I recently was evaluating a mixed-use investment in Omaha. The listing, like many others, proclaims that the property is In an Opportunity Zone! Opportunity sounds really nice. Just what opportunity are they selling? I did a bunch of research and I’m happy to pass the highlights on to you.
Opportunity Zones were created as part of the Tax Cuts and Jobs act of 2017. Like most tax breaks, it was designed as a way to get people to move their money to something. Tax breaks aren’t a way for the government to give back, they are encouragements to get you to do something that the government wants. Get married – tax break. Have children – tax break. Own your own home – tax break. Borrow money for your home – tax break. Invest for retirement, thereby decreasing your need to use government retirement support – tax break. You probably consider these either good or bad depending on whether you can take advantage of them. All get you to do something and give you a reward for doing it.
What Do Opportunity Zones Get You to Do?
The plan is to get you to invest in areas the government wants to have improved. These areas were selected by state policymakers. If you invest in these areas, the thought is that you will be creating jobs and spurring economic growth. Economic growth is happening all over the country, but certain areas are not experiencing this and the idea was to designate these as opportunity zones.
What is the Reward?
The investor is putting all this work into a property hoping to make a profit. The IRS calls that capital gain and requires taxes to be paid on the gain. If invested in an opportunity zone and held for more than 5 years, taxes decrease by 10%. If held for more than 7 years, it rises to 15%. After year 10 the tax is completely wiped away. That’s huge. A profit of $100,000 might see a $20,000 reduction in taxes. Additionally, funds used to invest can be brought over tax-free similar to the 1031 exchange. Of course, these benefits come with a bunch of rules that must be followed. And one giant catch.
How to Take Advantage of Opportunity Zones
- Create an LLC that is a Qualified Opportunity Fund. You need a statement in your articles of incorporation and file an annual 2-page Form 8997 (it’s brief). This LLC is now a fund and must use 90% of its investment in one or more opportunity zone projects. You could invest in someone else’s fund if you wish. Then you don’t do the next steps.
- Find a property within the opportunity zone. Don’t worry, sellers proclaim this from the mountaintops when listing.
- Do your underwriting with a 10 year horizon. The lower tax benefits aren’t really worth it. You’ll need to hold this for a long time.
- Get your investors together (if needed) and purchase the property
- Improve the property – more on that below
- Sell at 10 years or later, pay no capital gains tax, and feel good that you helped the community.
So, What’s the Giant Catch?
The IRS requires you to make a substantial improvement in the property. This is the whole reason for the notion of opportunity zones – improve the designated area. Substantial improvement in gov-speak is that the additions to the property must exceed the adjusted basis at the start. The timeframe is any 30-month period after acquisition of the property. This forces the investor to do big improvements quickly, not over 10 years. But, the improvements can start at any point in the future. Basically, you have to put an equal amount of money into the property as the value you purchased it for (minus what ever the land is worth).
That’s a big catch. It would be hard to use this tax benefit in any but the most distressed properties, and I suspect that is by design. If you buy an old restaurant, gut it, rebuild the dining area, and replace the kitchen, you probably have satisfied the requirement. It would be difficult to qualify if you purchased an apartment building and did some light rehab.
If you want to take advantage of this tax benefit, you’ll have to roll up your sleeves and get ready for a big rehab. This hurdle may deter a lot of investment, but may also drive investment into only the most depressed areas. Make sure you talk to your accountant and attorney before making your purchase. Let me know how your experience goes.