Opportunity Zones - new potential PERMANENT tax savings?

Tax, SDIRAs & Cost Segregation
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Opportunity Zones - new potential PERMANENT tax savings?

Austin Hendrickson
Investor · Minneapolis, MN · Member since 2016 · 139 posts · 143 votes

Hi Everyone,

As a CPA who specializes in real estate I have been doing some reading on the new Opportunity Zones (OZ) passed effective 1/1/18 with the new tax law. While guidance is still a bit unclear and more research has to be done I think this is a huge opportunity for real estate investors to have permanent tax savings (along with other benefits) - even better than a 1031 exchange!

From what I understand here are some key benefits of the Opportunity Zones:

 - Permanent gain exclusion on the appreciation of investments in Opportunity Zones 

- Deferral and reduction of capital gains used to invest in Opportunity Zones. I believe this is deferred until the investment is sold or 12/31/2026, whichever comes first. (this is the capital gain used to fund a deal in an OZ, not the appreciation on the investment). There are additional rules for holding it less than 5 years (100% deferred gain recognition), 5-7 years (90% deferred gain recognition), and > 7 years (85% deferred gain recognition).

- Any depreciation taken on the investment in the OZ is permanently saved and NOT recaptured if held for 10+ years. This is big and combined with the gain exclusion is essentially a double dip of tax savings!

Other items to consider:

- Income or loss from operations in an OZ is taxed normally

- An OZ is a lower income census tract designated by each states Governor. The zones have already been established. I have looked into the zones around the Twin Cities (Minneapolis & St. Paul) and Minnesota as that is where I live. If other investors have looked into zones in their local areas, feel free to chime in.

- I believe eligible investments in OZ's are real property, operating businesses and equipment. 

-However note that for real property the original use must be with the taxpayer or it must be substantially improved i.e. new construction or a major renovation - it does not look like turn key properties would qualify. The point of the law is to improve certain areas of the country by bringing in new structures and upgrades.

I will be doing more research and talking to additional real estate specialists at our firm for more guidance. Again this is just my best understanding of the current law, there is still a lot more guidance needed for OZ investments.  If anyone has additional info or guidance or sees something in this post that is incorrect please share!

Overall this could be a HUGE benefit for real estate investors and definitely something to consider. The potential for permanent depreciation savings, appreciation savings and reduction of capital gains could be very significant.

I can also run through a hypothetical example if it would be helpful.

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Paul Caputo
Cost Segregation Specialist · Naperville, IL · Member since 2016 · 204 posts · 168 votes
8y
This is an extremely interesting new wrinkle in the tax code. The forthcoming guidance on this will be very helpful, and by first glance it looks like a huge benefit for savvy investors. Using cost segregation and 100% bonus depreciation in tandem with the OZ seems like a no brainer, but the opportunity for using cost seg’s “little brother” an abandonment study would be perfect for this. An Abandonment study is basically the same as a cost segregation study, but it’s done on a property that will be torn down. You get all the benefits you’d normally get from cost seg, but there’s no recapture since the assets are immediately retired through demolition. Then you build the new property and do cost seg on the new assets as you’d normally do. Done right it’d be a windfall tax benefit and you’re doing your part to revitalize the area! The more I learn about the new tax law, the better it gets for real estate investors.
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  • Holly High
    Real Estate Professional · Islamorada, FL · Member since 2016 · 7 posts · 4 votes
    7y

    @Austin Hendrickson, please can you clarify?: However note that for real property the original use must be with the taxpayer or it must be substantially improved i.e. new construction or a major renovation - it does not look like turn key properties would qualify. The point of the law is to improve certain areas of the country by bringing in new structures and upgrades.

    I purchased a MHP in an O Zone this fall.  Will spending $$ to expand it and keep it as a MHP qualify?  Also, if we buy new homes for the expansion and then sell them to consumers will this disqualify us?  

    Thank you Austin!

    0Reply
  • Austin Hendrickson
    OP
    Investor · Minneapolis, MN · Member since 2016 · 139 posts · 143 votes
    7y

    @Holly High if you did not purchase the property using capital gains and did not purchase through a QOZ Fund then the investment will not qualify.

    If you buy a new home and sell it to a consumer that would also disqualify you as you would not meet the ten year hold requirement

    Any substantial improvement to the property must be 100% of your basis in the original property less the value of the land.

    For example: You buy an apartment building for $600k, and allocate $50k to the land purchase. You are left with $550k, so you would need to reinvest at least $550k within 30 months for the investment to qualify for OZ treatment.

