Posted about 2 years ago

How to Defer and Exempt Tax through Opportunity Zone

Amidst all the changes and political debate of the Tax Cut and Jobs Act of 2017, there was the often overlooked Investing in Opportunity Act. This part of the bill created the Opportunity Zone program to encourage reinvestment in communities and tremendous tax savings for investors.

I first heard about it maybe last March as a boat storage parcel with the potential to redevelop came across my desk. At that time, I felt the guidance was too vague and not enough to formulate an investment thesis. However, if a deal makes sense and we would've done it regardless if we get the tax benefit or not then I would still considered it. Since then there has been two more rounds of guidance from the IRS where I think most people feel comfortable pulling the trigger now. I like to think I am a step ahead of the game but the window is small. To fully maximize the tax benefit you need to have your fund set up this and close on the properties this year.

*** Please note this subject is complex with lots of nuances. This post is meant to be a high level overview and a personal opinion on the strategy, not as legal or tax advice. Although I know a lot about this than the average person, I'm not a CPA and there might be parts of the code that I'm interpreting differently than others. ***


What are Opportunity Zones?

The federal government took input from the governors of each state to designate the zones they'd like to encourage reinvestment. Although there was guideline on income level and others this process was fairly blind thus received a lot of criticism. If you look at the zones there are definitely some areas that seems perfectly fine like downtown Portland or parts of Seattle or Berkeley. I'm not a cynical person but if you told me there were some politics that went into this I wouldn't be surprised.


How Does It Work?

There are two components of Qualified Opportunity Zone (QOZ) tax incentive: tax deferral and tax exemption. Essentially, you can defer paying taxes if you have capital gain of any kind... real estate, stocks, or Bitcoin if you roll your capital gain into a QOZ fund to purchase another investment located in QOZ. It can be a business as well but that gets too tricky and out of scope of this post. If you hold the property for 5 years your tax basis is stepped up 10%. 7 years the basis is stepped up another 5% to 15%. The most you can defer is until April 15 of Year 8 when you'll have to pay that capital gain tax.

This is awesome because not only the tax reduction there's also the time value of money from tax deferral. Instead of paying capital tax to Uncle Sam, this money can go off to grow and spawn more gains for you. Let's consider a scenario with 15% long term capital gain tax on a $100,000 gain. Instead of paying that $15,000 tax bill now, it gets reinvested at 5% annual compound rate it will grow you an additional $4,144 in 5 years or $6,106 in 7 years.

This sounds nice and let's say you keep the money rolling. The most powerful part of this legislature is that after 10 years, the appreciation on your rolled over capital gain spawned or gains from new capital invested into QOZ fund is completely tax free.

fundrise-opportunity-zone-fund

(credit: Fundrise)

What's the Catch?

When something sounds too good to be true my spidey sense usually goes off to start looking for the catch. In this case, there's not a real catch. It's just really tough to make it work within the federal requirements. Here are some of the problems with QOZ investment strategy:

180 day roll over: You need to roll over your capital gain into a fund within 180 days from when the gain is recognized. This is not that big of a problem because the fund managers have additional time to deploy the capital but it does require some planning ahead of time. Not only should you have a fund in mind when you sell, the fund managers will also need to have a high likelihood of lining something up within the time period. This is similar to 1031 Exchange except it doesn't have to be like-kind properties. If your capital gain was from say a syndication then your 180 day starts from the end of the year when your gain is recognized.

Long holding period: I don't know about you but I don't have a crystal ball that looks out for 10 years. Most of the places designated as QOZ are in the wrong part of town and don't have that much prospect for future growth. Even in the areas that we're interested in a lot can go wrong in 10 years.

Illiquid: Real estate is illiquid, meaning you can't easily get your money in and out. The newest guidance has more language around how the fund managers can sell the property and rollover to another QOZ property within a year to relieve this potential problem but largely I'd encourage someone to look for properties they'd want to hold for the rest of theirs lives.

Doubling investment: Under the QOZ guideline, investors will need to double their purchase price minus the land value. For example, you bought a $1M property but the land value is $600,000. In this case you will need to reinvest at least $400,000 within 30 months of closing on the property. This automatically strikes out a lot of the deals we look at because 1) Often if we spend that kind of money the property will be way nicer than anything else on the market and won't be able to achieve premium rent to justify the CapEx. 2) If it's a rent controlled area it's going to be hard to get the tenant out to execute your business plan. 3) For land development, sometimes you can't even get your permit within 30 months.

Small window: To qualify for the 10 year hold criteria and exempt from capital gain tax, you will need to purchase your property by the end of 2019, which really gives you a little bit over 6 months from the time of this publication.

That said, I really like this strategy. Looking at the different rounds of guidances, the IRS is making sure people are not gaming the systems, finding loopholes, and the investment is actually directed at areas that need it. I know I am trying to think long term, piecing together information where the path of progress is going and where city/county/state agencies are putting in infrastructure or re-development plans. The properties that end up benefitting from this will be the ones that have been long overlooked, require heavy lifting, either they're vacant land or dilapidated POS buildings. It is a very capitalist approach for sure, but capitalism doesn't always have to be bad. Especially in this late market cycle, it opens up investment opportunities for capital that normally would've just sat on the sidelines.

Contact me if you have more questions about QOZ through the links in my profile. I've done a lot of studying on this and have closed on 3 deals with another one under contract. Comment below if you're working on a QOZ deal and any problems or hurdles you've came across.



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