Commercial real estate investors are always on the lookout for new opportunities. Commercial real estate opportunity zones are relatively new investment vehicles. They are great for improving your bottom line while benefiting communities. You might get tax benefits like preferential tax treatment when you invest in opportunity zones.
Read on to discover what opportunity zones are, their tax benefits, and why investors should consider them.
Opportunity Zones Explained
The Tax Cuts and Jobs Act of 2017 is the law that created the concept of opportunity zones. These zones were designed to encourage economic growth and create job opportunities. Simply put, opportunity zones are economically disadvantaged areas recognized by the federal government.
New investments in opportunity zones can benefit from preferential tax treatment. Tax incentives attract investors who will invest in long-term projects in low-income areas.
The first-ever opportunity zones got selected in April of 2018. These zones were in parts of 18 states. Since then, that number has increased exponentially. There are now 8769 opportunity zones distributed all over the country and in five of the nation’s territories.
Criteria That a Region Has to Satisfy to Be an Opportunity Zone
There are specific requirements that a region has to meet to get classified as an opportunity zone. The government used local input to ensure the program included communities that would benefit most from new investments.
Governors in each U.S. state and territory nominate low-income regions in their jurisdiction to become opportunity zones. These zone nominations go to the Secretary of the U.S. Treasury for certification. Once a zone gets certified, it becomes an official opportunity zone.
But how does a community get nominated to become opportunity zones? For one, potential commercial real estate opportunity zones must have poverty rates of 20% or more.
Communities must also have a median family income of no greater than 80% of the statewide median income.
Generally, opportunity zones are census tracts with high unemployment and poverty rates. They also have a low median family income.
Opportunity Fund
Commercial real estate investors must invest in an opportunity fund to enjoy the program’s tax benefits. If investors place their capital gains directly in an opportunity zone property or business, they won’t be eligible for tax incentives. What makes it an opportunity fund?
- An opportunity fund is an investment tool whose main purpose is to invest in certified opportunity zone properties.
- Opportunity funds are privately managed and structured like a partnership or a corporation.
- The fund must hold 90% or more of its assets in opportunity zones.
How the Fund Works
The Department of Treasury usually evaluates opportunity funds two times each year. They do that to check for compliance. As discussed above, opportunity funds must have 90% of their assets in opportunity zones. If the Treasury Department finds that a fund doesn’t follow that rule, it will charge a fee.
The fee is 6% annually until the fund complies with the 90% requirement. The property invested in must be a new one for eligibility. But, oftentimes, it is a rehabilitation project. In the case of a rehabilitation project, the funds that go into making property improvements must be equal to or greater than the funds used for the initial purchase.
Note that this rule only applies to the cost of the building, not the land. Take, for example, an opportunity fund that puts $1.7 million into rehabilitating a building in an opportunity zone. The building is worth $1 million. The land is worth $700,000.
The opportunity fund must invest $1 million in improvements to the property instead of the entire $1.7 million. Another rule is that new construction projects or rehabilitation must get done in 30 months.
There are restrictions if an opportunity fund wants to invest in a business. One, the business must not fall under the prohibited category. The category includes seemingly ‘sin’ businesses. That includes liquor stores, gambling businesses, and tanning salons.
Golf courses and massage parlors also fall under the prohibited category. An opportunity fund can own a commercial building that is then leased to prohibited businesses, but the fund cannot have shares in the businesses.
The second criterion a business must meet is to conduct 70% or more of its activities in an opportunity zone. This rule partly encourages initial opportunity investments to go to multifamily real estate rather than a business.
Why Commercial Real Estate Opportunity Zones Are Attractive for Investors
Opportunity zones encourage job creation and overall economic growth. Both these things are beneficial to economically disadvantaged communities.
But, the question of whether investing in commercial real estate opportunity zones is worth it remains. Here’s why opportunity zones could be attractive for commercial real estate investors.
Opportunity Zone Tax Benefits
The opportunity zone program encourages the development of specific locations. Eligible commercial real estate investors can enjoy major tax benefits by investing in opportunity funds. These tax benefits are:
Tax Deferral
A commercial real estate investor may choose to transfer their capital gains to an opportunity fund. The investor has a chance to defer paying taxes for such capital gains if they transfer the money within 180 days.
The deferral of capital gains is applicable for every investment gain. Examples include selling stock that appreciates or selling a business. Tax from investing in a commercial building in opportunity zones is not deferred indefinitely. It’s only deferred until 2026.
Take, for example, an investor who sold a zero-basis enterprise for ten million dollars in 2019-the sale results in a ten-million-dollar capital gain. The investor then invests all the money in an opportunity fund within the first six months of the sale. So, none of the proceeds from the sale will get taxed.
A lack of taxation lets the investor keep a portion of the proceeds that would have otherwise gotten taxed. Based on the IRS rate of 20% in 2019, two million dollars would have gone to taxation. By investing in an opportunity fund, the individual will get a significant investment return for the ten million.
Possible Decrease in Tax Liability
Opportunity zone investors can also minimize capital gains taxes; however, this is only under particular circumstances. A commercial real estate investor may keep their investment in an opportunity fund for five years before 31st December 2026. If they do so, they can limit their deferred capital gains tax liability by 10%.
In another scenario, an investor may hold their investment in an opportunity zone fund for seven years. Again, before 31st December 2026. By holding for seven years, the investor will reduce their deferred capital gains tax liability by an extra 5%.
Thus, the reduction amounts to 15%. Take the previous example where someone invested the whole $10 million from a business sale into an opportunity fund. After five years, the investor will get a $1 million basis in the fund. This amount comes from 10% of the initial deferred capital gain.
Seven years after the investment, the investor gets another $500,000 basis in the fund. This amounts to the additional 5% of the originally deferred capital gain. Seven years later, they can sell their ten million investments.
They then pay tax for $8,500,000 of the gain. That’s 15% less. The investor will enjoy significant tax savings by holding the investment for seven years.
Zero Tax on Appreciation
If an investor holds the investment for ten years or more, they can exclude 15% of the taxable gains from the initial amount of investment. The investor can also exclude 100% of the taxable gains of the investment in the opportunity fund. The exclusion is only applicable for gains garnered following investment in an opportunity fund.
Consider an investor who puts $10 million in an opportunity fund in 2019. Years later, in 2030, the investor sells their investment for $15 million. The investment will have appreciated by five million dollars. The appreciation will not get taxed.
Who Can Invest in an Opportunity Fund?
The longer you hold an investment, the greater the reward. So, experts find that investing in an opportunity fund might not be beneficial if you have an investment horizon of fewer than ten years.
When you have a minimum 10-year investment plan, you can fully benefit from the tax benefits of an opportunity fund. Investing in an opportunity fund may not be beneficial for commercial real estate investors who are:
- Advanced in years.
- Have deteriorating health.
- Needing to use their money in a short time.
Investing in Commercial Real Estate Opportunity Zones
Whether to invest in commercial real estate opportunity zones or not will depend on your finances. If you receive significant capital gains, it may be worthwhile to invest a chunk of the cash in an opportunity fund.
Make sure you consult experts in the area when investing in an opportunity fund. Doing so will ensure the investment benefits you and the community. Contact EXtrance today to learn how we can help improve your commercial real estate investments.