What is the Opportunity Zones program?
When the Tax Cuts and Jobs Act was enacted in December 2017, a new program was created with the goal of spurring economic development in low-income communities struggling with inadequate capital inflows. The program — called Opportunity Zones — aims to redeploy capital by creating new tax incentives for long term investment in economically distressed zones. According to the Economic Innovation Group, a policy think tank that first conceptualized the program, U.S. investors currently hold $6 trillion in unrealized capital gains, representing a significant untapped resource for potential reinvestment into those zones. The program has generated excitement among many economists, policy-makers, and investors alike, as it is projected to encourage the significant reinvestment of dormant capital gains into disadvantaged neighborhoods that have high potential for growth and returns.
New tax incentives for investing in low-income communities
Under the new program, a taxpayer is able to roll over capital gains (the profit from the sale of an asset) from previous investments into an Opportunity Zone Fund and receive up to three tax benefits: delay paying taxes on those gains, a reduction in taxable gains on the original investment, and exemption from taxation on any future appreciation of the new fund.
Gain Deferral
If a taxpayer realizes gains from the sale or exchange of an asset (referred to as the ‘original investment’), he or she can defer taxation on the gain by reinvesting it into a Qualified Opportunity Zone (“QOZ”) Fund within 180 days. The tax on the gains will be due at the time of sale or exchange of the new investment, or on December 31, 2026 (whichever is earlier).
Up to 15% Reduction in Taxable Gain on Original Investment
If the investment in the QOZ Fund is held for 5 years, 10% of the gains on the original investment will be exempt from taxation. If held for 7 years, an additional 5% of the deferred gains will be exempt from taxation for a total of 15% reduction in taxable gains.
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Tax exemption of QOZ Fund Investment Appreciation
The main advantage of the program is reserved for those who hold their interests for 10 or more years. After this time, the cost basis of the QOZ Fund will be adjusted to the fair market value when it is sold or exchanged. This effectively means that if the assets in the QOZ Fund increase in value, all capital gains from the sale will be permanently exempt from capital gains tax. If the value of the fund decreases over the 10 year period, the assets could be sold at a loss with savings on federal income tax.
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Cost basis is the original value of an asset for tax purposes, usually the price at which it was purchased. This value is used to determine the capital gain, which is equal to the difference between the asset’s current market value and its cost basis.
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Benefits for an OZ Fund over 10 years
Imagine you sold appreciated property or stock in a previous investment and realized $100K in capital gains. Within 180 days, you roll over the gains into an Opportunity Fund. The immediate benefit you receive is not having to pay tax on the $100K gain.
After 5 years of holding the investment, 10% of the capital gains initially invested in the QOZ fund will be exempt from tax. If the interests are sold at this time, only 90% (or $90K) of the original gain will be taxed. Of course, if the fund appreciated in value over the 5 years (for example, from the principal of $100K to $125K), you will also need to pay gains tax on the profit.
After 7 years, another 5% of the original investment is exempt from tax for a total of 15%. If you sell your assets at this time, you must pay taxes on 85% (or $85K) of your original capital gains instead of $100K. Any appreciation is still fully taxable if sold.
The juiciest benefit of the program is realized after 10 years. In addition to a 15% tax exemption on the original investment gain, any appreciation on the fund is exempt from taxation. If the $100K first invested is worth $175K after 10 years, the $75K in appreciation is completely tax-free.
How it works
Step 1. Sell an asset and realize gain
There are no restrictions on the type of gains that are eligible for deferment and may include the sale of virtually any asset including real estate, personal property, stocks, or equity.
Step 2. Contribute the realized gains into an Opportunity Fund within 180 days
All capital investments must flow through a fund, though the entirety of the realized gain does not need to be reinvested. It is also possible to contribute additional cash into the fund, but the portion that is not rolled over from realized capital gains is calculated separately and will not receive tax benefits.
