In the Zone: A Primer on Opportunity Zones
November 1, 2018
- Qualified Opportunity Zones (Opportunity Zones) were created by Congress in the 2017 Tax Cuts and Jobs Act (Tax Act) to stimulate investment in low-income communities throughout the United States1.
- Investments in Opportunity Zones must be made through a partnership or corporation, commonly known as Qualified Opportunity Fund (Opportunity Fund).
- Federal tax incentives include capital gain deferral and partial gain exclusion on realized gains reinvested in Opportunity Funds and full gain exclusion on appreciation of the Opportunity Fund itself (provided the investment is held for 10 years).
- Real estate and Venture Capital firms are interested in creating funds to invest in this space.
- Still, additional guidance is needed from the IRS on a number of technical issues before such funds are available to provide meaningful investment opportunities2.
- As a result, it is not expected that substantial investment fund opportunities will be available until 2019.
Overview of Tax Benefits3
There are three main tax benefits for investing in Opportunity Zones. The first two relate to the treatment of capital gains resulting from a taxpayer’s existing investment. The third relates to the treatment of gains after making a new Opportunity Zone investment.
Tax Benefits on Existing Investment
1. Capital Gains Deferral: Realized capital gains that are reinvested in an Opportunity Fund within 180 days can be deferred from taxable income until the earlier of December 31, 2026 or the date the Opportunity Fund is disposed of. The existing investment can include publicly traded stock, business assets, personal assets or any other property qualifying for capital gain tax treatment.
2. Step-up in Cost Basis: An investor can exclude up to 10% of the original realized gain if the Opportunity Fund is held for five years and up to 15% of the original gain if the Opportunity Fund is held for seven years. In other words, just 85% of the original gain will be included in taxable income if the Opportunity Fund is held for seven years.
Tax Benefits on Opportunity Zone Investment
3. Tax Forgiveness on Capital Appreciation: If an Opportunity Fund is held for ten years or more, the investor may elect to treat the cost basis as equal to the fair market value. The election permits an investor to exclude any gain on the sale of the Opportunity Fund from taxes.
It is important to note that all three of these tax benefits are only available to those investors who reinvest capital gains into an Opportunity Fund. Other sources of funding are not eligible for these tax benefits.
The chart below depicts the timing of tax benefits stemming from an Opportunity Fund investment. Tax treatment of the capital gains from an existing investment are shown in red and the tax benefits after making the Opportunity Fund investment are in blue.
The chart below illustrates how an investor’s after-tax gains could vary given the different hold periods set out in the Act. In each scenario, an investor starts with $100. The chart/scenarios assume that all investments 1) return 8% per year, 2) that the capital gains tax rate remains at 23.8%, and 3) that there are no applicable state taxes. Detailed calculations are available in the Appendix.
Investment hold period of five years: The investor sells Stock ABC in Year 1 and holds the subsequent investment until Year 5. Assuming the growth rates of either investment are at 8% annually, the original investment of $100 will grow to $147. In a diversified portfolio, the investor will pay $35 in taxes. By investing in an Opportunity Zone investment, the investor saves $2 in tax savings (~6.8%) from the 10% step-up in cost basis at Year 5 on the original investment.
Investment hold period of seven years: The investor sells Stock ABC in Year 1 and holds the subsequent investment until Year 7. Assuming the growth rates of either investment are at 8% annually, the original investment of $100 will grow to $171. In a diversified portfolio, the investor will pay $41 in taxes. By investing in an Opportunity Zone investment, the investor saves $4 in tax savings (~8.8%) from the 15% step-up in cost basis at Year 7 on the original investment.
Investment hold period of ten years: The investor sells Stock ABC in Year 1 and holds the subsequent investment until Year 10. Assuming the growth rates of either investment are at 8% annually, the original investment of $100 will grow to $216. In a diversified portfolio, the investor will pay $51 in taxes. By investing in an Opportunity Zone investment, the investor saves $31 in tax savings (~61%) from the 15% step-up in cost basis at Year 7 on the original investment and the tax forgiveness on the capital appreciation of the Opportunity Zone investment at Year 10.
As shown above, the full tax benefit is realized only after the investor holds the investment in a Opportunity Fund for ten years or longer. While the tax benefits are appealing, there are some inherent limitations and drawbacks with these investments. First, there are not many Opportunity Funds available for investment at this time. Second, the tax benefits scale with the underlying appreciation of the particular Opportunity Fund investment. Successful investments will provide tax benefits, while less successful ventures may provide only minimal or no advantages.
Legislation Considerations for Investments
Over the past year, each state has designated Opportunity Zones within their borders. Since the release of the initial list of Opportunity Zones in July, interest in investing in these communities has risen.5
Three requirements within the Tax Act are driving the creation of strategies in the space:
1. Hold Period: The Tax Act mandates a ten-year hold period of the investments in order to optimize tax benefits. Holding an investment for five or seven years provides limited benefits to people using realized gains, but firms interested in raising third-party capital to make investments are focused on the ten-year hold.
