund invests directly in the qualifying assets.”
Loomis says it’s important for investors to note that the fund you invest in owns the qualifying property, “because it is the taxpayer’s interest in the fund that receives the benefit under the law, and not the underlying ownership of the qualified opportunity area “.
He goes on to say that “while the law proposes a very simple transfer of earnings in this interest, the devil is very much present in the details as to the exit strategy with regard to the interest in the fund”.
Not all goods are eligible for tax benefits. Know the rules of what you can – and cannot – invest in with opportunity funds. âAn opportunity zone fund is required to invest, directly or indirectly, in an income-generating company located in a qualified opportunity zone,â says Jamie Null, lawyer at the global London-based law firm Eversheds Sutherland. .
The eligibility of a business may be subject to interpretation, depending on its use.
âIf the fund owns an apartment building and rents it triple net, is that a business? Maybe not, âLoomis says. On the other hand, “if the fund owns and operates an apartment building instead, it has much better reason to own qualifying properties in the opportunity area.”
Likewise, if a fund owns a shopping center, it most likely qualifies, except for certain types of property that might be present. There are specific categories of businesses that cannot benefit from indirect investments, including private and commercial golf clubs, tanning salons, country clubs, massage parlors, hot tubs, gaming establishments. and liquor stores.
Christian says areas of opportunity can also include developed or undeveloped land investments. Regarding the list of excluded companies, he notes that “the law simply prohibits investing in companies that operate in such industries, but an opportunity zone fund can still start such companies”.
Investors should focus on long-term ownership when choosing properties, says Scott Meyer, senior director and chief investment officer of Kairos Real Estate Advisors in South Miami, Florida.
âAn investor cannot benefit from the tax incentives if he plans to buy a stabilized asset, apply a new coat of paint to it and stop it,â Meyer said. Properties must pass the Substantial Improvement Test, Excluding Land Value, established by the Internal Revenue Service.
To pass the test, Meyer says, investors must double their adjusted base in their investment after the initial purchase and for any 30-month period in which they hold a Qualified Opportunity Zone property.
Think long term and keep the risk in perspective. Investing in distressed properties is not a new concept, but investors in opportunities areas shouldn’t ignore due diligence. This includes choosing the right fund structure, such as a real estate investment trust.
âLimited liability companies taxed as partnerships are likely to produce the best tax results during the operating phase, as well as at the time of divestiture,â Christian said. âReal Estate Investment Trusts are an authorized legal structure for Opportunity Zone funds, so REITs will gain more benefits by investing in Opportunity Zone properties. “
Null says more sophisticated investors may not understand that some tax benefits found in typical investments, such as loss of depreciation protection income, may not be available for qualified investments in areas of opportunity. Taxpayers should also be aware of state tax consequences and whether their state complies with federal tax rules for opportunity funds.
In terms of risk, Uldricks says investing in areas of opportunity is not materially different from other types of real estate investing. He thinks the capital will go primarily to founding real estate development, which has a unique set of risks. As such, “it is imperative to partner with program sponsors who are sophisticated in the underlying investment strategy of the fund or asset.”
A final consideration is how the Opportunity Zones fit into your larger portfolio image and your investment window.
âTo take full advantage of the tax benefits, investors must invest in the opportunity zone fund for 10 years,â says Uldricks. âTherefore, it is important that investors carefully consider their liquidity needs before investing. “