    1Reply
  • Joel OwensBusiness Member
    Moderator
    Real Estate Broker · Canton, GA · Member since 2010 · 15k+ posts · 11k+ votes
    7y

    Sounds like the key for a developer or investor is if all the red tape is worth the upside/risk factors?

    I can see some developers trying to land areas they feel will turn around in opportunity zones. The really low income areas is more of gambling and speculating and sometimes no matter what the tax benefit is looking like it is not worth owning in those areas.

    I personally like A to B areas because they tend to hold up better in an economic down turn. In more moderate to lower income areas people tend to live more hand to mouth so when economy starts going down it can become a big domino effect. The more affluent areas even if people lose their job or have reduced hours they tend to have assets and reserves saved up. Not always the case of course as some people overextend for what they make even in nice areas.

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  • Rodolfo Canon
    Commercial Real Estate Agent · Denver, CO · Member since 2018 · 109 posts · 81 votes
    7y

    EIG (Economic Innovation Group) was the political and intellectual driver behind the Opportunity Zone concept. They got it into the Tax Reform Act. The guy who started EIG, Steve Glickman, has left EIG and started Develop, LLC which has a website that is easy to find and has a FAQ section that simplifies the beast...

    0Reply
  • John FortesPro Member
    Multi-Family Syndicator · Abington, MA · Member since 2017 · 603 posts · 347 votes
    7y

    Currently looking into OZ in my hometown and the opportunity is tremendous. Kicker is finding investors trying to move capital gain taxed funds. Could be via stocks recently sold or an asset. Hard part is making sure you can improve/add to the existing property or a development is more ideal.

    One must double the basis minus the land for it to fit the criteria of the OZ. Example: you buy for $1.2M the land is worth $200k so you must improve the property by $1M. Opportunity I'm looking at is a building that has been approved for multifamily conversion.

    As it is now its a shell. Pending the cost of development and the type of financing we can leverage this may be a great opportunity for the high net worth looking to shield their current capital gains and defer it out. Goal is to hold for 10 years and a day before our exit. Still learning more about this and looking into the opportunity but that is all I can go on as an example. 

    Exploring financing options as we speak! Love the aspect of leveraging with debt and being able to refinance the initial capital or part of it back out upon completion and stabilization of the building. Sounds ideal and a great opportunity. @Austin Hendrickson please let me know if I'm missing anything. Lets connect!

    1Reply
  • Austin Hendrickson
    OP
    Investor · Minneapolis, MN · Member since 2016 · 139 posts · 143 votes
    7y

    @John Fortes sounds like that would qualify just ensure the investment is being funded with capital gains and acquired through an OZ Fund.

    1Reply
  • David M.
    Investor · Cincinnati, OH · Member since 2014 · 61 posts · 35 votes
    7y

    Sounds like previously owning rental property in an OZ (which I do) doesn't benefit from this at all, even if we improve it substantially. Is that correct?

    0Reply
  • David Monroe
    Real Estate Consultant · Mobile, AL · Member since 2015 · 78 posts · 96 votes
    7y

    Please Click Here for the update from the IRS on the first round of guidance that was released on the QOF's. One thing I want to clarify is that you qualify a fund by self certifying on IRS form 8996.

    You can invest in a QOF if you're not using capital gain funds, you don't the tax benefit the other investors get. You get a 10% step up in basis if you hold the property for 5 years and you get an additional 5% step up after 7 years. 

    In 10 years the original deferred capital gain must be paid. When the property sells after 10 years, the remaining capital gains on the money invested is stepped up 100%, giving you no capital gains on sale.

    0Reply
  • Adam Mayberry
    Architect · San Jose, CA · Member since 2014 · 90 posts · 57 votes
    7y

    @Austin Hendrickson How does it work if you are managing partner of the opz fund / opz project - as the sponsor?  You are essentially managing the development for fee then managing the property until the sale?  How does that sponsor benefit form partial ownership of said property if negotiated by the fund / investors inserting capital? 

    0Reply
  • Sam Dangremond
    Investor · Pueblo, CO · Member since 2012 · 96 posts · 63 votes
    7y

    Has anyone certified as an Opportunity Fund yet?

    The only IRS guidance I can find is here - https://www.irs.gov/pub/irs-dft/i8996--dft.pdf

    And the Form 8996 says "not for filing" here - https://www.irs.gov/pub/irs-dft/f8996--dft.pdf

    Wondering if there is there an updated 8996 somewhere? 

    0Reply
  • Austin Hendrickson
    OP
    Investor · Minneapolis, MN · Member since 2016 · 139 posts · 143 votes
    7y

    @David M. There needs to be a sale to an unrelated party in order for the OZ benefits to be realized.

