Opportunity zone investments bring bigger tax breaks if finalized this year
Real estate investors who want to maximize the return on investment from participating in the opportunity zone program will reap extra tax breaks if they finalize the transaction before the end of the year, but one expert is still urging they do their due diligence before rushing into the program.
The Tax Cuts and Jobs Act ushered in the tax break as a way to encourage more investment in economically distressed communities. The tax break has spurred much interest and appetite among investors, but they have been hampered somewhat by the slow rollout of regulations governing the program and communities that qualify. Areas can qualify as opportunity zones if they’ve been nominated for that designation by the state where they are located and if that nomination has been certified by the IRS. Still the benefits can be extremely attractive to investors. If an investment in a qualified opportunity zone is held for longer than five years, there’s a 10 percent exclusion of the deferred gain. If it’s held for more than seven years, that 10 percent exclusion becomes 15 percent. Plus, if an investor holds the investment in the qualified opportunity fund for at least 10 years, the investor is eligible for an increase in basis of the QOF investment equal to its fair market value on the date the QOF investment is sold or exchanged.
Marc Wieder, a co-leader in the real estate group at Anchin, a Top 100 Firm based in New York, is hearing from clients about their interest in the tax break. “The qualified opportunity zone program gives you four benefits,” he explained. “If you take your capital gain and invest it in a qualified opportunity zone fund or project, you get to defer the tax on that capital gain until 2026, provided you hold the investment through 2026.”
That means investors who jump into the program before the end of the year could potentially reap some extra benefits. “The way it works is, if you held the investment for seven years through 2026, you’ll pay tax on only 85 percent of that gain,” said Wieder. “If you’ve held it for five years by 2026, you’ll pay tax on 90 percent of the gain. So, worked backwards, in order to hold something for seven years by 2026, you had to have acquired it by 2019. To get the full benefit of the qualified opportunity zone program, you need to have made the investment by 2019. Once you get to 2020, you obviously can no longer only hold the investment for seven years come 2026. You lose that tax on 5 percent of the gain, so it’s going to cost you that much more by waiting until 2020. If you wait until 2022, you’re going to lose that full 15 percent benefit by 2026, so you’ll pay tax on the full gain in 2026.”
However, in the long run, the major incentive doesn’t depend on when a taxpayer begins investing in an opportunity zone fund. “The greatest benefit of the program, which is really the biggest incentive to most investors, and what most investors are looking at, is that once you’ve made the investment, if you hold the investment for at least 10 years and then sell the investment, you will not pay tax on the gain from that investment,” said Wieder. “To give you an example, if I have a capital gain, let’s say in 2019, of a million dollars, and I take that million dollars and I invest it in a qualified opportunity zone fund, and I hold that investment for over 10 years, the first thing that’s going to happen is in 2026, I’ve held it for seven years, so I will pay tax on $850,000 of that million-dollar gain in 2026, because I’ll get the full 15 percent exclusion. Then, if that million dollars at the end of 10 years is worth, let’s say, $10 million, that additional $9 million of gain that I recognized will not be taxable. That is what most investors will be focusing on. That is the biggest benefit to the program, so although you’re going to lose some benefits waiting until 2020 or 2021 or 2022 or later years in which to make the investment, you’re not going to lose that big windfall as long as you hold that investment for at least 10 years.”
Still, it pays to be cautious and not rush into making investments in dubious real estate schemes. “I don’t think the loss of 5 percent of the gain is driving people to rush and have to do it by the end of the year,” said Wieder. “I wouldn’t advise anybody to make a rash decision because of that 5 percent. When you stop and think about it, using federal income tax rates, the capital gain rate is roughly 20 percent, so 20 percent times 5 percent, it’s 1 percent effective tax on your gain that you’re giving up, not necessarily a lot of money. On a $100 million gain, that’s a million dollars, but if you have a $100 million gain, a million’s not going to seem like a lot. It’s got to be a sound investment.”
He also pointed out that the IRS is still issuing regulations about the program. “There are still issues to be resolved that have not been resolved yet through the regulations,” said Wieder. “I think people are being somewhat cautious in making these investments, and they’re not overly concerned about the clock ticking, because it’s not a significant loss to them.”
Wieder advises investors to do their due diligence. “Like any other investment, you should always do your due diligence,” he said. “It’s fairly easy enough to make sure that the investment is in a property that’s located within a zone. You do your normal due diligence like you do with any investment, no less so because of the benefits. I would not want a client of mine to be blindsided by the tax benefits because I never feel that an investment should be made for tax purposes. It should be a sound investment first, and if there are tax benefits in addition to it, great, but that should not be the reason for making the investment.”
Opportunity zones have become something of a political issue, with some observers warning that the funds could be used to invest in communities that aren’t truly economically distressed or that are already in gentrifying areas that would have been attractive to investors even without the extra tax breaks.
“Some of them are in gentrifying areas, and some of them are in areas that they’re hoping to gentrify through this program,” said Wieder. “The whole purpose really was to encourage investment in lower-income areas, to improve those areas. Some of those happen to be in gentrifying areas as we speak, so some of those people are just reaping the benefits of this program because they were investing there anyway.”
So far, his firm hasn’t seen a rush of investment in the program at this point. “People have interest,” said Wieder. “I don’t feel that it’s as active as people anticipated it would be, partially because the regulations that have come out have not clarified all of the issues, so it’s a little more difficult to operate an opportunity zone fund. There are some that are launching. It’s much easier to do a single investment than a fund structured with multiple investments. We have clients that have done it, and we have clients that are looking to find the right property to develop within a zone and looking to defer some of their gains. We have clients that have intentions, who haven’t filed their 2018 tax returns yet, who are looking to take some of that gain money and deploy it in an opportunity zone project, provided they can find it in the time frame that they’re allowed. So there is activity. I don’t think it’s nearly as much activity as everybody anticipated it would have, and that’s partially because of the regulations being a little vague.”
Anchin had some experience with the pre-TCJA program known as empowerment zones, which also sought to spur more investment in economically distressed communities by offering tax incentives under legislation dating back to 1993. But there are important differences between empowerment zones and the opportunity zones introduced under the 2017 tax law.
Empowerment zones “gave you certain real estate tax and other benefits different than this, and a lot of those were tied to employment,” said Wieder. “This [opportunity zone program] isn’t tied to employment. This is tied to funds invested. The intention here was for people to take capital gains that were sitting unrealized, and therefore the government was not getting tax revenue on it, to encourage people to sell investments that would create a taxable gain, but give them some benefit by taking that and investing that for the betterment of the country, and for that we’re going to give them certain tax breaks. The idea was actually somewhat of a revenue generator, in that everybody in 2026 that does this is going to be paying tax. So it was to encourage people to take unrealized gains that they were sitting with, gains on paper, and to actually sell the asset, recognize a gain, but be able to defer the payment of the tax, get a little discount on the payment of the tax, and improve the country. So the intent of the law was to generate revenue in 2026.”