The 2017 Tax Cuts and Jobs Act preserved many of the tax benefits available to investors in real estate and also provided several new incentives around this asset class. One new incentive is known as the Qualified Opportunity Zone program. The goal of the program is to drive private investment into real estate and businesses located in economically underserved neighborhoods throughout the country, known as Opportunity Zones, by providing meaningful tax incentives to those investors. With the IRS recently providing additional guidelines and clarification on the new tax code laid out by the 2017 Tax Cuts and Jobs Act, the potential benefits to real estate investors are becoming clearer.
This new program allows for a taxpayer to elect to defer all or part of a taxable gain by investing in an Opportunity Zone Fund property within 180 days from the date of the sale of the appreciated asset. The tax deferral is granted until the earlier of the date that the Opportunity Zone Fund property is either sold or exchanged, or December 31, 2026. The program also provides for a partial exclusion of the deferred capital gain of 10% after a five-year holding period in an Opportunity Zone Fund and an additional 5% step up in basis after a seven-year hold. Perhaps one of the most significant benefits is that any investment of capital gain held in an Opportunity Zone Fund for greater than 10 years will not incur any capital gains tax on the appreciation of the initial investment upon the sale. Additional funds added beyond the taxpayer’s initial investment are not sheltered from capital gains taxes on the appreciation. For more information on Qualified Opportunity Zones, please see our Wealth Planning Update: Qualified Opportunity Zones: What the Proposed Regulations Reveal.
While the program provides for a number of tax incentives for investment into Qualified Opportunity Zone Funds, investors should fully consider the merits of the specific investment in relation to their personal financial goals, beyond the tax benefits. This white paper will consider the potential benefits and challenges of Opportunity Zone investments and provide a comparison to a long-standing tax deferral strategy for real estate investors—the 1031 Exchange.
Benefits and challenges of Opportunity Zone investments for investors
Some of the benefits of investing in Opportunity Zones are both new and significant. First, any capital gain can—in part or in full—be deferred by investing into an Opportunity Zone Fund, an entity organized as a corporation or partnership in order to receive and invest funds in a Qualified Opportunity Zone property (such as Qualified Opportunity stocks, Qualified Opportunity partnership interests, and Qualified Opportunity Zones). Due to the potential tax benefits, this will likely make Opportunity Zone Funds an attractive option for business owners or investors with highly appreciated assets. Second, while geographically constrained, Opportunity Zone Funds can invest in businesses or real estate, which could open additional opportunities and increase the possibility for diversification for fund investors. The tax implication benefits appear to be clear: investors are only requiredto invest a recognized capital gain of an appreciated investment into Opportunity Zone Funds, meaning that they are entitled to a return of the cost basis in the relinquished asset. If the funds remain invested in an Opportunity Zone for five years, the investor receives a 10% exclusion of the deferred gain from the previous asset sold. If the funds remain invested for seven years, the investor receives an additional 5% step up, for a total exclusion of 15%. Finally, assuming that all investment criteria are met and the funds remain invested for 10 years, any capital gain carried into the Opportunity Zone Fund from the relinquished asset has the potential to grow tax-free until the earlier of when the asset is sold or December 31, 2047.
There are a few noteworthy potential challenges and complications of investing in Opportunity Zones. First, since the intent of the program is to improve underserved neighborhoods, there are capital infusion requirements (one dollar spent on improvements for every dollar spent on the underlying investment) that must be met within a 30-month period. By nature, this requirement dictates that Opportunity Zone investments will be development or significant redevelopment projects, which carry a certain amount of investor risk. Additionally, there are timing requirements that need to be met (the taxpayer must be invested in the fund within 180 days of the sale of the “downleg” asset or, in the case of an individual partner reinvesting proceeds, the last day of the partnership’s tax year). Furthermore, due to the development or repositioning requirement for each real estate project, it is not anticipated that these investments will provide a stable (if any) cash flow yield during the first few years, which may be an important aspect for some investors. Finally, there is the risk associated with the underlying investments. Not only do investors have exposure to traditional real estate investment risk such as real estate market conditions, illiquidity risk, tenant credit risk, vacancy, functional obsolesce, and economic cycles, but they also face the added exposure to development and construction risk including cost overruns, construction delays, as well as lack of demand for built product that can affect the viability and performance of the underlying assets and can have a significant effect on the overall performance of the investment.
Comparing and contrasting Opportunity Zones and 1031 Exchanges
As it relates to real estate, there are many differences between the mechanics of a 1031 Tax-Deferred Exchange and Opportunity Zones. Some of the most notable differences include the treatment of deferred capital gains and the investment flexibility that each of these strategies offers.
Capital gains tax deferral differences
Duration of deferral
Portability of deferral
Access to liquidity
1031 Exchange: Entire investment (basis plus gain) must remain invested in real estate. Liquidity may be achieved by refinancing equity in property.
Opportunity Zone: Upon the sale of an asset that has appreciated, original basis may be taken out of the transaction without triggering a capital gain event so long as gain is reinvested in an Opportunity Zone. After 10 years, an Opportunity Zone investment may be sold and converted to cash or reinvested in any asset class without effectively paying any tax on the “gain-on-the-gain.”
Investment flexibility
Market and asset selection
Timing to invest proceeds
Disclosures:
Note: Qualified Opportunity Zone Funds are not available to clients of Wells Fargo and this information is solely for educational purposes.
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