Opportunity Zones were the big news in commercial real estate when they came into being in 2017 as a result of political alchemy. Conceived on a bipartisan basis at the Federal level, they looked like a win-win. Real estate investors could save on taxes, while neglected and impoverished neighborhoods could benefit from an influx of investor capital.
It sounded good on paper, but you know what they say about the best-laid plans of mice and men. Commercial real estate Opportunity Zones faced a rougher-than-expected rollout. They failed to meet lofty investment projections as brokers, politicians, and industry cheerleaders tried to get investors excited about investing in markets traditionally written off as “war zones,” money pits, bad investments.
Still, commercial real estate Opportunity Zones enjoyed a surge of popularity as 2019 tax-saving deadlines approached. Now that the economy has ground to a halt in the face of a global pandemic of COVID-19, the future of these investments is more in doubt than ever. What can investors, as well as the commercial real estate industry, expect the future to hold for Opportunity Zones?
What is an Opportunity Zone?
The purpose of an “Opportunity Zone” is to attract private commercial real estate investment in low-income neighborhoods, historically ignored by ambitious investors and left to fall into decline. The idea was to offer tax incentives for investors to inject capital into underserved neighborhoods, make improvements, and (hopefully) improve distressed properties and raise the standards of living.
How Did Opportunity Zones Come Into Being?
The commercial real estate Opportunity Zones that exist today are a creation of the Tax Cuts and Jobs Act of 2017, signed into law by President Trump on December 22 of 2017 to take effect fiscal year 2018. It was the farthest-reaching Federal tax reform act since 1986.
Senators Cory Booker (D-NJ) and Tim Scott (R-TN) proposed Opportunity Zones in the form that ended up in the final law. Rep. Ron Kind (D-WI) supported the idea in the House, with support from the Economic Innovation Group run by Sean Parker, the Napster/Facebook entrepreneur famously portrayed by Justin Timberlake in The Social Network.
When the law passed, governors were allowed to nominate census tracts within their state as opportunity zones, to be ratified by the Department of Treasury. Up to 25% of “low-income” census tracts could be designated as commercial real estate Opportunity Zones. To qualify as “low-income,” a census tract would have to either have:
- 80% the median income of the surrounding census tracts.
- Have 20% or more of households living below the poverty level of income.
The Treasury Department ratified the first Opportunity Zones in April of 2018. To date, over 8,700 Opportunity Zones have been designated, including census tracts in all 50 states, plus American Samoa, Guam, the Northern Mariana Islands, Puerto Rico, and the U.S. Virgin Islands. Commercial real estate Opportunity Zones cover roughly 12% of the U.S. landmass.
What Are the Tax Advantages of Investing in an Opportunity Zone?
Three main tax advantages are available to investors by placing capital in Opportunity Zones or Qualified Opportunity Funds (QOF), a fund that directs investor capital into Opportunity Zone real estate.
1. Deferral of Previous Capital Gains
Many real estate investors are already familiar with the tax-deferral benefits of real estate through the 1031 exchange. This rule allows investors to defer paying capital gains if they reinvest proceeds from a property sale into a “like-kind” property (residential for residential, commercial for commercial, etc.). If investors keep flipping sale proceeds into new like-kind properties, they can defer these capital gains taxes indefinitely.
Opportunity Zones kick this benefit up a notch by allowing investors to flip proceeds into non-like-kind investments (residential to commercial or vice-versa), with gains not taxed until 2026 or at the time of sale.
2. Basis Step-Up of Capital Gains
Capital gains are calculated relative to a basis. This basis is usually the acquisition costs and immediate repairs. If an investor buys a property for $1 million and spends $500k to fix deferred maintenance, the basis is $1.5 million. If the investor sells the property for $2 million, that basis tells us that the investor realized a $500k taxable gain.
If an investor leaves money invested in an Opportunity Zone or Opportunity fund for at least five years, that basis increases by 10%. In the above example, this would increase the investor’s basis 10% up to $1.65 million, leaving him/her with a taxable gain of only $350k. This could result in big tax savings without any extra expenditure.
If the investor leaves capital in the Opportunity Zone or Fund for seven years, the basis increases by 15%.
3. No Taxes on New Gains
The real savings kick in after ten years. If the investor leaves capital in the Opportunity Zone for ten years or more, all new capital gains are excluded from taxation.