2. Substantial Investment: The Act requires that for a fund to qualify for the aforementioned tax benefits that “substantial” investment needs to be made into the asset within 30 months after purchase or start-up (if a new business). Generally, substantial means $1 of improvement for every $1 of purchase price. For example, a real estate investor buying an existing property for $100 would be expected to invest $100 to substantially improve the asset. If the investment is in an operating company, the investor would need to provide additional capital to further improve, or grow, the operations.
3. Partnership or Fund Investment: Each investment must be made through some pooled investment vehicle, such as a corporation or partnership entity (i.e. an Opportunity Fund). It is not possible to invest into a particular opportunity on an individual basis.
The IRS recently released some Proposed Regulations which provide clarity regarding its thinking on a number of technical details6. While this initial round of guidance helps resolve some critical unanswered questions for investors7, there are a number of other technical details that require IRS clarification. The most important unresolved issue to investors is whether the ten-year hold period applies at the fund level or to each individual investment within the fund. The answer will impact how an Opportunity Fund invests and the timing of capital distributions back to investors.
We believe many would-be fund sponsors will not proceed until additional IRS guidance is provided. While this additional guidance is expected in the near future, we do not anticipate significant investment opportunities until 2019, due to the need for investment funds to organize, identify qualifying investments, and raise capital.
Types of Investments into Opportunity Zones
Given the three legislative considerations outlined above (hold period, substantial investment, and partnership or fund vehicle requirement) two types of institutional investors are heavily evaluating the opportunity set within Opportunity Zones: 1) real estate – both residential and commercial and 2) venture capital. Key considerations for each are outlined below.
Traditional real estate investing falls into three buckets: 1) new construction, 2) value add and 3) distressed. Each set of investors will be exposed to their own set of risks.
1. New Construction: New build of real estate is inherently risky as the investor will have to be comfortable with construction and development risks. Adding to this risk will be the fact that Opportunity Zones are generally in economically distressed communities, which may increase likelihood of vacancy and turnover of leases.
2. Value Add: In traditional value-add plays, investors buy an asset and spend 10-20% of the original price on upgrading the facility. These facilities usually generate cash flow and have moderate improvements that could aid the investment. At this point, given the information that has been released surrounding the substantial improvement mandate, many real estate investors are reluctant to focus on strategies in the value-add space, as they do not believe it is economically viable.
3. Distressed: Buying distressed assets with the intention of turning them around is riskier than other forms of real estate investing, given the profile of the assets and the substantial amount of development needed. Distressed assets usually do not generate cash flow and are sold at a significant discount given how troubled the asset is. Some distressed real estate investors are interested in Opportunity Zones as they have invested in many of these communities in the past.
Early-stage venture capital investors may show interest in Opportunity Zones, as there should be adequate opportunities to continue investing capital to meet the substantial improvement threshold. However, given the hold-period considerations for tax-free gain treatment, and the current lack of guidance on whether that hold period applies at the fund level or investment level, venture capitalists are further away from launching strategies in the space than real estate investors. Venture capital firms typically aim to exit investments after a five- to seven-year hold period, making the ten-year hold period requirement longer than industry standard and potentiallyless attractive from an investment perspective.
Alternatively, venture capitalists could invest in Opportunity Zones through building tech hubs and incubators. This path would allow these businesses to attract early-stage investors and also invest into companies at the seed level to build out venture opportunities in the space.
Investments into Opportunity Funds offer attractive tax benefits, while catalyzing capital inflows into economically distressed communities. However, prudence is necessary in evaluating these investment opportunities as they come to market. The tax benefits will not outweigh the negative consequences of a bad investment.
Moreover, large numbers of investment opportunities have not yet materialized. While the initial round of IRS guidance has answered some questions, additional information, expected shortly, is necessary, and then firms will need time to evaluate and identify qualified investment opportunities before launching investment funds. Currently we assume that there will be Funds available for investment in 2019. While questions remain, Opportunity Zones offer an exciting space to monitor and evaluate for tax-sensitive and impact investors.
Appendix: Tax Scenarios
Below are the detailed calculations for the different tax scenarios highlighted on page 3. The following scenarios illustrate how an investor’s after-tax gains would vary given different hold periods. Each scenario assumes an investor with $100 of capital gains from the sale of Stock ABC realized Year 1. Investment returns from all sources are assumed to be 8% per year, the capital gains tax rate is assumed to remain at 23.8%, and no state taxes are included.
The investor sells Stock ABC in Year 1 and holds the subsequent investment until Year 5.
His first option is to invest in a diversified portfolio. His investment into a diversified grows to a value of $146.93 by Year 5. The capital gains tax paid on this is $34.97 in Year 5.
His second option is to invest in an Opportunity Fund. In this case, the investor sells Stock ABC in Year 1 but does not pay capital gains taxes until Year 5. When the investor sells his investment into the Opportunity Fund in Year 5, he must pay taxes on both the investment into Stock ABC and the investment into the Opportunity Fund.
