Navigating the Land of OZ: Understanding Opportunity Zones and Opportunity Funds [Emerging Trends 2019, Urban Land Institute/PWC]
Flying under the radar in the 2017 tax reform package was a sleeper provision that authorized the designation of “opportunity zones” and the creation of “opportunity funds.” This versatile program has the potential to stabilize and revitalize distressed neighborhoods and surrounding communities by unlocking private investment capital through a series of tax benefits.
There are three separate tax benefits - individual and corporate investors may defer capital gains tax until 2026 if those gains are reinvested into new construction or major rehabilitation of projects in economically depressed areas via designated “opportunity funds.” If held for five years, the original amount of capital gains tax due is reduced by 10 percent; if held for seven years, it is reduced by an additional 5 percent. If the investment is held for at least ten years, gains on the invested amount accrue tax-free. At least 90 percent of the opportunity fund assets must be invested in designated opportunity zones.
Estimates suggest that $6.1 trillion of unrealized capital gains is held by American households ($3.8 trillion) and American corporations ($2.3 trillion). Getting to that capital will be a bit trickier. Much of the money is disaggregated across individual accounts managed across myriad institutions and platforms.
The governor of each state was able to designate up to 25 percent of the state’s low-income communities (LICs), or 5% of contiguous tracts, as opportunity zones. The zones are designed to be in areas that have a poverty rate of at least 20 percent or that have a median income that does not exceed 80 percent of the metropolitan area’s median income. Final designations of the 8,700 opportunity zones, were made by state governors and approved by the U.S. Department of the Treasury in the spring of 2018. The zones range from a few blocks in large metro areas to entire municipalities in some rural states. The Treasury Department has indicated that no additional opportunity zones will be added.
The expectation is that the added tax incentives will make investment in these disadvantaged areas just a little more enticing and add another option to the capital stack. However, neither the statute nor the guidance does anything toensure investments benefit low- and moderate-income residents of the O-Zone communities. It is expected states and cities will provide guidelines to ensure that the objectives of affordable housing, strong neighborhoods, and vibrant, diverse, and sustainable communities are met.
On October 19, 2018, the IRS issued proposed guidance on O-Zone investments. While a number of questions remain unanswered, the rules are generally favorable to long term real estate. These include: 31 months for the O-Fund to invest capital in an O-Zone; exclusion of the land basis in the “substantial improvement” test; and allowance for an asset sale and subsequent reinvestment of capital in an opportunity zone without triggering a taxable event. Significantly, taxpayers are allowed to rely on the proposed regulations as long as certain requirements are met. This will allow investors, fund managers, real estate developers and business owners to move forward with a level of certainty.