Why Should Investors Pay Attention to Qualified Opportunity Zones?
A new incentive allowing investors to realize capital gains and invest those gains into other businesses was introduced in the 2017 tax law – these ‘other businesses’ include real estate in designated low income and high poverty areas referred to as opportunity zones (OZ.) These zones, if utilized correctly, could be a rare and treasurable opportunity for investors apprehensive to realize capital gains because of the associated tax bill. Real estate investors have long enjoyed favorable tax treatment for capital gains through the 1031 exchange mechanism – for those with appreciated real estate assets, how does the OZ program benefits compare to the more traditional 1030 exchange? This question has been weighing on the minds of savvy investors since the incentive’s inception, but the correct utilization of these zones comes with three tax benefits: deferral of paying capital gains tax, reduction in the amount of owed gains tax, and tax-free appreciation.
The thought process behind OZs, at its core, encourages investors (who otherwise might not sell appreciated assets) to put their gains to use by either investing in real estate or businesses in lower income areas. Although the details of the OZ program can be complicated, an in-depth understanding of its inner workings can lead to a compelling alternative for those considering a 1031 exchange. This traditional exchange allows investors (with capital from appreciated real estate investments) to sell those properties, reinvesting those gains into other ventures without triggering a taxable event – it also allows investors to roll one real estate investment into another venture, amassing a sizable portfolio in the process and leaving the option to pass the portfolio to his or her children. The major difference, however, between a 1031 exchange and an OZ lies in the breadth of available investment opportunities, as an opportunity zone investment is not limited to real estate. The source of the capital gain can be from any appreciated asset, and subsequent investments can be in any type of business – for the purpose of this article, however, real estate investment is the focus (almost all OZ investments are in real estate given the way current rules are written.)
Opportunity Zones and Capital Gains
Although opportunity zones can present themselves as a valuable asset to investors, it is important to note that tax benefits only apply to funds sourced from capital gains. After selling an investment property, however, real estate investors who take advantage of OZs have the flexibility to consider other investment options with the remainder of their gains. This attribute greatly differs from a 1031 exchange because these investors must roll the entire amount into a new venture in order to enjoy the full tax benefits. Let’s say, for example, that you sell a building for $100,000 generating a capital gain of $15,000 – whereas a 1031 exchange would require you to reinvest the entire $100,00, an OZ investment would allow you to simply reinvest the gain of $15,000. This attribute is especially useful for investors who wish to expand their portfolios. In addition to this expansion, there are significant tax assistances as well.
Deferrals: In addition to deferring the recognition of capital gains, the OZ program also provides a reduction in capital gain taxes (depending on how long an investment is held.) Investments held for five years receive a 10 percent reduction and 7-year holdings receive a 15 percent reduction. No such reduction is present in a 1031 exchange. In addition, an OZ investment does not preclude an investor from deploying the non-capital gain portion of a sale into real estate. This may give investors much-needed breathing room when considering a potential venture, as they are not held under the same rollover restrictions as a 1031 exchange.
Tax-free appreciation: Depending on who you ask, the most compelling feature of the OZ program is its tax-free appreciation. If an asset is held for 10 years, the tax basis for that investment upon sale is increased (or decreased) to the fair market value at the time of sale. This creates a proportionate response to market conditions. It is important to note, however, that these investments cannot be held forever – current provisions require that investors exit their OZ investments by December 31, 2047. Upon this date, however, (given the breathing room offered by this type of investment,) investors have the opportunity to reinvest proceeds into real estate or any other asset class.
The Scope – and Future – of Opportunity Zones
Looking at the United States holistically, there are approximately 8,700 opportunity zones from California to New York. Because of their sheer number and location in areas ripe for real estate investment, many funds have been launched with the sole purpose of seizing the unique prospects OZs present. CIM Group, for example, manages $30 billion in assets and has launched a $5 billion Opportunity Fund. Starwood Capital has dedicated $500 million to an OZ fund, and countless other firms have realized the potential of these specialized zones.
Both the U.S. Treasury and IRS have clarified many of the regulative specifics of investing in opportunity zones, reassuring potentially apprehensive investors that their capital is safe and will qualify for the subsequent benefits. If you are interested in getting involved but want to avoid any potential pitfalls, Alta Capital Group has the knowledge and experience to help you take full advantage of this tax incentive. Contact them at (844) 402-2582 and see if your next project is a good fit!