It’s considered the hottest topic to dominate the real estate world in decades. Indeed, it’s a phenomenon that has sparked a wildfire of intrigue, excitement and debate amongst developers, investors, and the like. There are countless articles written about it (a Google News search turns up over 1,780,000 hits), dozens of podcasts solely dedicated to it, and there’s at least one conference (if not four) somewhere in the county on the topic in any given month. In December alone it attracted $2 billion in investments, marking a total of $6.7 billion—a whopping 50% increase from the $4.46 billion at the beginning of December. And, if that isn’t enough to convince you of craze it has caused, just two weeks ago—in the aftermath of news articles describing how wealthy, well-connected investors have benefited from it—the Treasury Department announced an internal investigation into it.
Opportunity Zones were created by the Tax Cuts and Jobs Act of 1997 (“TCJA”) to spur economic growth and investment in designated distressed communities...
What is “it”? A “Qualified Opportunity Zone”, otherwise known as an “Opportunity Zone” or “OZ” for short.
The OZ Basics. Opportunity Zones were created by the Tax Cuts and Jobs Act of 1997 (“TCJA”) to spur economic growth and investment in designated distressed communities—i.e., OZs—by providing Federal income tax incentives for investments of eligible capital into those communities. To accomplish that goal, the TCJA added two sections to the Internal Revenue Code.
The TCJA designates certain distressed communities on population tracts as OZs. It then affords three major tax incentives to eligible taxpayers (e.g., individuals, C corporations—including RICs and REITs, partnerships, S corporations, and trusts and estates) who make long-term investments of new capital in one or more of those OZs through qualified opportunity funds and qualified opportunity zone businesses. The three tax benefits can be summarized as follows:
• First: The deferral of capital gains which would be recognized for Federal income tax purposes before January 1, 2027, to the extent the corresponding amount of gains are invested into a qualified opportunity fund within 180 days after the sale or exchange that gives rise to the gain, until the earlier of the date on which the investment into the qualified opportunity fund is sold or exchanged, or December 31, 2026 (at the tax rate existing at that time). However, the gain cannot arise from a sale or exchange with a related party (i.e., a party with a 20% direct or indirect relationship existing either before or after the sale);
• Second: The partial exclusion of such deferred gains from gross income when certain qualified opportunity fund holding period requirements are met—i.e., if the qualifying investment in the fund is held for at least 5 years, there is a 10% exclusion of the deferred gain from gross income; and if held for at least 7 years, the 10% becomes 15%.
• Third: For qualifying investments in a qualified opportunity fund that are held for at least 10 years, a step-up in basis of such property to the fair market value on the date it is sold or exchanged (thus eliminating capital gains tax liability on the appreciation of such investments).
As further guidance, the Treasury Department and the Internal Revenue Service released proposed Income Tax Regulations interpreting the OZ tax incentive in October 2018 and April 2019, followed by 544 pages of final regulations on December 19, 2019.
OZ Investment or 1031 Exchange. The appeal of the OZ tax incentive in the realm of real estate is clear: deferred taxes on capital gains and a potential tax-free profit down the road. In this sense, OZs have been compared to Section 1031 Exchanges, also known as “Like-Kind Exchanges”, which—until the advent of OZs—were hailed as one of the most (if not the most) tax efficient investment vehicles available to real estate investors. 1031 Exchanges allow real estate investors to defer taxes on gains from the sale of property by reinvesting the proceeds from the sale in another property (if they’re of the same nature or character, even if they differ in grade or quality) within 180 days—a process sometimes referred to as “swapping”. In doing so, a 1031 Exchange enables an investor to preserve the gross equity earned from a real estate investment, thereby increasing their buying power. A high-level comparison of the two investment options can be summarized as follows:
• Rollover: In 1031 Exchanges an investor must reinvest the principal and capital gains within 180 days of the sale of property, and in many circumstances the transaction must be conducted through a qualified intermediary. However, in OZ investments, an investor is only required to reinvest capital gains in an OZ within 180 days of the sale to qualify for the tax advantages and they can choose to only roll over the portion eligible for the advantages (not the entire gain). In other words, OZ investments are more flexible than 1031 Exchanges in that (1) investors who sell property at a gain can defer gains and take cash off the table by investing in an OZ; and (2) partnerships that hold appreciated real estate can dispose of it while letting each partner decide whether they want to cash out or defer the gain. Additionally, in OZ investments, no intermediary is required to conduct the transaction.
• Qualified Assets: As of December 31, 2017, only real property held for use in a trade or business or for investment (except for real property held primarily for sale) qualify for favorable tax treatment in 1031 Exchanges; personal and intangible property no longer qualify. However, in OZ investments, capital gains from the sale of real estate and certain other investments may qualify.
• Investment Structure: 1031 Exchanges are more suitable for swapping single assets whereas OZ investments, through qualified opportunity funds, directly enable the pooling of investments in multiple assets.
• Capital Gains Tax Deferral: The main advantage of 1031 Exchanges are that capital gains tax payments for the initial investment may be deferred indefinitely. However, in OZ investments the clock starts ticking on the date of the investment, and the gain will be recognized on the earlier of: (1) the date on which the interest in the qualified opportunity fund is sold or exchanged (or any other “inclusion event”), or (2) December 31, 2026.
• Capital Gains Tax Reduction: The only capital gains reduction is through a step-up in basis at death for property in 1031 Exchanges. However, as described above, in OZ investments, capital gains on the initial investment is reduced by 10% after 5 years, and 15% after 7 years through a step-up in basis.
• Capital Gains Tax on Final Sale: An investor eventually owes capital gains tax on the sale of the final asset in 1031 Exchanges. However, in OZ investments held for at least 10 years, there will be no capital gains tax on any appreciation on the initial OZ investment upon its sale.
In determining which option is best, it’s important for investors to consult with their personal tax advisor. However, generally speaking, 1031 Exchanges are most suitable for active real estate investors with gains stemming from a real estate sale, investors who do not need access to their principal capital, and/or investors hoping to bequeath their 1031 Exchange assets to take advantage of the step-up in basis for inheritances. On the other hand, OZ investments are typically more suitable for passive investors looking to diversify their portfolio, investors with gains from the sale of assets (e.g., stocks, bonds, or real estate), and investors who want or need access to their invested principal.
OZ Considerations in Massachusetts and Beyond. It’s important for investors to determine whether an OZ investment makes sense, practically speaking, without letting the potential tax advantages cloud their judgment. As my tax professor always said, “don’t let the tax tail wag the dog.” A number of factors that could impact the future economic prospects of the OZ area that are relevant and important to consider include zoning restrictions, the condition of public infrastructure such as roads and utilities, whether local authorities are amenable to working with private investors, and whether the local government is investing in services such as public safety and schools, or plans to do so at a later date.
Additionally, because Massachusetts does not conform to the Federal OZ tax benefits, Massachusetts residents cannot defer their capital gains for state tax purposes and therefore they must pay full state income tax when they sell their OZ investments. Furthermore, since only 9% of Massachusetts’ census tracts are OZs—one of the lowest rates in the county—there are limited OZ opportunities. Only time will tell if Massachusetts jumps on the OZ bandwagon to incentivize economic development in its distressed communities.