How are Opportunity Zones Affecting the Commercial Real Estate Market?
The new landscape created by Opportunity Zones was expected to open up floodgates of capital into distressed and impoverished neighborhoods. Economic forecasters in and out of government projected a total of $12 billion in private investment to find its way into Opportunity Zones and Opportunity Funds.
By early December of 2019, investments in Opportunity Zones had lagged far behind projections at only $4.46 billion invested. The 2017 law had a deadline built in, however—in order to take advantage of the 15% basis increase, investments had to fund by the close of 2019. December 2019 saw over $2 billion flood into Opportunity Zones to take advantage of the savings before the cutoff dates, resulting in a total of $6.7 billion invested by January 2020.
Real estate lenders are keeping a close eye on the Opportunity Zone landscape as well. The debt market stands to see substantial opportunities open up in the placement of smaller or middle-market construction and bridge loans in Opportunity Zones where no viable opportunities or demand existed before.
Opportunity Zones are still in their infancy. Whether or not these infusions of capital result in increased property value and living conditions remains to be seen.
What does the COVID-19 Pandemic Mean for Opportunity Zones?
The designation of the novel coronavirus outbreak as a global pandemic has rocked the world to its core. In addition to the massive loss of human life and ensuing curtailment of freedom, travel, and human interaction, financial and monetary markets have reacted with seismic changes. Investors with capital in Opportunity Zones or QOF may be wondering how the pandemic stands to affect their investments.
Owners of Opportunity Zones Property
Owners of property in Opportunity Zones will probably see their plans minimally derailed by the pandemic. Most of them have time windows ranging from five to ten years before statutory benefits kick in. By then the pandemic is expected to have subsided with due to vaccines, treatments, and increased hospital capacities.
Tenants living in opportunity zones are likely to qualify for federal relief funds, helping them make rent obligations. Their cash flow and solvency could be further alleviated due to loan forbearance, widely available as lenders try to avoid flooding their balance sheets with non-performing assets.
Opportunity Zone Construction and Development Projects In Process
Construction and development projects in opportunity zones are typically designated as Qualified Opportunity Zone Businesses (QOZB). A QOZB faces a rigorous series of deadlines outlined by the U.S. Treasury Department.
The financial chaos precipitated by the pandemic means that most of those deadlines will go up in smoke. Mass layoffs and the widespread shutdown of businesses will almost certainly result in the work required by the deadlines to be postponed.
Investors with capital invested in QOZB should resist the temptation to panic. Several relief clauses are contained in the regulatory guidelines released by the Treasury Department in 2019.
For example, if the QOZB maintains a working capital safe harbor (WCSH), the provisions of that WCSH are limited to 31 months. However, the 2019 guidelines stipulate that the provisions can be extended 24 months in the event that the Opportunity Zone is declared a disaster area. 27 states and territories have been declared disaster areas, roughly corresponding to the states that have experienced the most severe outbreaks and resulting restrictions.
QOF Facing a Penalty if they Fail an Asset Test
A QOF earns its designation by holding at least 90% of its assets in the form of capital invested in an Opportunity Zone. It faces stiff penalties if it falls below this 90% mark. QOZBs, which don’t face this “asset test,” may be downgraded to QOFs if they fail to requalify as a QOZB due to the pandemic. Will they face penalties?
The Treasury Department’s guidelines allow for exceptions to me made to penalties due to “reasonable circumstances.” They do not go into any detail about what might constitute such circumstances.
One would think that if a global pandemic didn’t constitute a reasonable circumstance for a penalty waiver, nothing would. Still, investors should proceed with cautious optimism if they find themselves in the position of defending themselves against unexpected asset test penalties.
Despite the slow rollout and the red tape that always accompanies government incentives, Opportunity Zones, QOFs, and QOZBs still represent a significant opportunity for investors to enjoy tax savings on long-term commercial real estate investments. Only time will tell if they elevate the quality of life in declining neighborhoods, as envisioned by the laws that created them.
The COVID-19 novel coronavirus pandemic may make it harder to clear the regulatory hurdles imposed by the Treasury Department on Opportunity Zone investments, but both explicit and implicit relief clauses could be activated to relieve the pressure. At the end of the day, everyone wants these projects to succeed—not just the investors but also the lenders, the brokers, the government, and most of all the people who live and work in the Opportunity Zones.