A new program that incentivizes real estate development in struggling communities could spur a flurry of investment activity as it helps uplift beleaguered areas.
The Tax Cut and Jobs Act of 2017 contained a provision that allows investors to avoid taxes on capital gains if the money is reinvested in designated “Opportunity Zones.” The goal is to generate economic activity in areas that have fallen on hard times.
To qualify as an opportunity zone, areas must have above-average unemployment rates and income significantly below the regional median. More than 8,700 areas in the U.S. that encompass about 35 million residents have been certified by the U.S. Department of the Treasury as opportunity zones.
How It Works
The program’s mission is to incentivize investors to reinvest in capital gains. The gains can come from any investment, including stocks, bonds, real estate, art or partnership interests.
Gain dollars must be invested in a qualified “Opportunity Fund Zone” within 180 days of the event and cannot be invested directly into a property. The fund must invest 90 percent of its capital into opportunity zone properties and submit to testing twice per year.
Shareholders are rewarded for keeping long-term interest in the funds. Shareholders who keep their investments for five years will pay no taxes on 10 percent of its gains. After seven years, 15 percent of the gains will not be taxed. Shareholders who hold the investments for 10 years can avoid paying taxes altogether.
Opportunity zone funds can invest in a variety of assets, such as property, land, energy infrastructure, startup businesses and equipment. Given the structure, commercial property is likely to be one of the major recipients of the funds. Residential real estate, for example, is not usually held long-term, and the chief lure of opportunity zones is the tax-free appreciation gains after the 10-year hold period.
Investment Vehicles Off to the Races
Despite the questions and the newness of the legislation, fund managers are beginning to jump into the fray. Dozens of funds have started capital-raising efforts, including PNC Bank, Goldman Sachs, Fundrise, RXR Realty and several others. Market players estimate that over the next few years, opportunity zone funds could draw up to $100 billion of capital.
As important as how much the funds will draw is where the money will come from and where it will be invested. Major markets and most downtown areas that are performing well in the current commercial real estate boom are exempt as destinations. That means capital will be concentrated in small and middle-market projects and transitional properties that need substantial upgrading.
Since institutions tend to focus on stable assets, core markets and properties in which large sums can be invested, opportunity zone funds are more likely to be attractive to high-net-worth individuals and family office investors.
Revitalizing Hard-Luck Areas
The other potential impact from opportunity zone funds is reviving markets that may have once thrived.
Successfully rehabilitating a submarket, however, requires more than just a facelift. To operate and increase in value, commercial properties need income from tenants. Demand is derived from a strong economy where people feel safe, have amenities and access to work.
The Beekman/Enterprise fund, for example, is aiming at redeveloping downtowns of small cities in the Southeast where major employers are no longer present. The firm targeted value-add and socially conscious investors before the opportunity fund legislation was passed, but the tax program could be a good incentive to draw long-term capital.
The fund is scouting out dozens of small communities that have the potential for growth, which involves not only real estate that can be rehabilitated but also partnerships from governments and the business community. Key to the redevelopments will be commitments from the government and local businesses to spend money on things such as education, transportation and infrastructure to stimulate economic activity.
Beekman is scouting small communities that have the potential for growth, including partnerships with governments and local business communities. Commitments from such partners to spend money on education, transportation and infrastructure to stimulate economic activity are key to the redevelopment efforts.
“pay no taxes on 10 percent of its gains. After seven years, 15 percent of the gains will not be taxed. Shareholders who hold the investments for 10 years can avoid paying taxes altogether.”
This isn’t correct. You’ve confused the step-up in *original* basis at 5 and 7 years, with the exclusion on *new* gains (inside the Opportunity Fund).