CEO of Driftwood Capital, focuses on the investment, development and syndication of institutional-quality hotel assets.
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The opportunity clock is ticking. As a critical deadline in the qualified opportunity zone program approaches on December 31, 2021, investors are finding the potential tax benefits of the program increasingly attractive — in no small part because capital gains tax rates are almost certain to go up in the weeks ahead.
Just to recap, the opportunity zone program was created as part of the Tax Cuts and Jobs Act of 2017 to incentivize private capital investments in low-income communities. Initially, investors shied away from allocating dollars to qualified opportunity funds (QOFs) due to their complexity. Over time and with additional guidance and clarification from the IRS, the program has gained momentum — and by the end of 2020, investors had poured over $15 billion in equity into QOFs, according to Novogradac.
Now, with Congress contemplating raising capital gains taxes from 20% to 39.6%, investors are even more eager to allocate realized capital gains into tax-free vehicles. Thus, opportunity zone funds have become an attractive option for gain harvesting. While deferred capital gains ultimately pay taxes at the applicable rate at the time of realization (i.e., they will likely be greater in the future than today), the ability to pay no taxes on the “new” capital gains generated by opportunity zones investments is extremely attractive, especially given the potential future rate of 39.6%.
By investing capital gains into a QOF, investors can defer capital gains tax liability until December 31, 2026, reduce tax liability on the original gain by 10% and eliminate tax on any capital gains realized from an opportunity zone investment after a 10-year holding period.
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When the basis of the investment from an investor’s original, rolled-over gain is taxed in 2026, that gain will decrease by 10% if they’ve been in the QOF for five years, making the end of this year — December 31, 2021 — the final deadline to be eligible for the 10% reduction.
For investors interested in this program, here are four general pieces of advice about investing in real estate through a QOF.
1. Don’t invest in a pipe dream.
The potential tax benefits of investing in a QOF are alluring, but the fundamental commercial real estate principles still apply. The project should stand on its own. It should make financial sense with or without the capital gains tax benefits. In other words, think of the QOF as the cherry on top — not the deal driver itself.
Similarly, work with a sponsor that is already far along in the process. For example, they’ve already secured financing and received all necessary approvals (or are close to it). If it’s a retail project, there should be an anchor tenant; if it’s a hotel asset, a flag should be signed on.
Another reason this is important in today’s inflationary climate is the seesawing cost of construction materials and labor. For new development projects, make sure the GC contract has been inked, as that could have a material impact on costs.
2. Consider single-asset funds over multi-asset funds.
Traditionally, real estate funds often hold multiple assets in order to maintain a diversified portfolio and reduce risk. But when it comes to QOFs, investing in single-asset funds could be the safer bet.
There was originally a great deal of uncertainty surrounding the tax benefits of multi-asset QOFs, though later guidance from the IRS did clear up some of the concerns. Still, single-asset funds offer investors a greater understanding of the specific opportunity zone they are investing in and the true potential for ROI when considering the associated tax breaks.
3. Choose a sophisticated, seasoned sponsor.
The QOF program is not for the amateur sponsor/developer. There are complicated and ever-evolving IRS regulations and rules that must be followed to remain in compliance and ensure the maximum tax benefits are achieved.
It’s extremely important to invest alongside a sophisticated, experienced sponsor that has both real estate and fund administration expertise. Go with a group that is receiving sophisticated legal and tax counsel and is very engaged and communicative regarding the underlying project as well as the fund’s administrative side.
4. Consider the asset class carefully.
Given that there is a 10-year holding period to qualify for the tax elimination granted to QOFs, investors should carefully consider the type of property they are putting their money into before diving in.
No one can predict the future, but there are clear trajectories for certain asset classes that are undeniable. Retail, for example, has been on the decline for many years and suffered massive losses during widespread shutdowns due to Covid-19. In contrast, multifamily properties, especially in the suburbs, are in great demand given the current residential market. And while hospitality has gone through the gauntlet over the past year and a half, there are now tremendous opportunities in that space.
While it’s nearly impossible to pick specific winners 10 years from now, it’s still important to go into it with the assumption that you’re in it for the long haul — and can’t reposition your capital during that 10-year hold period.
In summary, it’s all but certain that capital gains rate hikes are just around the corner. With three months left until the critical December 31, 2021, QOF deadline, investors have an unprecedented opportunity to stash their stock market or property markets gains of the last year and put them to work elsewhere to continue earning returns that will ultimately be tax-free beginning in 2031.
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