For developers — and investors — these opportunities run deep.
It’s already been a year since the fervor and political debate that led up to the Tax Cuts and Jobs Act, passed by Congress near the end of 2017. While there has been plenty of press about the actual cuts and their impact on citizens, businesses and the government, there hasn’t been nearly as much of a focus on one somewhat unique element of the act: the establishment of “Opportunity Zones” meant to encourage community development.
Here’s a brief summary: individual states were given six months (until June of this year) to designate distressed communities which could benefit from development. The Opportunity Zones have now been approved by the U.S. Treasury, and investors can re-invest their unrealized capital gains (within 180 days of a sale) into “Opportunity Funds” (OF) that are dedicated to investing into these Opportunity Zones (OZ).
There are attractive opportunities in this program for both businesses, real estate developers and investors:
For developers, establishing a fund for their qualified projects can help generate third-party investment capital. Developers can also use their fund to defer tax on the sale of capital assets. For example, if a developer puts capital gains generated from the sale of a capital asset into a fund for eight years, with the basis increase and a 5% present value discount to value the deferral, investors would pay only 57% of what they otherwise would pay in taxes.
In the case of a passive investor, OF investments can defer tax payments on recognized gains for up to eight years. In addition, if the investor holds the investment in the OF for at least ten years, all appreciation of the OF investment would accrue tax-free.
Within the investment community the program is considered quite generous: one of the better tax-reducing efforts put forth by the government in years. Like tax credits for historic rehabilitation, toxic land clean-up, development of affordable housing, and the creation of renewable energy, the program is an example of how developers and investors can contribute to the public good while being allowed to profit for their efforts.
Companies like The Cherrytree Group are working with developers to help them take advantage of this program, and plan to introduce funds for investors who wish to be part of this initiative.
I won’t jump too far into all the details of the OZ program, but here are some points that are of particular interest for real estate developers and investors:
- No investments will be allowed in “sin” businesses, i.e. country clubs, golf courses, massage parlors, gambling establishments, alcoholic sales businesses
- An investment must be used in the OZ for “substantially all” of the holding period (we assume this will be interpreted by the IRS as 70-80%)
- Original use must commence with the taxpayer, or the taxpayer “substantially improves” the property during the 30-month period after acquisition
- Substantially improve” means the improvements are for 100% or more of the purchase price
- The funds are not limited by the taxpayer, and the funds are not traced. Purchases must be from unrelated parties, i.e. ownership of less than 20%
- Taxpayer has 180 days from the date of a sale to invest into a OF, which then has 180 days to invest into an OZ property. A very attractive aspect of the OZ legislation is that a taxpayer can invest up to the whole gain, but not are required to invest all of it, and the taxpayer is able to retain the non-taxable basis, which is not permitted in the 1031 Rules.
- Capital gains rates will be 15% for amounts under $426,700 and 20% for over that amount. Additionally, we are required to add the 3.8% tax that funds Affordable Care, which is sometimes referred to as the “Obama Medical Tax”. As an example, consider a $1 million capital gain invested into an OF. The capital gains rate currently is 23.8%, or $238,000 in taxes. Those taxes can be deferred to 12/31/2026 per the OZ legislation, at which point the taxes would be due at 85% of the amount, i.e. $202,300, representing a $36,000 savings. Moreover, if the $1,000,000 appreciated to $1.5 million over the 10 year period, there would be no tax on the $500,000 appreciation.
So, how do Opportunity Zones stack up against other ways for a developer to structure a deal or for an investor to place his/her money? In of themselves they are a “shallow” subsidy, (i.e. by itself it is not enough of a return), but when coupled with other economic returns (tax credits, depreciation, cash flow) Opportunity Zones become a good, even great, investment.
The Cherrytree Group has been successful in helping both developers and investors realize major tax savings through the syndication of both state and Federal tax credit programs for historic renovation, renewable energy or land clean-up. Many of the projects that are ideal for tax credit deals, if located in a qualified Opportunity Zone, have the potential to yield even greater benefits.
Even the savviest investor requires expert assistance in navigating this field, and we’re pleased to discuss the pros and cons of Opportunity Zones to anyone who is interested in exploring the opportunity.