- His investment into Stock ABC has a gain exclusion of 10%, so of the original tax bill of $23.80, the investor pays $21.42 and saves $2.38.
- His investment into the Opportunity Fund has grown to $146.93 of total value, and he must pay $11.17 in taxes.
Under these assumptions, investing into an Opportunity Fund with a five-year hold period can save $2.38 in taxes paid, or 6.8% of the $34.97 of taxes owed.
The investor sells Stock ABC in Year 1 and holds the subsequent investment until Year 7.
His first option is to invest in a diversified portfolio. His investment into a diversified grows to a value of $171.38 by Year 7. The capital gains tax paid on this is $40.79 in Year 7.
His second option is to invest in an Opportunity Fund. In this case, the investor sells Stock ABC in Year 1 but does not pay capital gains taxes until Year 7. When the investor sells his investment into the Opportunity Zone in Year 7, he must pay taxes on both the investment into Stock ABC and the investment into the Opportunity Zone.
- His investment into Stock ABC has a gain exclusion of 15%, so of the original tax bill of $23.80, the investor pays $20.23 and saves $3.57.
- His investment into the Opportunity Fund has grown to $171.38 of total value, and he must pay $16.99 in taxes.
Under these assumptions, investing into an Opportunity Fund with a seven-year hold period can save $3.57 in taxes paid, or 8.8% of the $40.79 of taxes owed.
The investor sells Stock ABC in Year 1 and holds the subsequent investment until Year 10.
His first option is to invest in a diversified portfolio. His investment into a diversified grows to a value of $215.89 by Year 10. The capital gains tax paid on this is $51.38 in Year 10.
His second option is to invest in an Opportunity Fund. In this case, the investor holds the Opportunity Fund for ten years and realizes the full tax benefits. While the investor sells Stock ABC in Year 1, he does not pay capital gains taxes until December 31, 2026.
Additionally, because he has held his Opportunity Fund for ten years, the capital gains tax on that investment is forgiven.
- His investment into Stock ABC has a gain exclusion of 15%, so of the original tax bill of $23.80, the investor pays $20.23 and saves $3.57.
- His investment into the Opportunity Zone has grown to $215.89 of total value, but he gets a 100% gain exclusion on this investment. He saves $27.58 in taxes.
Under these assumptions, investing into an Opportunity Fund with a ten-year hold period can save $31.15 in taxes paid, or 61% of the $51.38 of taxes owed.
For more information:
Jennifer Wong, CFA
Impact Research Analyst Private Investments
Jeffrey P. Dowds, CPA, CFP®
1. Opportunity Zone Resources. CDFI Fund. https://www.cdfifund.gov/Pages/Opportunity-Zones.aspx
2. Schultz, Abby. “Opportunity Zone Funds to Deliver a Tax Break.” Barron’s. October 4, 2018. https://www.barrons.com/articles/opportunity-zone-funds-to-deliver-a-tax-break-1538680532
3. While this section is focused on federal tax incentives, Opportunity Zone investment tax incentives are currently being offered by, or are under consideration in, a number of states. You should consult a legal or tax advisor prior to any investment to determine whether any such incentives exist or will be passed through to you in the event you ultimately participate in this asset class.
4. For illustrative purposes only. Assumptions are not indicative of actual or future results. Investors should consult their tax and investment advisors prior to any investment. There can be no assurance that Opportunity Zones would meet or exceed ordinary investment returns, or that returns from any investment type will be positive. All investment has risk, including the risk of loss of principal. Opportunity Fund investments may have specific risks which should be considered prior to investment.
5. Jacob Adelman. “Skyscraper, not strip mall, now planned on North Broad Street, courtesy of Trump Tax Break.” Philadelphia Inquirer, October 15, 2018, http://www2.philly.com/philly/business/real_estate/opportunity-zones-trump-philadelphia-skyscraper-north-broad-20181015.html.
6. Goldman, Jeffrey and Maxwell, Korb. “IRS Issues Proposed Regulations for Qualified Opportunity Zone Funds”. The National Law Review, October 20, 2018, https://www.natlawreview.com/article/irs-issues-proposed-regulations-qualified-opportunity-zone-funds.
7. While these Regulations are not final the IRS has stated that taxpayers may rely on these proposed rules as long as they apply them consistently and in their entirety.
This piece is intended to be an unconstrained review of matters of possible interest to Glenmede Trust Company clients and friends and is not intended as personalized investment advice. Advice is provided in light of a client’s applicable circumstances and may differ substantially from this presentation. Opinions or projections herein are based on information available at the time of publication and may change thereafter. Information gathered from other sources is assumed to be reliable, but accuracy is not guaranteed. Outcomes (including performance) may differ materially from expectations herein due to various risks and uncertainties.
Any reference to risk management or risk control does not imply that risk can be eliminated. All investments have risk. Clients are encouraged to discuss the applicability of any matter discussed herein with their Glenmede representative.