The Real Opportunities in Opportunity Zones

The Real Opportunities in Opportunity Zones

By Jim McGrogan, SVP, Commercial Real Estate

The 2017 Tax Cuts and Jobs Act did more than rewrite long-established tax code. It created a new program for commercial real estate investors, owners and developers seeking to shelter capital gains.

Whether a capital gain is long-term or short-term, or realized through the sale of real or personal property, you now have the option of reinvesting that gain in an Opportunity Zone (OZ) through a Qualified Opportunity Fund (QOF).

The potential tax benefits are threefold:

  • Capital gains deferral on just the realized gain portion of an appreciated asset sale.
  • Step-up on the tax basis depending on when the sale is made and how long the qualified OZ program investment is held.
  • Capital gains exclusion on the appreciation of the reinvestment in the QOF.

For developers specifically, the program is expected to create a steady stream of long-term liquidity, especially for affordable housing projects.

Opportunities for Improvement

Opportunity Zones are geographic in nature. There are over 8,700 of them scattered across the U.S. along with all of Puerto Rico. The zones were chosen by each state’s governor and include distressed urban areas and underdeveloped rural parcels, along with isolated pockets within economically prosperous areas.

The potential for social impact from QOF investments is expected to be significant due to the dollars theoretically available for investment in them. U.S. investors are estimated to be holding $6.1 trillion in unrealized gains that would qualify for investment in the program.

The property to be developed under the OZ program needs to be tangible and used in trade or business, since key objectives for the program are to create sustainable jobs along with affordable housing. The purchase date must occur after 2018 and the original use of the property needs to be original to the QOF or represent improvements that are at least equal to the value of the property’s purchase. Those improvements must be made within 30 months.

Not a Replacement for 1031 Exchanges

While both OZ investing and 1031 Exchanges offer tax deferral on gains, they differ significantly on how those deferrals are accessed and treated. Here’s a high-level summary of the differences based on what is currently known about OZ investing. Consult with your tax advisor about the advantages of each, given the specifics of your situation.

 

Opportunity Zone

1031 Exchanges

What taxes may be deferred

Capital gains from real and personal property

Like-kind gains on real property.

Restrictions on the reinvestment of realized gains

Only the amount equal to the actual gain—or a portion of it—may be reinvested in a Qualified Opportunity Fund. That gain can be long-term or short-term. It may also be from a partnership interest or from the sale of corporate stock.

The proceeds of sale need to be rolled over.

 

Reinvestment is geographically restricted to Qualified Opportunity Zones and may only be made through a Qualified Opportunity Fund.

May reinvest anywhere through a qualified intermediary.

Timeline for tax benefits

Time limit for gaining full advantage on tax benefits:

  • Taxes on capital gains deferred until 2026; at that time there is a 10% reduction of the liability for investments held by the Qualified Opportunity Fund for five years.
  • Gains that have been invested for seven years receive a 15% reduction.
  • Gains on subsequent appreciation are tax-free after an investment period of at least 10 years (excludes the original amount invested, however) and applies to assets held until 2047.

May never have to realize gain either by not selling or by engaging in a series of future 1031 Exchanges.

Identification of reinvestment

No limit for identifying the next investment, but reinvestment in a Qualified Opportunity Fund needs to be made within 180 days.

Seller has 45 days to identify a specific property for purchase and 180 days to close on it.

Acceptable means of investment

Through Qualified Opportunity Fund only; however, you may self-certify as a Qualified Opportunity Fund.

Seller needs to reinvest directly into a similar type of real asset.

Considerations Before Committing

Whether you are an investor or a developer, here are some of the things you may want to consider before becoming involved with a project:

  • Will the QOF be able to find enough projects to invest in? QOF investors are hoping for tax deferrals until 2026. With the amount of money already in QOFs, there is concern the demand for viable OZ projects will exceed the supply.
  • What is the risk for unintended consequences? The underlying goal for this program is to revitalize areas throughout the country, for those currently living in them. Developers are encouraged to work with neighborhood groups to ensure that their projects do not create unintended consequences and local animosity.
  • Is the necessary infrastructure in place to support planned development? In truly distressed or rural areas, an understanding is needed regarding the local municipality’s commitment to provide infrastructure and public services.
  • How long can you comfortably stay involved? The tax benefits require a longer holding period than many commercial real estate investors are used to. That may necessitate looking at deals a bit differently to ensure enough capital is reserved to fund operations and management-related expenses.

Stay Updated

The 35-day government shutdown in early 2019 delayed drafting of final guidelines regarding the OZ program. But the clarifications are expected soon. Once available, it’s widely expected that the money that has been gathering in the QOFs will be quickly deployed.

Until those final guidelines are released, it may be a good time to dig in to fully understand the program’s nuances versus its benefits, along with the location of the zones and types of projects available for investment. Exploring the potential consequences of your involvement with your tax professional is also advised. It could make taking action once the guidelines are released that much easier. Speed, after all, is relevant. The program’s greatest benefits may accrue to those who can invest sooner rather than later.

Contact Us:
Jim McGrogan
SVP, Commercial Real Estate

The views expressed by the author are not necessarily those of Fifth Third Bank and are solely the opinions of the author. This article is for informational purposes only. It does not constitute the rendering of legal, accounting, or other professional services by Fifth Third Bank or any of their subsidiaries or affiliates, and are provided without any warranty whatsoever.