In the Zone: A Primer on Opportunity Zones

The following writing was initially published in November 2018 and has been revised aligned with regulatory updates and clarifications.

  • 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).
  • Eligible investors include individuals, C and S corporations, partnerships, trusts and estates.
  • 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. 

You may also be interested in: Top 5 Things You Need to Know About Qualified Opportunity Zones 

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 prior to December 31, 2026 and up to 15% of the original gain if the Opportunity Fund is held for seven years prior to December 31, 2026. In other words, just 85% of the original gain will be included in taxable income if the Opportunity Fund is held for seven years. However, in order to achieve the maximum 15% exclusion, gains must be reinvested in an Opportunity Fund before the end of 2019.

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 until December 31, 2047. Additional guidance has been requested from the IRS on whether an Opportunity Fund investment needs to be sold by December 31, 2047 or whether a “step-up” in basis would apply to the Opportunity Fund’s value as of December 31, 2047.

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, 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. Second, state tax benefits vary. Some states have conformed with the federal tax breaks and will offer state incentives as well, but a handful of states will not offer state tax breaks for Qualified Opportunity Fund investments.4

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. Qualified Investment: The Act requires that for a fund to qualify for the aforementioned tax benefits, the fund invest in new Opportunity Zone property or “substantially improve” existing Opportunity Zone property within 30 months after purchase. . 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.

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.

Real Estate

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.

Venture Capital

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.

In November 2018, the initial publication date of this primer, large numbers of investment opportunities had not yet materialized as IRS guidance was needed to answer additional questions. However,  as of June 2019, investment opportunities benefiting from the new tax benefits have begun to materialize in the form of direct investments and fund investments. The legal structures and entities being utilized are varied from open-ended to close-ended funds, REITs and more.

Other Considerations

From an estate planning perspective, the death of an investor will not result in the recognition of any deferred gain and the investor’s estate will receive a “carry over” holding period and remain eligible for tax benefits available at the five-, seven- and ten-year holding periods. However, the same does not apply if an interest in an Opportunity Fund is gifted. Gifting of one’s interest in an Opportunity Fund will result in the realization of deferred gain and loss of tax forgiveness available at the aforementioned holding period timeframes. An exception applies if the gift is to a grantor trust.

While much of the interest around Opportunity Zone investing is driven by the tax benefits, a growing cohort of impact investors are also evaluating investments in these underserved communities. However, as it currently stands, no provisions in the Act mandate impact reporting or investing responsibly. The designation of Opportunity Zones within each state was also based off 2010 census data, which has come under criticism as the data allows for the designation of zones which are no longer underserved.

Conclusion

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. Opportunity Zones offer an exciting space to monitor and evaluate for tax sensitive and impact investors. Due diligence remains paramount as investments are wide-ranging and carry various tax implications that will require detailed planning.


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.


Scenario A: 
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.


Scenario B:
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.


Scenario C:
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
jennifer.wong@glenmede.com 

Jeffrey P.  Dowds, CPA, CFP®
Wealth Planner
jeffrey.dowds@glenmede.com

 

You may also be interested in: Top 5 Things You Need to Know About Qualified Opportunity Zones 

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. 


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.