By Adelaide Polsinelli, vice chairman, Compass
Not since Cash for Clunkers has a government effort to jump start economies in depressed neighborhoods caused such excitement at both ends of the wealth spectrum.
Opportunity Zones, a derivative of the Trump Tax Cut and Jobs Act, promise to give big-money investors an opportunity to defer, or even eliminate taxes on capital gains, while pumping much-need cash into some of the poorest neighborhoods in the nation.
Previously hamstrung investors will be able to free up wealth tied to real estate holdings and stock portfolios without fear of commodious capital gains taxes and with the promise of profit at the end of the investment cycle.
And large swathes of America that have been left behind in the Great Recession reset will be able to tap into pools of private equity to generate economic development and create jobs.
But like anything that sounds too good to be true, there’s a lot that could go wrong for investors set on following this rainbow to a pot of gold.
Here, we’ll take a look as some of the pros and cons of Opportunity Zones and how you can make them work for you:
PRO: Using low income tracts identified by the Census Bureau and the Treasury Department, each state has been able to nominate [designate] is own Opportunity Zones. New York’s Empire State Development opted for a blend of 514 areas where little or no investment has taken place, like the Finger Lakes and Mowhawk Valley, to the Brooklyn Navy Yards and South Bronx. The state’s hope is that money will start to be funneled into everything from aging upstate retail centers and multifamily housing to University R&D facilities and even rising startups.
CON: The program provides no guarantees to the areas selected as Opportunity Zones. If no Opportunity Fund sees a path to profitability in a particular zone, then it is unlikely to see any investment at all. Conversely, if Funds see big potential in another area, it will see a flurry of investment dollars flow its way. Investors don’t have to direct their money in-state – they can opt for a fund anywhere in the US and still qualify for the tax breaks.
PRO: In order to qualify for the tax incentives, investors must invest through a Qualified Opportunity Fund. The Funds themselves can be set up by a corporation, bank a group of partners or a pool of investors working with a manager, as long as they follow the guidelines set out by the statute and Treasury. There is no cap on the amount of money that can be invested in an Qualified Opportunity Fund, but a fund must hold at least 90 percent of its assets in qualifying property. Opportunity Funds will give individual investors the chance to put their money to work in the designated communities, the idea being that a broad array of investors can pool their resources to increase the scale of the investments going to underserved areas.
CON: The IRS and Treasury Department are charged with monitoring the program. As it stands, anyone could set up a fund and solicit investment dollars but there is currently no real oversight to ensure the money goes where it is supposed to. There is also plenty of room for error among what investments qualify for the tax relief and what penalties might result from problems within the Opportunity Zone if projects aren’t successful.
PRO: Investors will have 180 days to flip a capital gain into a Qualified Opportunity Fund. The investor will benefit from an immediate deferral of capital gains taxes until the program ends in 2026. Capital gains tax on this deferred gain is reduced by 10 percent if the investment is held for five years or 15 percent if the investment is held for seven years. Capital gain generated from the investments made by the Opportunity Fund are exempt from capital gains tax altogether if the investment in the Opportunity Fund is held for at least 10 years. So if a million-dollar investment turns into two million dollars, you get to keep the full second million.
CON: The exclusion of capital gain for investments in Opportunity Funds held for 10 years is only available to equity investments that are financed with rolled over gain. That means, if a taxpayer invests $10 in an Opportunity Fund, but only $7 represents gain from a prior investment, then only 70 percent of the taxpayer’s equity investment is eligible for the capital gains exclusion (assuming the investment is held for 10 years). New capital that cannot be traced to gain from a prior investment is excluded from the program. Equity investments must be made by the end of 2019 in order to get the full 15 per tax basis step-up that comes from investing in a fund for seven years. In order for an Opportunity Fund investment to qualify for the tax incentives, the underlying property must be acquired after Dec. 31, 2017
PRO: Opportunity Funds will be able to invest in more than just property. The program allows for investment in qualified opportunity zone stock, a partnership interest or a qualified opportunity zone business property acquired after December 31, 2017, used in a trade or business conducted in a Qualified Opportunity Zone or ownership interest in an entity (stock and partnership interests) operating with such property.
CON: A fund that buys a property already being used in the zone will not qualify without substantial improvement. The program stipulates that such ‘substantial improvement’ must be equal to the Fund’s initial investment in the property over a 30-month period. That means, if an Opportunity Zone Fund acquires existing real property in an Opportunity Zone for $1 million, the fund has 30 months to invest an additional $1 million for improvements to that property in order to qualify for the program. But yet again, there are certain properties — golf courses for example, or country clubs — that do not qualify for ‘substantial improvement.’ The guidelines do not address what constitutes a substantial improvement if the purchased asset is vacant land.
Despite the promise Opportunity Zones present, there are very specific rules that surround the program, so investors should look before they leap into the program and make sure they don’t end up with a clunker.