The Opportunity Zones (“OZ” or “”OZones”) program was established as part of the Tax Cuts and Jobs Act in 2017 and allows investors to defer paying taxes on capital gains after December 22, 2017, if they invest them in underserved communities through a dedicated fund. Every state designated census tracts is designated as a Qualified Opportunity Zones (“QOZ”), and they can easily be found on Internet. It is one of the few bi-partisan ideas that became law in the last two years, and while the final regulations have not been issued yet, it offers one of the most interesting investment opportunities in decades. Following is what you need to know:
What are the benefits for investors?
The OZ program provides four benefits to investors who, within 180 days of realizing a capital gain, reinvest their gain in an opportunity zone through a Qualified Opportunity Fund (“QOF”):
1. Investors can defer paying tax on the gains obtained until either the investor sells the QOF investment or December 31, 2026, whichever comes first.
2. Investors can reduce their original capital gain by 10% by holding their QOF investment at least 5 years.
3. Investors can reduce their original capital gain by an additional 5% by holding their QOF investment at least 7 years.
4. Investors can exclude all of the gain eventually recognized on the sale of their QOF investment by holding their investment at least 10 years.
When do capital gains have to be deployed?
QOF must deploy 90% of its assets into eligible property within six months of the fund’s designation or Dec. 31 of the year in which the fund is formed, whichever comes first.
Do all moneys in a QOF has to be invested in the Opportunity Zone?
As little as 63% of the fund can be invested in qualifying assets, depending on how the fund is structured. That’s under the “70-30 rule” included in IRS guidelines issued last October.
Does any existing building or business in an Opportunity Zone qualify?
Properties must be newly- constructed or “significantly rehabbed” within 31 months. The property may be commercial or residential, but can’t be a golf course, liquor store or massage parlor. Businesses located or created in OZones also qualify.
Where are the deals?
As the frenzy about OZones continues, the main question is, “Where are all the deals?” Once the initial novelty of what sounds like a game-changing tax deferral vehicle has worn off, investors want to know where they can find quality deals. The answer to that question is not as simple as one might hope. The main issue for potential OZone deals is, “Do the deals make sense on their own merit, independent of the potential tax advantages an investor might realize?” If a deal doesn’t pencil out on its own over the 10-year hold period required to meet the OZ, an investor could end up losing money even though they are able to offset some significant capital gains on the front end. This reality seems counterintuitive to why the program was created in the first place. Like any new program, the early adopters tend to search for low-hanging fruit. Groups are targeting designated areas that tend to be adjacent to stable submarkets or those that have already experienced significant development growth in recent years where they can benefit from an existing economic activity. For example, parts of East Hollywood, Korea Town and Downtown LA are in OZones. There is no shortage of qualified capital chasing the deals that actually make sense right now, so access to those opportunities for the average investor becomes very challenging. We’re seeing deals promoted by many national funds that simply don’t stand up on their own merit. Investors should look for deals promoted by local players who know the local market and make conservative deals.
The key is to not become blinded by the potential tax-deferred benefits of Opportunity Zone investing and really look for deals that you would want to invest in regardless of their designation. Patience and solid due diligence is going to be key in order to achieve this goal.