How Astute Investors are Avoiding Capital Gains

While still very much in its infancy, we are approaching the first year mark on the release of the $1.5 trillion tax cut signed by President Trump. Since its inception, an often overlooked section on page 130 has been gaining more traction with venture capitalists, state government officials, individual investors, and family offices alike. The provision unveils the 8,700 ‘Opportunity Zones’ around America with an average poverty rate of 32% and unemployment rate of 13%. This initiative hopes to be rejuvenate these designated tracts by providing tax incentives and deferred capital gains for long-term investors. This program was kickstarted to address the deeply uneven economic recovery from the Great Recession. About 10% of the U.S. population lives in an Opportunity Zone and less than one quarter of U.S. counties had gained back the number of businesses they lost to the recession. These demarcated areas range from parts of New York, Los Angeles, Washington D.C., some rural areas and the entire US territory of Puerto Rico. Treasury Secretary Steven Mnuchin recently predicted the zones will attract over $100 billion in private capital, yet multiple uncertainties remain unresolved. “This is the biggest initiative of this type by the federal government with the least debate, the least staff support, the least research and still the least clarity,” says Los Angeles Mayor Eric Garcetti.

These Opportunity Zones were enacted by Senators Tim Scott (R) and Cory Booker (D), which were then driven by Washington D.C. think tank Economic Innovation Group with its patron tech mogul Sean Parker (of Napster and Facebook fame), who enlisted Scott and Booker for legislation sponsorship. “This isn’t about the redistribution of other people’s wealth,” Parker declares, “it’s about the redistribution of their time, attention, and interest.” $2.3 trillion is currently sitting on individual and corporate balance sheets across America as a result of profitable investments in stocks and mutual funds, waiting to be taxed at least 20%. Instead, pioneer investors are deploying those capital gains into Opportunity Funds within 180 days of their portfolio reallocation. According to the IRS, “Investors can defer tax on any prior gains until the earlier of the date on which an investment is sold or exchanged, or December 31, 2026, so long as the gain is reinvested in a Qualified Opportunity Fund.” Capital gains tax on this deferred gain is reduced by 10% if the investment is held for five years, 15% for seven years, and exempt from capital gains entirely if held for 10 years (including property value appreciation). However, the exclusion of capital gain for investments in Opportunity Funds held for 10 years is only available to equity investments that are financed with rolled-over gain. Policymakers will still need to consider extending the Opportunity Zone benefits to new capital. Opportunity Funds will be organized domestically as either a partnership or corporation and operated by a single individual, partners, or pool of investors.  In theory, investors will seed new businesses or real estate development by creating Opportunity Funds at an estimated cost of $50,000–a majority of the cost derives from organizing a private placement memorandum.

Revitalizing distressed communities into attractive investments is far from a sure-fire success–research suggests many federally aided initiatives have fallen short (e.g. Clinton’s ‘Enterprise Zones’). It should be noted that these Opportunity Funds may not collect tax incentives by creating or investing in sin businesses (i.e. alcohol, tobacco, gambling, sex-related, weapons manufacturing). Concern was also raised by municipality officials about designating and subsidizing areas that would have been invested in anyways. Further, the IRS will measure and track progress of Opportunity Funds on a bi-annual basis, which will cause a hindrance during the development fundraising phase (a time when capital is held for months before deployment). These Opportunity Funds will need adequate time to raise capital, conduct due diligence, and build their initial portfolio of investments. Treasury’s rules should include an “on-ramp” period that allows newly-formed Funds time to conduct these activities. Another encumbrance that has arisen is the question of how these Opportunity Funds will be regulated. As the law is currently written, “there is no impact accountability or impact transparency,” says Fran Seegull, executive director of the U.S. Impact Investing Alliance. “We need to be able to track job creation and individuals that are lifted from poverty.” Foundations and high-net-worth individuals will want assurance their dollars are creating valuable impact in a community. States and municipalities will want data transparency in order to assess whether the programs are effective and worth continuing.

Overall, these Opportunity Funds are auspicious for ground-up development and property repurpose (investing more capital than the purchase price of the property within the initial 30-month period), but not as ideal for an acquisition and unsubstantial rehab. In the end, real estate investment in an Opportunity Zone will only be as good as the underlying asset and the Fund operator. The Opportunity Fund structure may result in a unique model where local entrepreneurs with knowledge and expertise partner with visionary investors, creating a new framework of business leaders and lasting benefits for the community.

Viktor Simco is an associate director at Palomar Realty Partners. The views expressed here are the author’s own and not that of ALM’s Real Estate Media.