Step 3. The OZ fund makes investments in Qualified Opportunity Zone Property
In order to qualify as an OZ fund, 90% of its assets must consist of Qualified Opportunity Zone Property (QOZP). QOZP includes any of the following entities:
- Qualified Opportunity Zone Business Property (QOZBP)
- Qualified Opportunity Zone Corporate Stock (Portfolio Company)
- Qualified Opportunity Zone Partnership (Portfolio Company)
The above diagram illustrates the relationship between the taxpayer, the OZ Fund, and OZ Businesses. The definitions are surprisingly flexible. The taxpayer can be a single individual or multiple investors, and the fund can invest in one or many projects ranging from real estate, infrastructure, private equity, or venture capital. Broadly speaking, an OZ fund is able to directly invest in a QOZBP or invest in OZ businesses through a portfolio company such as a partnership or corporation.
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Requirements for a Qualified Opportunity Zone Business (QOZB)
There are a few restrictions on what type of business is acceptable for a QOZBP. Financial services that deploy capital such as a bank, payday loans, or another fund do not qualify.1 In addition, ‘sin businesses’ including country clubs, golf courses, liquor stores, and massage parlors are not eligible for the program.
Beyond these exceptions, there are 3 tests for whether a business qualifies.
- Substantially all of the tangible property of the business must be in Opportunity Zones. This includes physical items such as office space, desks, or computers.
- The property must either be a brand new business, or if it is an existing business, it must be “substantially improved” within 30 months after purchase. See the adjacent box on how this clause is interpreted.
- It must be an active conduct business, i.e., one that is actively engaged in the operations of a trade. This would preclude any shell company that makes passive investments without a proper employee workforce or office from being considered an opportunity zone business.
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What qualifies as ‘substantially improved’?
Currently, there is limited guidance on the topic of how to determine whether an existing business has been ‘substantially improved’. The IRS and Treasury plan to provide more regulatory clarity, but the current understanding is that at least the same amount of capital must be invested into improving the property as acquiring the property within 30 months of purchase. For example, if an existing office building cost $1M to purchase, another $1M must be spent on renovating or expanding the property in order for the existing business to continue as a QOZB.
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How does a fund or business get certified?
There is no qualification process for the business, but the Opportunity Fund will need to self-certify by submitting a form (to be released in late 2018) with their federal income tax return for the taxable year. While the method the IRS will use to check compliance is not explicitly stated, the law stipulates that the fund show the IRS every 6 months that they are investing over 90% of their capital into qualified Opportunity Zone assets.
Where are the Opportunity Zones?
There are Opportunity Zones in every state, and the entire island of Puerto Rico has been designated as a set of Opportunity Zones. The designation process began earlier this year, with the Treasury issuing a list of eligible census tracts. The governor of each state was tasked with nominating up to 25 percent of these eligible districts by the March deadline (with the possibility of a 30 day extension.) If a state had less than 100 tracts to choose from, up to 25 could be nominated. On June 14th, the U.S. Treasury Secretary certified the final round of nominations, bringing the total number of designated Opportunity Zones to more than 8,700. Thus roughly 12 percent of the approximately 74,000 census tracts in the United States and Puerto Rico have been designated as an Opportunity Zone for the next 10 years. The final list of approved zones can be found on the IRS page here, or you can explore them on this map.
How did states do in selecting Opportunity Zones?
Nationally, about 43 percent of all census tracts are deemed low-income communities (LIC) and were eligible for nomination to the program. After the Treasury added another 10,000 non-LIC tracts, a total of about 57 percent of America’s neighborhoods were available for states to choose from. This list encompasses a wide range of districts, of which many are not severely distressed or are beginning to gentrify. If states choose tracts that are already experiencing substantial capital inflow, the program would primarily help developers and investors reap higher profits from projects that were most likely going to happen anyway. Additionally, low-income residents in districts that are already experiencing large socioeconomic changes may be at an increased risk of displacement. In order for the program to engender economic growth and benefit the most disadvantaged residents, it is crucial that state governors select districts that both have a need for capital infusion as well as the potential for favorable returns on investment.
