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How Has Official Guidance on Opportunity Zones Affected Investors?

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In 2017, as part of the Tax Cuts and Jobs Act (TCJA), state governments were allowed to designate certain low-income Census tracts, up to 25% of those tracts in the state, as “opportunity zones.” This allowed certain tax benefits, provided certain standards were met. The problem was that the plan, as passed, was very much a work in progress, and clarity hasn't arrived until relatively recently. So, how has that clarity affected investors?

The Rules

To get the tax benefits, investors have to set up what's called an Qualified Opportunity Fund, which must invest more than 90% of its assets into a Qualified Opportunity Zone Property. The property has to be “significantly” improved, generally defined as an original use, or the basis of the property must be worth at least twice of its non-land assets. Capital gains taxes are deferred for investments put into these zones, and if they're held for ten years, all capital gains are waived.

There's quite a bit more detail to the rules, of course, but these are the basics: It has to be an investment inside one of these tracts, it has to be an original use, and it has to increase the value.

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The Risks

Capital gains deferment is just one factor to consider when building.

The main problem, as any experienced developer knows, is how you define significant improvement. Is remediating a brownfield and turning it into a solar farm one, for example? Would demolishing an old housing development and constructing a new one qualify? So the more clarity available, the better, although it's likely as more investors arrive with different approaches, and as disputes work their way through the courts, the regulations will have detail added to them.

One core factor is that the sooner a project starts, the better; while some rules have a grace period before they go into effect, or sunset certain provisions, it's a narrow slice of time in the real estate process.

Complicating matter has been how individual states designate opportunity zones. Some states have been criticized for designating relatively affluent areas as "opportunity zones," which may open the door to further risk down the road or even loss of the benefits in the first place. The lack of a requirement that residents in the tract itself benefit from the investment has also raised concerns among critics. For projects that lack any real interest from the public, such as industrial use, this may not be a factor; for others, it may render any tax benefits worthless.

The core lesson most have taken away from the guidance is that this policy is not going to radically alter the economics of any particular project, or inspire completely new ones, for the most part. Instead it will create another factor to consider in the complex web of decisions that go into any real estate development project. In an industry where a tax break can make the difference between breaking ground and abandoning the plans, understanding Opportunity Zone regulations thoroughly will be key to whether they should be used. Investors should get involved because they believe in the project overall, not because there may be a tax break.