It has been more than a year since Qualified Opportunity Zone legislation became law, though not all the details have been released.
Developers and property owners in many major markets are taking advantage of a new law that presents an incredible potential for profitability: the ability to develop projects where the appreciation in property value could be tax-free.
A new report from Real Capital Analytics shows that on average, land prices in census tracts designated as opportunity zones are not significantly lower than outside of them. Since the Tax Cuts and Jobs Act was passed, transaction volume for land purchases have grown in every quarter, with Q3 seeing a year-over-year increase of more than 50 percent. Deal volume outside of opportunity zones have remained stagnant over the same period, according to RCA.
The Opportunity Zone program, established in The Tax Cuts and Jobs Act of 2017, is a tax incentive designed to encourage long-term private investment in low-income communities. Opportunity Zones are in census tracts must either have poverty rates of at least 20 percent or median family incomes of no more than 80 percent of statewide or metropolitan area family income.
In California alone, there are 3,516 census tracts in 54 counties that qualify under one or both of the criteria. California’s Governor designated 879 tracts, and the U.S. Department of the Treasury certified all 879 of them.
At a recent conference I spoke to about Opportunity Zones, the group was shocked at the number of great areas that are prime for development within designated areas. Tracts that are not totally in distress but prime for development have been certified as Opportunity Zones, giving developers a big incentive to invest in redevelopment.
Among these incentives is their eligibility for four tax benefits under the new law:
- Temporary deferral of taxes on capital gains. Investors can place existing assets with accumulated capital gains into Opportunity Funds. Those capital gains will not be taxed until the end of 2026, or on the date when the asset is disposed.
- Basis step-up of capital gains invested. Capital gains placed in Opportunity Funds for specific, predetermined lengths of time deliver lucrative predefined increases to the investors’ basis; 10 percent for investments of at least five years, and 15 percent for investments of at least seven years.
- Return of Basis in Initial Transaction. Unlike a Section 1031-Tax Free Exchange, when investing in an Opportunity Zone property, one can take out the basis of the original property. For example, suppose an investor sells a property for $15 million and the investor’s basis in the property was $5 million. The investor can take the $5 million and use it for anything and only needs to invest the gain or $10 million in this example, into the new property.
- Permanent exclusion of taxable income on new gains. For investments held in an Opportunity Fund for at least ten years, investors pay no taxes on capital gains produced through their investment. In other words, after ten years, the taxpayer’s basis is equal to the fair market value of the fund investment as of the date it is sold or exchanged.
Potential for Tax-Free Treatment of Future Real Estate Appreciation
If an investment of existing capital gains is held for 10 or more years in an Opportunity Fund and eligible Opportunity Fund investments, at disposition or sale of the Opportunity Fund interest, the appreciation on the initial investment would not be subject to taxation.
A developer must improve the property substantially to benefit. One just can’t buy a property in the zone to benefit.
The Internal Revenue Code defines “substantial improvement” as follows – during any 30-month period beginning after acquisition date, additions to basis exceed an amount equal to the adjusted basis of such property at the beginning of such 30-month period in the hands of the QO Fund, so long as "during substantially all of the QO Fund's holding period of the property, substantially all of the use of such property was in a Qualified Opportunity Zone."
For example, if a multifamily developer would invest $20 million in an Opportunity Fund that invests in eligible qualified Opportunity Zone property (i.e. new apartments in the zone and other commercial properties) and the investment appreciates to $35 million over a 10-year investment horizon, the $15 million of capital gain would be tax-free to the investor at disposition or sale of the interest in the Opportunity Fund.
This tax-advantaged treatment of long-term investments in qualified Opportunity Zones provides significant planning opportunities for real estate, project finance, and infrastructure projects.
Investors will benefit most in Opportunity Zone financing when the underlying assets, real property or business investments are subject to rapid 10-year appreciation. Because of this, utilization of Opportunity Zone financing with structured leveraged may result in substantial tax-advantaged appreciation vis-à-vis traditional real estate investment models.
If you are interested in Opportunity Zone investment in your state, email me to find out which tracts have been designated and are available. You will be surprised how many there are!