Opportunities in Opportunity Zones
Recently, investors have become infatuated with Opportunity Funds, a popular new vehicle to reap attractive tax incentives while investing in positive social impact projects. Opportunity Funds stimulate private investment, rather than committing federal taxpayer dollars, in projects that encourage real estate development and economic activity in designated opportunity zones. Created by the Investment in Opportunity Act and introduced with the 2017 Tax Cuts & Jobs Act, opportunity zones target economically distressed or low income communities in 8700 designated areas across the US. There are opportunity zones in all 50 states, the District of Columbia, and in five US possessions: American Samoa, Guam, Northern Mariana Islands, Puerto Rico, and the Virgin Islands.
Opportunity Zones are created and designated by governors based on criteria set up the IRS. Essentially, an area can qualify as an opportunity zone if more than 20% of the population lives in poverty or if the median family income falls below 80% the state median income levels . A neighboring community could also qualify if median family income is less than 125% of the adjacent opportunity zone.
To qualify for preferential tax treatment, a Qualified Opportunity Fund must invest 90% of its holdings in Qualified Opportunity Zone property. This may include partnership interests, stock ownership, or property based in a designated Opportunity Zone. Opportunity Fund treatment only applies to new construction and to substantial improvements to existing structures.
Compared with other existing programs that endeavor to stimulate private investment in low income communities, Opportunity Zones are not a tax credit program. This means there are no limits on the number of potential projects or on the dollar amount a project may provide to a community. Since the only limit to these programs’ impact is the ability to create viable profitable projects, there’s greater opportunity for scale and impact than with other existing programs.
Some investors are drawn to these investments because of their potential for social impact. To encourage long term capital investment in Opportunity Zones, the Tax Cuts & Jobs Act provides significant tax incentives. Primarily, you can defer capital gains, receive a step up in basis, and potentially earn a higher after-tax return than comparable investments. First, you can defer capital gains that are reinvested into Opportunity Funds until you dispose of the Opportunity Fund, or December 31, 2026, whichever is earlier. Second, you receive a partial step up in basis for holding the investment for at least 5 or 7 years. This step up in basis lets you exclude a portion of the original gain on the investment at the time you sell the fund, so you pay less taxes on capital gains. You receive a 10% step up if you hold the investment for 5 years, or a 15% step up if your holding period is at least 7 years. Last, you may be able to permanently exclude the gain from the Opportunity Fund if the investment is held longer than 10 years. All in all, these tax incentives encourage long term investment in underserved communities. As a benefit for your investment, these tax incentives can help you potentially realize higher after-tax returns than comparable investments, while investing in social impact projects.
Although some Opportunity Funds make genuine attempts at financing social change, not all are consistently measuring social impact in meaningful terms. Opportunity zones self-certify, which lowers the administrative burden and cost for these programs. On the other side of that coin, there’s a lack of regulation governing the impact of each fund on the community it serves. What’s more, there’s little consistency in how Opportunity Funds talk about their community impact. The US Impact Investing Alliance has proposed some guiding principles for fund managers. Look for investments that reach low income or underinvested communities, with a special focus on diversity. It’s important to find fund managers who understand how to address local needs in the communities they intend to serve. Look for transparency, accountability, and fairness in practices. Lastly, projects should track real change in their communities, providing metrics that show they are sound investments and that they are generating real change.
Remember that Opportunity Funds are not charity; they are investments that need to be profitable for you to take advantage of the tax incentives. Funds must be evaluated to determine if they will be successful investments over the long term. Because these investments should be held long term for the greatest tax benefit, investors should have a clear understanding of their liquidity needs.
Opportunity Funds were recently introduced as a tax-incentivized vehicle for investing in underserved communities. It may be an appropriate option for investors looking for real estate investments while providing positive social impact. These funds may help you defer or even exclude capital gains, which may ultimately increase your after-tax rate of return. To get started, it is important to evaluate the profitability of potential investments to ensure they will be viable long term investments, allowing you to take advantage of tax incentives while investing in underserved communities.