- What is the Opportunity Zones Program?
- The Tax Benefits of Opportunity Fund Investing
- How Opportunity Zones Were Designated
- How Opportunity Funds Work
- Who Should Invest In An Opportunity Fund
- Opportunity Funds and The LIHTC Program
- Financing Properties in Opportunity Zones
- Opportunity Zones Map
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What is the Opportunity Zones Program?
The Opportunity Zones program allows investors to gain capital gains tax benefits by investing in eligible properties and businesses located in specific, economically disadvantaged census tracts across the country, referred to as Qualified Opportunity Zones (QOZs). There are currently 8,700 of these Qualified Opportunity Zones (QOZs) across the country. To gain the tax benefits of the Opportunity Zones program, an investor must invest in an Opportunity Fund, a special investment vehicle which needs to hold at least 90% of its assets in eligible property or businesses located inside an Opportunity Zone.
The Tax Benefits of Opportunity Fund Investing
There are three main tax benefits of investing in an Opportunity Fund; first, if they invest assets in an Opportunity Fund within 180 days of their sale, investors may defer capital gains taxes until they sell their investment or by December 31, 2026, whichever occurs first. In practice, this means they will not have to pay the taxes until April 2027. In addition, investors who keep their money in an Opportunity Fund for at least 5 years will receive a 10% reduction of their capital gains tax liability, while those who keep their investment in the fund for at least 7 years will receive an additional 5% discount, for a total 15% capital gains tax discount. And, in what may be the most appealing element of Opportunity Fund investing, investors who keep their money in an Opportunity Fund for at least 10 years will not have to pay any capital gains taxes on any additional appreciation their investment has experienced since it was placed in the fund.
How Opportunity Zones Were Designated
The Tax Cuts and Jobs Act of 2017 requested that the governors of every US state and territory, as well as the mayor of Washington, DC) nominate specific, low-income census tracts in their area to become Opportunity Zones. In order to qualify, potential Opportunity Zones would need to have a minimum poverty rate of 20%, as well as a median income of no more than 80% of the statewide median family income (for rural areas), or no more than the greater of 80% of the statewide median family income or 80% of the median family income for that metropolitan area.
How Opportunity Funds Work
As mentioned previously, Opportunity Funds must invest 90% of their assets in eligible real estate or businesses located inside a Qualified Opportunity Zone. The U.S. Department of the Treasury will conduct an asset test twice annually to ensure compliance. Funds who do not meet the asset test will be levied a variable fee (currently set at 6% per year) until they reach compliance.
To be eligible, a property must either be new construction, or if it is a rehabilitation project, the Opportunity Fund must invest equal or greater funds into property improvements than it did to initially purchase the property. However, a recent regulatory ruling posits that this only applies to the cost of the building, not the cost of the land. For instance, if an Opportunity Fund invested $1 million into an outdated apartment building, and it was found that the building was worth $600,000, while the land was worth $400,000, the Opportunity Fund would only need to invest $600,000 into property improvements, not the full $1 million. In addition, all construction or rehabilitation projects must be completed within 30 months.
For an Opportunity Fund to invest in a business, the business must not be in a prohibited category. Prohibited business categories include liquor stores, massage parlors, gambling-related businesses, golf courses, tanning salons, and several other types of “sin” businesses. Despite this, an Opportunity Fund can generally own property that is being leased to these businesses, they just cannot own shares in these types of businesses themselves. Plus, the business must do at least 70% of its business inside the Opportunity Zone in order to qualify. This rule has caused serious concern for many Opportunity Funds, and is part of the reason why most initial O-Zone investments have gone toward commercial and multifamily real estate, not businesses.
Who Should Invest In An Opportunity Fund
In general, most experts believe that it’s not worth investing in an Opportunity Fund unless you have a minimum 10-year investment horizon. This way you can take full advantage of all of the tax benefits of Opportunity Fund investing. Therefore, if an investor is elderly, in poor health, or may need to use their funds within a few years, investing in an Opportunity Fund may not be the best choice.
For commercial or multifamily real estate investors who wish to start their own Opportunity Fund, it’s generally recommended that they have at least $1 million in assets to invest. Otherwise, the operational and administrative costs of opening a fund may negate the potential tax benefits.
Opportunity Funds and The LIHTC Program
For those looking to invest in affordable housing using the Low Income Housing Tax Credit (LIHTC), using an Opportunity Fund to do so can create additional tax benefits, increasing investment yields and overall profitability. For those who are not familiar, the LIHTC program is a federal tax credit program that provides investors a dollar-for-dollar credit against their federal income tax liability. In 2016, the LIHTC program offered investors approximately $8 billion in tax credits.
In addition to the LIHTC program, Opportunity Fund projects may also make use of other tax credit programs, such as the New Markets Tax Credit (NMTC) or the Historic Tax Credit (HTC). The New Markets Tax Credit offers investors a 5-year, 39% tax credit for investing in commercial real estate in certain low-income census tracts. Most Opportunity Zones are also NMTC-qualified census tracts, so this overlap means the two tax incentive programs could fit nicely together. The Historic Tax Credit, in contrast, is designed to give a tax credit to investors who substantially rehabilitate qualified historic properties, typically those built before 1936.
Financing Properties in Opportunity Zones
As Opportunity Funds are private investment vehicles, fund managers have a lot of options to choose from when deciding how to finance commercial properties located in Opportunity Zones. For office, retail, and industrial properties, borrowers will typically need to get commercial construction financing from a bank, which they then may wish to refinance into a fixed-rate CMBS loan, or, if the property is extremely high quality, a life company loan. Commercial real estate loans for multifamily properties are somewhat more diverse, as Freddie Mac®, Fannie Mae®, and HUD multifamily loans also become options (at least for rehabilitation and refinancing, as only HUD offers ground-up multifamily construction loans with their HUD 221(d)(4) loan program.
In fact, for properties utilizing the aforementioned LIHTC program, Freddie Mac has a wide variety of financing products specifically designed to assist with this process, including Freddie Mac Bond Credit Enhancement with 4% LITHC, which provides forward commitments for both the new construction and substantial rehabilitation of LIHTC properties, and the Freddie Mac LIHTC Enhancement which insures investors against potential losses should an LIHTC-funded property owner default. Fannie Mae also offers LIHTC-focused products such as the Fannie Mae Credit Enhancement of Variable Rate Tax-Exempt Bonds (Index Bonds), which allows LTVs up to 90% for properties using 4% LIHTCs.
Opportunity Zones Map
To help you better understand the Opportunity Zones program, we’ve included a link to an interactive Opportunity Zones Map created by the Economic Innovation Group (EIG), an advocacy group that helped push for the creation of the O-Zones program.