While they attracted relatively little attention initially, Opportunity Zones are now one of the most talked-about topics in commercial real estate.
The opportunity zone program represents a significant long-term opportunity for a range of investors, allowing them to defer and ultimately reduce capital gains taxes on projects located in economically distressed areas across country.
However, many unanswered questions about the program remain. And how quickly those are resolved may influence how effective the program may be – both locally and nationwide – since 2019 is the critical year for those interested in the program.
Opportunity Zones Background
The Opportunity Zone program was included in The Tax Cuts and Jobs Act, and provides a path for any investors – foreign and domestic, retail and institutional – to defer and ultimately reduce capital gains taxes on any assets by reinvesting gains in Opportunity Zones – economically distressed areas.
While the poverty rate is elevated in opportunity zones (average = 31%) compared to non-opportunity zones (average = 15%), there is considerable variation. One in five opportunity zones – or roughly 757 tracts – had poverty rates under 20%.
The challenge and opportunity for investors will be to identify the opportunity zones with the best economic and demographic characteristics and/or where a process of economic improvement has already begun.
Local Opportunity Zones Focus
In Massachusetts, the heaviest concentrations of tracts involved are located in Boston (13 tracts), Springfield (7 tracts), and Worcester (6 tracts). One of the more focused concentrations is in the area around Somerville, Charlestown, Everett, Chelsea, and Malden.
The continued explosion of the lab and office markets in East Cambridge, as well as the ongoing extension of the MBTA Green Line, may provide some added momentum for projects in that area.
The program’s potential has generated a great deal of interest. Cushman & Wakefield is currently tracking 45 funds targeting in excess of $10 billion equity to deploy in opportunity zones.
Some have estimated that up to $100 billion could be deployed over the next several years.
How it works
The program allows a tax deferral for any capital gains realized after December 22, 2017 that are invested in designated “opportunity zones” within 180 days.
After reaching certain holding period hurdles, the basis for the original capital gain is adjusted upwards not only deferring but reducing tax liability by up to 15%. The balance of the deferred gain, unless the investment is disposed of earlier, will be recognized in 2026. Finally, if the opportunity zone investment is held for at least 10 years, then no capital gain tax is assessed on the opportunity zone investment itself.
Here’s a step-by-step breakdown.
There are two main limitations to the program. First is the requirement that 90% of opportunity zone fund assets must be invested in designated opportunity zones. Opportunity zone funds can either make equity investments in businesses that derive most of their income and have “substantially all” of their tangible assets located in opportunity zones or can hold opportunity zone property directly.
Recent IRS guidance defined “substantially all” in this context as 70%. This means that if a fund invested in opportunity zone businesses, it would only need to have 63% of its tangible property, including real estate, located in an opportunity zone. Additional tests require that an opportunity zone business derive at least 50% of its gross income from operations in the opportunity zone, which a real estate development and/or leasing business certainly would.
In addition to the location restriction, the real estate involved needs either to be put to “original use” or the fund needs to “substantially improve” the property – meaning that the investor needs to more than double their basis in the building (not including the land cost) within 30 months of acquisition.
By way of example, the following investments would qualify:
- An investor purchases undeveloped land within a designated opportunity zone and builds affordable housing on the site. This is an example of the property being put to original use with the investment and of the Opportunity Fund substantially improving the property by doubling its basis within the 30-month period.
- An investor purchases of an office complex within a designated opportunity zone for $25 million and converts the property to residential. The purchase price is allocated as $10M to land and $15M to structure. Within 30 months of acquisition, the fund has deployed an additional $15 million (plus $1) into the property, thereby more than doubling the fund’s basis in the property. This is an example of the property having been “substantially improved”.
However, the following investments would not qualify:
- An investor purchases a retail center within a designated opportunity zone and continues to operate the property. The property is not being put to original use nor has it been substantially improved.
- An investor purchases a multifamily property for $25 million to renovate. Purchase price is allocated as $10M to land and $15M to structure. Thirty months after acquisition, the fund has invested an additional $10 million into the building. The property is not being put to original use and while the fund has increased its basis in the property, it does not fulfill the requirement for substantial improvement.
From a high-level perspective, the only real estate investments likely to qualify for the program involve either ground-up or redevelopment and capital-intensive asset repositioning. The Treasury guidelines also put forward the idea that investment in existing property would qualify as “original use” if it had been unused or vacant for some extended period. Accordingly, as further guidance and debate take place, it is possible that final rules will expand the range of eligible investments.
All told, the goal of the program is to incentivize new investment in economically blighted areas. This narrows the investment options for investors and by extension the types of investors that will be attracted to the program but makes it more likely that the investments will catalyze or accelerate economic revitalization of targeted zones.
The tax benefits from the program are meaningful – potentially adding hundreds of basis points to after-tax IRRs – and in some cases will be able to make an opportunity attractive when it would not be otherwise. However, most investors first look to use this program on investments that can be justified purely on a fundamental basis and then use the tax benefits as a return enhancement or a capital raising tool.
There are more than $6 trillion in unrealized capital gain that could potentially be deployed under the opportunity zone program. While only a small fraction of this amount will actually be invested, the impact could still be significant.
While many of the funds created to this point include industrial and office properties in their target product mix, multifamily investment is by far the most prominent, notably affordable housing or as part of a mixed-use development. Fund managers include an assemblage of local developers, equity funds, social impact funds and large asset managers, including Goldman Sachs and PNC Financial Services Group.
Now that many of the most critical questions have been partly resolved, fund formation should accelerate further and more importantly, capital will begin to be put to work in the near future.
With the deadline of December 31, 2019 for investors to realize the maximum program benefit, the clock is ticking.
As Senior Marketing Coordinator for Cushman & Wakefield in Boston, Timothy Griffin creates a wide variety of internal and external communications pieces, such as presentations, proposals, and blog articles, covering commercial real estate trends as well as technology, finance, and other issues which impact the market.