Since the final list of certified census tracts was announced in June, several organizations have aimed to evaluate whether governors prioritized both need for capital and growth potential in their selections. The Urban Institute compared existing investment flows and socioeconomic changes between OZ-designated tracts and eligible but non-designated tracts, and concluded that there is not much difference in the two groups. (The study actually shows that socioeconomic change,2 a proxy for gentrification, was on average higher for designated tracts at 3.7 percent by the Urban Institute’s measure, compared to 2.4 percent for non-designated eligible tracts.) The Economic Innovation Group published a more optimistic analysis that suggested states had indeed chosen districts that had both need and growth potential.
Implications for real estate and construction
The OZ program’s requirements with respect to tangible property imply that investments in construction will comprise a large share of the capital flowing into Opportunity Zones. Much of the investment in construction is likely to involve the redevelopment of existing lots and structures into new buildings for residential or commercial use. Indeed, the program is especially appealing to real estate investors for two reasons.
First, it is easy to identify which real estate assets qualify for the program, as they either lie within the designated Opportunity Zone or do not. Once a property is established as a qualified OZBP, there is little concern that the status would change during the duration of the program.
Secondly, real estate investors are familiar with how to take advantage of tax incentives for such projects because community investment has typically been closely tied to real estate development. For example, the New Markets Tax Credit (NMTC) program — from which large portions of the Opportunity Zone program was drawn — provides modest tax credit incentives to private investors for projects in struggling communities through an intermediary vehicle known as Community Development Entities (CDE). According to a 2015 report from the Treasury, the NMTC program allocated slightly more than 50 percent of their funds to real estate businesses.3 The impact of the program on construction as a whole extends beyond those real estate businesses; another report notes that 84 percent of all projects involved construction or renovation, and an estimated 21,704 construction jobs were generated under the NMTC program between 2003 and 2014.4
Similarly, the Opportunity Zones program is no way limited to real estate investments and will most likely spur a wide range of approved businesses from startups to restaurants. Whether this means new construction, or repurposing and renovating existing properties to suit the new investment, it will often require businesses to engage the construction industry. Especially for those unfamiliar with property development and construction, this can be not only daunting, but also genuinely time-consuming, costly, and risky. Construction projects are notoriously difficult to keep under budget and on-time, and those seeking to substantially improve an existing business will be working under the additional constraint of completing those improvements within 30 months of purchase.
The quality and expertise of the contractor often determines the success of a construction project. Finding the right contractor can make all the difference in whether the overall venture is profitable, and BuildZoom can help take the risk out of hiring. With data on every licensed contractor in the country and nearly 200 million building permits, BuildZoom has helped thousands of business owners connect with the best professionals for every type of residential and commercial development. Start by telling us a bit about your project, and our personal consultants will help connect you with the best construction professionals in your area.
Notes
1. See US Code §1400Z-2(d)(3)(A)(ii) by reference to §1397C(b)(8). Nonqualified Financial Property. Less than 5 percent of the average of the aggregate unadjusted bases of the entity’s property is attributable to nonqualified financial property. The term nonqualified financial property means debt, stock, partnership interests, options, futures contracts, forward contracts, warrants, notional principal contracts, annuities and other similar property.
2.The Urban Institute’s “socioeconomic change flag” took four measures into consideration:
- Percentage-point change in the share of residents with a bachelor’s degree or higher
- Dollar change in median family income
- Percentage-point change in the share of non-Hispanic white residents (which, for example, can help to explain difference in assets, not just incomes)
- Change in average housing burden
3. CDE investments fall into real estate and non-real estate Qualified Active Low-Income Community Businesses (QALICB). Real Estate QALICBs are entities whose predominant business activity (more than 50 percent of gross income) is the development (including construction of new facilities and rehabilitation/enhancement of existing facilities), management, or leasing of real estate that will be sold or leased to third parties. Read more from the New Markets Tax Credit (NMTC) Public Data Release.
4. See the New Markets Tax Credit Progress Report from 2017.
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