Did you know that real estate developers have a new source of investment opportunity for their projects, established by the Tax Cuts and Jobs Act of 2017?
Since its creation, the federal Qualified Opportunity Zone (QOZ) program has been a frequent topic of conversation in the worlds of real estate and taxes. So what are opportunity zones, and how do they apply to the real estate industry?
Growth Incentive Where It’s Needed Most
According to the United States Treasury Department, the QOZ program was established “to spur investment in distressed communities throughout the country.” By encouraging investment in underserved and low-income communities, opportunity zones have the potential to create jobs and facilitate economic growth in areas that are often overlooked by real estate investors.
Beginning in early 2017, governors in all 50 states and U.S. territories, plus the mayor of Washington, D.C., were able to nominate zones within their states, defined by their census tracts, to be designated as opportunity zones (OZ). By the March 21 deadline of that year, the U.S. Treasury received over 8,700 submissions, ranging from a few city blocks to entire towns. Submissions covered all 50 states, Washington, D.C. and five U.S. territories. On June 14, the Treasury announced all 8,700 zones submitted had been certified.
Although the program is designed to be accessible to all who want to participate, there are certain requirements and restrictions that must be adhered to in order to qualify for the tax benefits.
All investments in QOZs must be made by an Opportunity Fund, or “O Fund.” Anyone can form an O Fund, but it must be structured as a partnership or corporation that is created specifically to invest in a QOZ, and the Fund must be self-certified on its federal tax return.
To illustrate how the program works, let’s suppose an investor has a $1 million gain in stocks and decides to sell. Let’s also then assume the investor is in a 20 percent tax bracket, totaling $200,000 in capital gains tax. Instead of paying the tax, the investor reinvests the $1 million in an Opportunity Fund. By doing so, the tax due on the gains is deferred until the earlier of selling the investor’s interest in the Fund or December 31, 2026.
If the investor holds the investment for 5 years: That payment of $200,000 is completely deferred, plus the investor gets a 10 percent readjustment (also known as a step-up) on the original gain deferred. In this case, the investor pays $180,000, saving $20,000 in capital gains taxes.
If the investor holds for 7 years: An additional step-up in original basis of 5 percent is applied, and the capital gains tax bill goes down to $170,000, saving $30,000 on the taxes owed from the investor’s initial gain.
If the investor holds for more than 10 years: The investor pays ZERO capital gains tax on the appreciation of that asset.
OZ vs. 1031
Since the program was created, real estate investors have speculated how opportunity zones compare to a 1031 exchange. Some have called the 1031 exchange “a perpetual deferral until the ultimate exit” since, when the time comes for the investor to sell the asset—no matter how long it’s been held—the investor will be culpable for the gains. This leaves most investors holding their real estate until death. With opportunity zones, investors do not have to die to eliminate the capital gains tax burden. After 10 years, the entire basis automatically steps up. This includes saving taxes on any depreciation of the asset—unlike the 1031, where an investor may have to pay “depreciation recapture.” In essence, an investor can use depreciation to offset income in the rest of the portfolio.
Due to their nature, opportunity zone investments can allow more creative use of capital. With a 1031, usage is more black-and-white in that the initial investment is locked in along with the capital gains accrued over the life of the investment, and it all goes into the rollover asset chosen next.
Currently, qualified opportunity zones are only a federal program, but states will likely be reviewing their tax codes to identify ways to build off the federal government’s groundwork. For example, states that want to make their zones more attractive to investors might ease their state capital gains obligations by duplicating the federal program.
Unlike other economic development programs, rather than being limited to real estate investments, the opportunity zone program’s incentives are open to almost any business that will deploy capital and operate within the designated zone. However, certain “sin” businesses such as bars, gambling establishments and tanning salons are not eligible to participate.
As of this publication, only the first round of proposed rules governing opportunity zones have been published. A second set of proposed rules to answer issues and questions that the first did not address are anticipated in early 2019. These further rules are expected to clarify other aspects of the program, including reinvestments by O Funds and defining “original use” of QOZ business properties. The final rules are not expected until spring 2019, following a public hearing.
There are still many questions surrounding opportunity zones, but it appears they have the potential to be very valuable to not only real estate investors, but also to the businesses and communities within the zones. IREM will continue to monitor the issue and make sure the concerns of IREM Members are represented during the rulemaking process. If you have any questions about opportunity zones or other issues facing the real estate management industry, please contact us at IREMLegislation@irem.org.