    - @Adam Mayberry - if a developer is a part owner in the QOZ Fund then there may be some tax benefits there. I can hook you up with a good RE CPA who knows more if you would like. 

    1Reply
  • Austin Hendrickson
    OP
    Investor · Minneapolis, MN · Member since 2016 · 139 posts · 143 votes
    7y

    @David Monroe if an investor does not use capital gains to fund the OZ purchase then no QOZ tax benefits will arise from the investment.

    You can use cash in addition to capital gains however it will dilute the tax benefits.

    0Reply
  • David Monroe
    Real Estate Consultant · Mobile, AL · Member since 2015 · 78 posts · 96 votes
    7y

    @Austin Hendrickson After reading my post I realized I wasn't clear. You're correct, if the investor does not use capital gains money from another investment then they do not get the tax benefits from the fund. They can, however, still invest their money in the fund, but they will be liable for all capital gains incurred. For sponsors that agree to have this kind of structure will have to get a well qualified CPA to keep track of the investors tax benefits.

    0Reply
  • Tony Kim
    Rental Property Investor · Los Angeles · Member since 2018 · 844 posts · 1k+ votes
    7y
    Originally posted by @David Monroe:

    In 10 years the original deferred capital gain must be paid. When the property sells after 10 years, the remaining capital gains on the money invested is stepped up 100%, giving you no capital gains on sale.

    I believe the original deferred capital gain liability will be recognized at the end of 2026 or in the 7th year after the 2nd tier step up benefit kicks in.

    0Reply
  • Zak Strome
    Member since 2011 · 10 posts · 3 votes
    7y

    It is important to note that the tax benefits of Opportunity Zone Investments only apply to funds sourced from capital gains. After selling an investment property, OZ real estate investors roll only their capital gain into an OZ investment, and then have the flexibility to consider other investment options with the remaining proceeds from the sale of their property. 

    For example, if a real estate investor sells a building for $120, generating a capital gain of $20, he or she can reinvest the $20 portion in an OZ investment, not the entire $120. With a 1031 Exchange, the investor must roll the entire $120 into a new investment to enjoy the full tax benefit.

    Source: https://www.arixacapital.com/opportunity-zone-investment-vs-1031-exchange/

    0Reply
  • Heather H.
    Rental Property Investor · Las Vegas, NV · Member since 2016 · 83 posts · 98 votes
    7y

    Hi All, thanks for this great information. I'm having a hard time finding an explanation of the improvement requirements, and several sources don't even mention them.

    Are you sure the tax advantages are tied to improving the property?

    For example, https://eig.org/opportunityzones/about only addresses the requirement to hold the property, not the improvement requirements. 

    On the IRS OZ FAQ website, it states:

    https://www.irs.gov/newsroom/opportunity-zones-fre...

    A. Opportunity Zones are designed to spur economic development by providing tax benefits to investors. First, investors can defer tax on any prior gains invested in a Qualified Opportunity Fund (QOF) until the earlier of the date on which the investment in a QOF is sold or exchanged, or December 31, 2026. If the QOF investment is held for longer than 5 years, there is a 10% exclusion of the deferred gain. If held for more than 7 years, the 10% becomes 15%. Second, if the investor holds the investment in the Opportunity Fund for at least ten years, the investor is eligible for an increase in basis of the QOF investment equal to its fair market value on the date that the QOF investment is sold or exchanged.

    0Reply
  • Andrew ReyesPro Member
    Investor · New York, NY · Member since 2016 · 52 posts · 15 votes
    7y

    @Heather H.

    The resources you referenced focus on investing in a QOF, which appears to be a requirement of the law. The requirement to substantially improve the property is imbedded in what a QOF is:

    In order to qualify as a QOF, 70-90% (depending on structure) of an entity's assets must be "qualified opportunity zone business property", which  is either "original use" (hard for real estate to qualify unless new construction) or "substantially improved" (see IRC 1400Z-2(b)(2)).

    2Reply
  • Heather H.
    Rental Property Investor · Las Vegas, NV · Member since 2016 · 83 posts · 98 votes
    7y

    Thanks @Andrew Reyes

    I have another question if you would be so kind - I understand that the substantial improvement requirement is on the basis of the building and not the land. My question is, how is the value of the building calculated for the purpose of assessing this - is the the tax assessed value, or does it rely on an appraisal? Thanks!

