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While the term “Opportunity Zones” may sound familiar now, it’s a relatively new term, and plenty of investors still know little about what they are and how to use them to their benefit. Whether you’re considering your first property investment or your thousandth, it’s smart to understand what they are, and whether this is the right program for you.
Opportunity Zones were created as a result of the 2017 Tax Cuts and Jobs Act, and are now in all 50 states as well as Puerto Rico, American Samoa, the Northern Mariana Islands, the Virgin Islands and Guam. By definition, they are distressed areas that now enjoy a federal tax incentive designed to promote long-term investment in those areas that require help rebuilding. Tenants have moved out; buildings and areas are in disrepair. These blighted areas are generally not attractive to commercial institutional investors.
On the other hand, Opportunity Zone investments are attractive to nontraditional investors like high-net-worth individuals, family offices and endowments and others. The core of the program is to encourage investors to reinvest capital gains, which can come from any investment — including stocks, bonds, real estate and partnership interests — into these zones.
How The Program Works
Investors are able to invest in qualified Opportunity Zones through an investment called an Opportunity Fund. This allows them to realize tax incentives that are exclusive to this program. The Opportunity Fund provides both temporary and long-term tax deferrals for eligible investors. The IRS has published answers to frequently asked questions that provide information on various aspects of the program.
The longer shareholders keep their interests in the funds, the more rewards they receive. After five years shareholders will pay no taxes on 10% of the gains. After seven years, 15% of the gains will not be taxed, and those holding investments for 10 years avoid paying taxes on all gains.
While investors can benefit by investing in Opportunity Funds, the communities can benefit as well. One of the requirements of earning a designation as an Opportunity Zone is that the area includes a poverty rate of at least 20%. It all ties back to promoting sustainable economic growth for these areas, which was one of the main goals of the Tax Cuts and Jobs Act.
Making Smart Investments In Qualified Opportunity Zones
Investors who participate in an Opportunity Fund are joining a privately managed investment that’s created as a partnership or as a corporation for the main purpose of investing in qualified Opportunity Zone properties. Something to consider is the fact that we’re in the midst of a very long cycle, and we’re probably approaching the tail end of a great expansion. If you’re planning to invest in an Opportunity Zone, be sure you question whether your investment will perform in light of a worst-case scenario. Bear in mind that many Opportunity Zone areas are in low-income communities, where there is economic distress.
One way to analyze investment potential in a worst-case scenario is to convert different possibilities into hard numbers. As an example, if the property is located in an Opportunity Zone and the potential returns look great with a 5% vacancy rate, run the numbers and see how it will perform with a 10% vacancy rate, or if rents will not increase for a few years. Is the opportunity still profitable, do you break even or lose money? You need to have profit to enjoy special tax incentives, like those that the Opportunity Zone program offers. If the opportunity is not profitable, then you are seeing losses and the tax breaks from the Opportunity Zone program are not as great an incentive or as helpful at that point.
Smart investors realize that, as with other areas that undergo refurbishing and renovation, the properties surrounding the Qualified Opportunity Zones may present attractive investment opportunities as well. Hence, don’t exclusively focus on Opportunity Zone areas. And when looking at properties within an Opportunity Zone, be sure to look at the median household income of the area to make sure that the tenant base is solid and there is rent and job growth in the market.
Location is still key when it comes to real estate investing. An investment in a bad neighborhood will not make it a great investment just because it is eligible for Opportunity Zone tax incentives. A colleague recently reminded me that another risk facing investors is finding a fund manager who understands how the program works. Due diligence is needed, and vetting the qualifications of the fund manager is critical, especially since this program is relatively new.
Summary
The interest in Qualified Opportunity Zone investments has been increasing lately, as the program could be attractive to many investors. Don’t be tempted to invest in an Opportunity Zone deal without checking the fundamentals of the deal, as you would with any other real estate investment. Remember to consider the risks of these investments, too, as you would with any property deal.
If the deal makes sense even without the tax breaks from the Opportunity Zone program, then investing in an Opportunity Zone fund might be a lucrative investment. Don’t be blindsided by the new program, and always make sure to be conservative in your analysis.