The new Opportunity Zones created in the Tax Cuts and Jobs Act of 2017 (the “Tax Cuts and Jobs Act”) are the darlings of real estate right now. And for good reason. These Zones could potentially enable trillions of dollars in current and future capital gains to be deferred, discounted and even fully exempted from taxes by investing them in some of our country’s poorest areas. If you think this all this sounds too good to be true, you may be right. These vehicles are not a foolproof path to wealth. Rather, investors must carefully assess each investment opportunity to make sure they can stand on their own independent of the potential tax benefits.
What Are Opportunity Zones?
Opportunity Zones are a community development program established by the Tax Cuts and Jobs Act to encourage long term investment in low income areas throughout the United States. Each Governor has now designated a certain number of its State’s poorest areas to receive special tax treatment based on the most recent Census data. By investing in these Opportunity Zones through Qualified Opportunity Funds, taxpayers can receive the following benefits:
- If the tax payer redeploys capital gains from a prior investment into an Opportunity Zone, the tax on such capital gain will be deferred until the earlier of (a) the sale of the new asset or (b) December 31, 2026. Note that the gain can be derived from, and re-invested in, any tangible asset or business and, unlike with a 1031 tax free exchange, only the gain must be reinvested in the new asset as opposed to all of the original sale proceeds.
- If the new investment in the Opportunity Zone is held for at least five (5) years, the tax payer will receive a 10% discount on the capital gains tax. If the new investment is held for at least seven (7) years, it will receive a 15% discount on such capital gains tax. Because the gain cannot be deferred beyond December 31, 2026, the money must be invested no later than December 31, 2021 to receive the 10% discount and by December 31, 2019 to receive the 15% discount.
- In addition to deferring and potentially discounting the capital gains tax from the original investment, if the tax payer holds the new investment in the Opportunity Zone for at least 10 years, it will pay NO TAXES on the ultimate sale of the new investment.
Let’s look at an example to illustrate how the tax benefits work. Assume that in December 2018 Mary Smith sells a valuable piece of artwork for $5 million and realizes a $1 million gain. On January 1, 2019, Mary (through a Qualified Fund) invests her $1 million gain in a business located within an Opportunity Zone and the Opportunity Fund then sells that business on January 1, 2030 for $3 million. The sale of the business generates a $2 million gain for Mary. What are her tax obligations?
Under the Tax Cuts and Jobs Act, (x) Mary gets to defer the payment of her capital gains taxes on the artwork until December 31, 2026, (y) at such time, Mary will pay taxes on only $850,000 of her gain from the sale of the original artwork (i.e., a 15% discount off of the $1 million gain) because, when the tax became due on December 31, 2026, she had held her new investment in the business located within the Opportunity Zone for seven years and (z) Mary will owe no taxes ($0) on the sale of the business because she held that investment for more than 10 years.
Clearly, the tax benefits of Opportunity Zones can be substantial. However, Opportunity Zones will only be good “opportunities” if the underlying investments themselves make economic sense. Unlike pre-1986 tax shelters which could, and often did, become great investments even if the underlying real estate deals lost money, this will not be the case with Opportunity Zones. If the taxpayer loses money on the new investment, it could more than wipe out the benefit of any initial tax deferral or discount and render any exemption illusory.
As a result, before jumping into an Opportunity Zone investment, investors need to consider the following risks:
- Because Opportunity Zones are generally located in the very poorest neighborhoods, investments in these areas may be riskier than those in wealthier, more established neighborhoods.
- To qualify for the tax benefits, the capital gains realized from the initial investment must be redeployed into the Opportunity Zone within 180 days of the sale—a very tight timeframe. If the seller of the asset in the Opportunity Zone is aware of this time sensitivity, they may increase their asking price thereby requiring you to overpay.
- Some Wall Street analysts are estimating that the potential benefit of the tax deferral, discount and ultimate exemption could be worth as much as 500 and 700 basis points to an investor if things all go smoothly. There is a risk that some Qualified Fund sponsors may try to peddle investment opportunities with very modest cash on cash returns by claiming that the overall investment return will be enhanced by the tax benefits. Thus, they may offer returns that, on a risk adjusted basis with respect to the underlying asset itself, don’t make sense.
- Qualified Opportunity Funds, which are the vehicles through which any investments must be made in the Opportunity Zones, are merely partnerships or corporations that can be formed and managed by anyone. The fact that they are “qualified” should not be construed to mean that they or their proposed investments have somehow been vetted or approved by any regulatory authority or that their ongoing operations or management will be monitored by such bodies. As a result, investors need to make sure that the fund sponsors are reputable and have meaningful experience and demonstrated success with the types of investments being offered.
- The investor will need to pay its capital gains tax by December 31, 2026 whether or not the new investment has been sold by then. Thus, investors must make sure they have liquidity to pay this liability when the tax collector comes calling.
The Tax Cuts and Jobs Act of 2017 provides us with compelling incentives to make much needed investments in some of our country’s most vulnerable and impoverished areas. However, investors need to be careful not to rush into these investments based solely on the promise of tax savings or avoidance. There is a reason the federal government had to offer such compelling tax benefits to incent people to invest their money in these neighborhoods—there is significant risk involved. Before throwing money into these opportunities, investors will need to do their due diligence and make sure that the underlying investments are sound, and the sponsors are credible.