    0Reply
  • Lane Beene
    Member since 2010 · 26 posts · 12 votes
    7y

    Great discussion on OZ.  I believe this is a very sharp strategy to leverage into real estate investing.  But it's not a stand alone strategy. The underlying investment has to be fundamentally sound.  Many OZ locations are very difficult investment locations and the information about substantial improvements is accurate.  I have dug deep into this topic and can discuss specifics if interested.  PM me

    2Reply
  • Austin Hendrickson
    OP
    Investor · Minneapolis, MN · Member since 2016 · 139 posts · 143 votes
    7y

    @Heather H. basis of the building is based on purchase price less land value

    1Reply
  • Vladimir K.
    Rental Property Investor · Missoula, MT · Member since 2017 · 4 posts · 0 votes
    7y

    I've seen several comments regarding the substantial improvement requirement of opportunity zone real estate, but they don't seem to match with how the law is written, at least as I am interpreting it. Can anybody explain where I am making the mistake in how I am interpreting the law? Here is the relevant language:

    "(ii) Substantial improvement

    For purposes of subparagraph (A)(ii), property shall be treated as substantially improved by the qualified opportunity fund only if, during any 30-month period beginning after the date of acquisition of such property, additions to basis with respect to such property in the hands of the qualified opportunity fund exceed an amount equal to the adjusted basis of such property at the beginning of such 30-month period in the hands of the qualified opportunity fund."

    So to me, this seems to say that you do not have to make a substantial improvement to the property in the FIRST 30 months. It can actually be during ANY 30 month period after the date of acquisition. Also, you don't need to invest an amount equal to the purchase price or your original basis, but you can invest an amount equal to the ADJUSTED basis at the time that the 30 month period commences. So doesn't this mean that you could wait to improve the property at a later date, and actually invest significantly less into improving the property, while still meeting the substantial improvement requirement? If you depreciate the property, your adjusted basis would decrease over time, and thus the amount needed in order to meet the substantial improvement requirement would also decrease, would it not? I haven't seen anybody mention this, so I'm sure it's not correct, but I'd love it if someone could explain why it's not correct. 

    0Reply
  • Michael PlaksPro Member
    Tax Accountant / Enrolled Agent · Houston, TX · Member since 2014 · 5k+ posts · 6k+ votes
    7y

    @Vladimir K.

    I like your thinking, comrade! Your interpretation is certainly sensible, given the somewhat ambiguous language. 

    I believe that it was not the intention though. What they probably meant was that the two dates: formation of the fund and acquisition of the property are two different dates. Once the property is acquired, the 30-month clock starts. Likewise, if the fund raises more money and buys another property 2 years later, the 30-month clock for that other property will kick in.

    But since it says "after the date" rather than "on the date" - the door seems to be open for your interpretation as well. Only time and further clarifications (if not already issued) will tell if this loophole was intentional or accidental. Maybe it will have to be litigated in the future.

    If I had a client acting on your interpretation, I would warn them about the legal uncertainty and the risk of being disqualified.

    Thanks for bringing this up.

    0Reply
  • Lane Beene
    Member since 2010 · 26 posts · 12 votes
    7y

    We created an educational video to explain OZ and benefits.  Most of the OZs (75%) don't provide financial requirements for economic return, however when OZs are paired with the right market conditions the investor is $44 richer for each $100 invested in OZ vs standard investments with no tax benefit (SP500).  If you understand the power of tax advantaged investments then study OZs and prospect in your area and leverage your investment strategy with this powerful tool!  

    https://www.youtube.com/watch?v=2lAkhbHW0us

    https://www.youtube.com/watch?v=5XHqq7-0Tp8&t=307s

    "helping you become a better Millionaire!" 

    1Reply
  • Lane Beene
    Member since 2010 · 26 posts · 12 votes
    7y

    @Vladimir K.

    I just attended the IPED conference on OZs and this exact topic was discussed.  The treasury guidance is not clear on the timeline for substantial improvements (first 30 months or any 30 months) and clarification has been requested.  Prior to additional guidance the recommendation was assume first 30 months to avoid being disqualified for the OZ load test and timing requirements.  

    The 2nd tranche of Treasury guidance is expected out soon and hopefully will clarify this and other issues with this new program.  

    1Reply
  • Lane Beene
    Member since 2010 · 26 posts · 12 votes
    7y

    @Vladimir K. second topic adjusted basis.  Upon purchase into an OZ an investor acquires $0 basis.  Therefore any front-loaded depreciation or expense is deferred until offset with passive gains.  This doesn't reduce the adjusted basis as assumed.  Complex topic that would require pages of email but your assumption is not correct.  

    1Reply
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