OPPORTUNITY ZONES: WALK, DON’T RUN
by Timothy D. Carkin, CAIA, CMT Senior Vice President
Opportunity Zones: Walk, Don’t Run
Opportunity zones have become a trending topic in financial circles of late and we are taking a “walk, don’t run” approach when reviewing the space.
What Is an Opportunity Zone?
For years, legislators have tried different programs to encourage economic development in economically distressed communities. The Tax Cut and Jobs Act of 2017 established such a program, giving preferential tax treatment to investments made in qualified opportunity zones. State governors were given the power to identify low-income census tracts to be qualified resulting in 8,700 zones across the country. Due to differing political, social and economic ideologies, selection of these zones varies widely between states.
Opportunity Zone Triple-Threat Tax Benefit?
The benefits from an opportunity zone fund starts with the realization of a gain in any capital asset. Some describe the benefits as a kind of 1031 exchange “on steroids” since the benefit extends to gains more than real estate. You can roll gains from stocks or other investments forward into the fund. The investment made in the opportunity zone fund benefits from three preferential tax treatments as defined below.
1) Deferral of Gains:
If the gain is invested in an opportunity zone fund within 180 days, the tax due on those gains is deferred until December 31, 2026.
2) Step-Up in Basis:
If the opportunity zone investment is held for five years, the investor gets a 10 percent step-up in basis on the original gain. Holding it for another two years (seven in total) earns the investor another 5 percent step-up for 15 percent total.
3) Zero Capital Gains:
If the opportunity zone investment is held for more than 10 years, no capital gains are paid on the appreciation of the opportunity zone investment. This benefit extends to 2047.
Walking, Not Running
There are a few factors we consider that lead to our measured approach when reviewing opportunity zone funds for our clients. First among them, the rules have not all been written. Though opportunity zones were established in 2017 by way of legislation it was done in very broad strokes and many key aspects were left up to the interpretation of the Treasury Department and the Internal Revenue Service. It takes time to review and opine on the minutia of the tax code … and then the government shutdown ground that work to a halt. As a result, many large managers in the real estate space have waited for finalization of the tax code to enter the arena.
Another aspect we look at is “dumb money.” It is estimated that more than $13 billion will be raised in opportunity zone funds in the first half of this year. That is a lot of money that needs to be put into qualified projects in a short amount of time. This may cause a bubble in the pricing of “shovel-ready” projects in qualified opportunity zones. Deals that have marginal investment merit become attractive to large syndicators raising huge funds. In this case, “dumb money” refers to those managers who let the need to put capital to work outweigh their investment discipline.
Lastly, investing in an opportunity zone fund is a long-term commitment to developmental real estate. The tax benefit is an alluring idea, but the fundamental investment will be the definition of success and failure. We are reviewing myriad opportunities in the qualified opportunity zone space with a measured approach.