Opportunity Zones (OZs) have been in the spotlight quite frequently this past year, with varied opinions and understandings of their applicability and potential. There are over 8,762 OZs in the U.S. in all 50 states and the U.S. territories. As clients begin inquiring about these opportunities, it’s important to understand the pros and cons and some soon-to-be major pitfalls of this program
How do you develop a profit with an Opportunity Zone and what are the pitfalls?
- Investors can temporarily defer or eliminate taxes on their previously earned capital gains. Their existing assets can be placed into an Opportunity Fund which will not be taxed until the end of 2028 or until the asset is disposed of.
- Investors benefit through a Basis Step-up in Capital Gains that are reinvested into an Opportunity Fund.
- The program may encourage development in distressed areas and create economic enhancement, job creation, real estate and sales tax and further attraction for more development.
- While the OZs are meant to help the residents, there is no requirement or guarantee that it does so. This means that OZs could solely benefit investors and not its community.
- Investors are not required to include the community in their planning and are not required to follow any community rules. Therefore, investors are likely to have no knowledge of how their investments are affecting the community members.
- The tax benefits are estimated to cost $1.6 billion in lost federal revenue over a 10-year period.
- Scholars have found that both in the U.S. and the U.K., OZs were not successful in its intended function. Of the 75 enterprise zones studied in 13 states, researchers found that the tax incentives had “little or no positive impact” on the economic growth in the zones.
- The program phases out Dec. 31. 2026 with a full OZ designation expiration of Dec. 31, 2028. Therefore an investor does not currently have 10 years to benefit for a full tax exclusion. This is by far the deepest pitfall unless Congress extends this program.
In some cases, OZs are not in distressed areas but are rather in strong markets or undeveloped markets. For instance the entire island of Puerto Rico is considered an OZ. Another example is Washington Center in Portland, Oregon. It’s a high-density development opportunity and value-add office in the center of downtown Portland.
Another large hurdle of the program is the Safe Harbors related “50% Test.” As of October 2018, at least 50% of the gross income of an OZ business must be from the active conduct of a trade or business within the OZ. It’s similar to the Foreign Trade Zone criteria.
As of early December 2019, another issue facing the program was that Senator Ron Wyden (OR) introduced legislation that would make alterations to the OZ program. The bill would modify some of the requirements for incentives, as the legislation would mandate sun-setting of the designation of “contiguous zones” that are not low-income, but instead adjacent to low-income communities. Some wealthy landowners with large acreage of land adjacent to an OZ are trying to claim that being adjacent and contiguous qualifies their properties for OZ and capital gain exemption. This new bill would prevent multi-family developments from utilizing the incentive unless at least 50% of the units are affordable to residents earning 50% or less of an area’s median income.
For now, investors want to be cautious in 2020 as the number of years (ten) does not exist before OZ sunsets and expires in 2028. By 2021, the five-year holding period is no longer applicable and the gain must be recognized by Dec. 31, 2026. The investing point may be too late for a full tax exemption unless Congress extends this program. It is unclear at this point what Congress will do.
Another pitfall is that a property located in an OZ may not be zoned for its highest and best use. Many of these sites are also not permitted. Changing entitlements can be pricey and time consuming. Additionally, new development can price out older neighbors as they experience new real estate tax assessments skyrocket and/or rents. The solution, such as in Nashville, is to educate fixed income neighbors that they can apply for a tax assessment freeze. Battling gentrification is important. Inclusionary zoning is a challenge too. Entitlement can be a win-win for both the developer and neighbors with frozen assessments.
Stay tuned in the coming issues of the SIOR Report, as we will be elaborating on these and other implications of OZs as they become more and more prevalent throughout our industry.