The day is Wednesday, February 3, 2019 and the whole real estate world is a buzz over Opportunity Zones and the way that the New England Patriots beat down my Los Angeles Rams. I have not seen such excitement and willingness to throw money at an investment, since just before the “.com” bubble burst in 2000. Are we seeing a hysterical zealousness or is there good reason for the excitement? Before I answer this primal question, let’s take a look at what an Opportunity Zone is, who it is for, and what are some of the benefits.
You may ask, why did I start this article, citing the date. Simply put, as of this writing, the details of who will qualify and what types of investments qualify for the significant tax incentives promised by Opportunity Zone legislation, is yet to be finalized.
WHAT IS AN OPPORTUNITY ZONE?
Opportunity Zones, or as I call them, “oZones” are a creation of the Tax Cuts and Jobs Act of 2017, “TCJA”. The statutory, stated intention of the TCJA is to help economically disadvantaged communities, located in these oZones, by encouraging investment through various tax incentives made available to investors.
There are a limited number of oZones, which are only located within the geographic borders of the United States. For a map of oZone locations, (Click here). Each state nominated the oZones within their own state borders. The final designation was made by the United States Secretary of Treasury.
WHO SHOULD CONSIDER INVESTING IN AN oZone?
Anyone who realizes capital gains from the sale or exchange of property, may, potentially benefit from an oZone investment.
For illustrative purposes, please consider the following, simplified, example:
Assume that you purchased a rental property for $500,000 on January 1, 2016 and the property was sold on December 31, 2018 for $1,000,000. Further assume that, you invested another $100,000 in improvements to the property, leaving you capital gains of $400,000 upon the sale of the 2016 property.
WHY CONSIDER INVESTING IN AN oZONE PROPERTY OR BUSINESS?
Deferral of Capital Gains: Using the, above example and assuming that you meet all of the qualifications for an investment in an oZone business, you can defer tax treatment on the Capital Gains of $400,000 from the sale of the 2016 property until you sell or exchange your oZone investment or until December 31, 2016.
Exclusion from Gross Income Gains Realized from the sale of the oZone investment if the investor holds the oZone investment.
10-year hold: The most significant tax advantage is that you get a step-up in basis allowing you to avoid taxes on any capital gains earned from your investment in an oZone property, if you hold your investment for 10 years. To be clear, this is a 100% write-off and avoidance of capital gains taxes;
7-year hold: If your hold your oZone asset 7 years, you get to write off 15%; and
5-year hold: If you hold your oZone asset 5 years, you get to write off 10%.
This is much, much more than deferring your capital gains tax, as you would with a 1031 Exchange. There is no equivalent write-off in a 1031 exchange. Therefore, if your total basis of your investment in an oZone property is $400,000 and you sell it 10 years and 1 day from the date of your purchase for $1,000,000, although you will profit by as much as $600,0000, you will not incur a tax on that $600,000 profit.
No requirement of a “Like-Kind” exchange. As compared to a 1031 Exchange, there is no requirement that the exchange of property be “like-kind”. In a 1031 exchange, you cannot defer capital gains tax on the sale of stock or equipment if you then invest in real property. An oZone investment allows you to sell your Apple stock today and tomorrow invest your capital gains in a qualified oZone property or business tomorrow.
The oZone investment need not be limited to real property or buildings. An investor can invest in a business that is located within an oZone, so long as the investment is in an ownership interest and not just debt.
COMPLICATIONS, DETAILS, & RULES, OH MY!
As a former CEO of mine used to say, “the devil is in the details”.
First, let me just say, THIS AIN’T EASY! Please forgive my poor grammar, but that is exactly what was going through my mind as I delved into this topic.
YOU NEED TO WORK WITH A TEAM OF EXPERTS
As a lawyer for over 42 years, I am accustomed to reading statutes, rules and regulations, although I must admit, the Internal Revenue Code is not one of my favorite bedside readers. I’ve attended two seminars totaling about 8 hours of detailed information, two webinars of about 3 hours, read multiple articles and here is the real kicker, 75 pages of proposed rules with IRS footnotes and citations. I estimate that I have spent over 25 hours on this topic and expect to invest more of my time. This is not for the faint of heart.
If you are considering an oZone, you better arm yourself with a very knowledgeable team, including tax accountants, lawyers, brokers and financial experts who are willing to put the time in to learn and stay on top of the law and rules. While I intend to be one of the most knowledgeable brokers on oZones, I am not going to get any of my clients and investors involved in an oZone investment with out my trustworthy team of experts.
THE RULES ARE NOT CURRENTLY CLEAR
I now, emphasize the date of this article, January 30, 2019.
As of today’s date, the Internal Revenue Service and the Treasury Department have not finalized the rules and regulations relating to oZone investments.
Congress, through the passage of the Tax Cuts and Jobs Act of 2017, created oZones as an investment vehicle to incentivize investments and capital improvements in economically depressed communities. The portion of the act creating oZones, only set forth general guidelines, leaving it up to the Internal Revenue Service and the Treasury Department to set forth the details, including how an investor can qualify for the tax incentives and other details, fundamental to the success of oZone investments.
On October 22, 2018, IRS issued its first set of proposed rules. These rules probably created more questions than answers. From my many conversations with tax and other experts, there seems to be a great deal of disagreement and speculation regarding what the final rules will look like. Public comments were sought by the Treasury Department, which scheduled a public hearing on the proposed rules and comments for January 10, 2019. Unfortunately, the hearing was cancelled due to the federal government shutdown. Again, this is where the date of this article is relevant. As far as I know, there has not been a rescheduled hearing.
Investors could have started investing in oZones in 2018, but that would have been a blind investment. Even after the issuance of the proposed rules in October 2018, a current investment in an oZone is still a blind investment without further clarification and finalization of the rules. It seems to me that this is a minefield of issues for the unwary and wary alike. Again, you better have your team of experts up-to-date and attached at the hip.
TO PROFIT OR NOT TO PROFIT, THAT IS THE QUESTION
It should be remembered that an investment should be about making a profit. Communities that have been chosen for advantageous oZone tax treatment, were chosen because they were economically disadvantaged communities. These communities haven’t been favorite targets of significant capital investment. Put another way, as an investment, there may be a greater chance of losing money in these communities than in other places. Investors need to be very particular and careful about investing in oZones and should not invest in oZone assets predominantly because of the tax incentives. The tax incentives are only to sweeten, what otherwise should be a good deal.
Final Thought: This article is not a complete analysis of Opportunity Zones, their value for investment purposes or their value to the communities affected. I will be following up with other articles as the rules become finalized. I will also address the issue of the effect of Gentrification on oZone communities and the people who currently live and work there.
Howard F. Kline is a Nevada licensed real estate advisor with SVN The Equity Group, located in Las Vegas Nevada. He has also been a licensed California attorney for over 42 years, primarily focused on commercial real estate and has been a licensed California broker and a licensed New York real estate agent. He is also the founder and host of CRE Radio & TV, an online commercial real estate magazine since 2010 and recently founded the Las Vegas Business Journal, an online, media rich, interactive business magazine. For more information, contact Howard at 702.706.4433 or at howard.kline@svn.com.