Many investors are weighing up the new Opportunity Zones as good places to develop, and that makes sense – it is a good deal for investors with capital gains to defer. However, it’s not as simple as locating your development in a specific place.
Here are three things you should understand and consider before making an Opportunity Zone Investment:
1. An Opportunity Zone Investment is a Massive Capital Gains Tax Offset
Capital Gains Tax is a huge burden for investors and developers because they are buying and selling investments all the time. Though it is a natural part of the tax system, Capital Gains is no joke – it can be up to 20 percent of your profit, which is why investors are always looking for ways to offset that tax burden.
Opportunity Funds tax benefits offer a temporary deferral on capital gains earned during that year. When done right, the capital gains tax burden can drop to zero. The US Treasury wants to encourage private investment in low-income areas, so it has gazetted them as Opportunity Zone investments. Housing and operating an Opportunity Fund in these zones helps investors unlock the tax benefit. When investors plow what would have been their capital gains tax monies into a qualified Opportunity Fund, they can unlock the following benefits:
- Those capital gains are not taxed until the end of 2026 or when the asset is disposed of.
- After 5 years of keeping the investment, the capital gains investors’ basis increases 10 percent.
- After 7 years, it increases to 15 percent.
- After a decade, investors pay no taxes on capital gains produced through their investment.
2. The Program’s Goal is to Lift Low-Income Communities with Private Investment
When talking about tax offsets, we usually focus on the savings to investors but with Opportunity Funds, it’s important to understand the goals of the program and how it will impact your investment.
The idea of Opportunity Zone investments goes back to the Reagan era when Enterprise Zones were designated in economically depressed areas to encourage private development. It has had a few incarnations and its current form was created in the Tax Cuts and Jobs Act of 2017, with state Governors identifying census tracts that were disadvantaged but with good opportunities for development.
While the act is very permissive about the types of investments you can make with Opportunity Funds, it does have some requirements, which include:
- The Fund must be certified by the US Treasury.
- It must be a corporation or partnership for the purpose of investing in Qualified Opportunity Zone (QOZ) property.
- Must hold at least 90% of their assets in QOZ property.
- The property must include newly issued stock, partnership interests, or business property in a QOZ business.
- Opportunity Fund investments must be equity investments in businesses, real estate or business assets in a QOZ. Loans are not eligible.
- Real estate investments must undergo substantial rehabilitation, which is usually equal to the purchase cost.
That’s why there is a decade-long lock-in period: the Government wants to incentivize you to keep your investment. So think about the aims of the program and how they fit with your goals before diving in.
3. Do Your Homework: Normal Investment Rules Still Apply
Just because it looks like a good tax offset does not necessarily mean an Opportunity Zone investment property is a good investment for you. If you’re thinking about branching into a new type of investment, or an area where you don’t have a connection, the usual caveats apply.
Do your due diligence, make sure you understand the basics of Opportunity Zones for investors as well as the relevant state and local regulations. Consider the impact of your investment on your portfolio and don’t be tempted to invest in a bad deal just because it’s a good tax incentive. Ten years is a long time to have your money held somewhere if you have no connection to the place.
Remember that a good real estate investment may not equal a good investment in an Opportunity Zone. A property that is fully leased to long-term tenants is usually a sure bet for real estate investors.
However, in an Opportunity Zone investment, fully occupancy can be a poisoned chalice due to the substantial improvement requirement. You basically have to plow as much into the property as you paid for it, and that means kicking tenants out for long periods while you fix it up, and probably not being able to recoup the sunk monies or lost rent in a timely way.
Investor David Brim told Forbes that investors should look for properties with deferred maintenance, land that could accommodate expansion, new developments or properties that could be repositioned.