Is Anyone Looking at Investing in Opportunity Zones?

Opportunity Zones may be a great CRE investment program, however, most practitioners are not aware of them or how they work. OZs were created by the Tax Cuts and Jobs Act of December 22, 2017 and provide for deferral and elimination of capital gains for real estate investments in distressed areas. Per the tax act, an OZ is an economically-distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment. Localities qualify as OZs if they have been nominated for that designation by the state and that nomination has been certified by the Secretary of the U.S. Treasury through the Internal Revenue Service. OZs are listed for almost every state and are designated by state, county and census tract number. Anyone can do a search for OZs and see the zones in their state and county.

OZs were created by the Trump administration as an additional economic development tool for distressed areas. They are designed to spur economic development and job creation in distressed communities. OZs provide excellent tax benefits to investors including a deferral of capital gain taxes on the sale of any capital asset until the earlier of; the date the investment is sold or exchanged or December 31, 2026, so long as the gain proceeds are reinvested in a Qualified Opportunity Fund (QOF). Secondly, if any investor holds the investment in a QOF for at least 10 years, the investor is eligible for an increase in basis equal to the fair market value of the investment on the date it is sold or exchanged. This means that the basis will be equal to the sale price and therefore, no capital gain will be recognized, and no tax will be due.

The new tax law created QOFs as a new investment vehicle with the above tax advantages. The rationale for the tax benefits is to direct resources to low-income communities designated as OZs. A QOF can be organized as a corporation or a partnership that holds at least 90% of its assets in qualified OZ property. An investor has 180 days from the sale of an appreciated asset, like stocks, bonds, real estate or a business, to invest in a QOF in either stock or an interest in the fund.

An example from the sale of a small business is as follows. An investor sold his business for a $2 million capital gain in 2018. The investor located three properties in two OZs with a total purchase price equal to the $2 million gain. The investor forms a limited partnership as his own QOF and made sure the limited partnership agreement contained appropriate language to be treated as a QOF. If the investor holds the QOF for five years, the basis is increased by 10% of the deferred gain. If the investor holds the QOF for seven years, the basis is increased a further 5% of the deferred gain and if the investor holds the QOF until after December 31, 2026, the basis is increased to the fair market value which in most cases will be the sale price at that time and no gain will be due. The capital gain tax owed on the $2 million company sale is deferred until the time the OZ investment is sold, but the gain from the assets in the OZ is eliminate per above. To qualify for the 10% and additional 5% basis increase, the investment in an OZ or QOF must be made by 2021 and 2019, respectively.

The QOF must hold at least 90 percent of its assets in Qualified Opportunity Zone Property (QOZ), which includes stock, partnership interests, or business property. QOZ stock includes stock of a domestic corporation that was obtained by the fund after Dec. 31, 2017, from the corporation, either directly or through an underwriter, solely in exchange for cash. QOZ partnership interests include any capital or profits interest in a domestic partnership that was acquired after Dec. 31, 2017, by the fund in exchange for cash. QOZ business property includes tangible property acquired after Dec. 31, 2017, that is used in a QOZ trade or business and either the use of the property in the QOZ originates with the fund, or the fund substantially improves the property. The business must also generate at least 50 percent of its total gross income from active business conduct with, a substantial portion of the intangible property of such entity used in the active conduct of any such business and the business cannot be a; private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises.

Although some of the rules above are complex, this appears to be an excellent capital gain deferral and elimination vehicle similar to 1031 exchanges but without the complex time periods and mechanics of like-kind exchanges and the basis reduction for the carryover gain. OZs may be better than 1031 exchanges as they eliminate the capital gain in full, while exchanges only defer the gain, by reducing the basis of the new property. Many investors today have large stock capital gains due to the surging market and some of these gains can be reinvested in a QOF for elimination. There are also numerous crowdfunding sites forming QOFs that should be attractive to certain investors.

Joseph Ori is the executive managing director at Paramount Capital Corp. The views expressed are the author’s own and not that of ALM’s Real Estate Media.