One of the least publicized provisions of the federal Tax Cuts and Jobs Act signed into law last December will be getting a lot more attention in coming weeks. The provision has the potential to stimulate a new round of investment in commercial real estate, mostly in struggling urban, suburban, and rural communities across the United States.
A provision of the law offers tax benefits to investments in so-called Opportunity Zones, economically distressed communities defined by state and federal officials. The Department of Treasury this summer officially designated more than 8,760 such zones eligible for the benefits based on recommendations from each state.
The flow of money coming into deals in those areas could be staggering. In its analysis of the tax law, the U.S. Joint Committee on Taxation implied $86 billion of investments in qualified opportunity zones. Real estate investors organizing funds to take advantage of the tax benefits estimate the total could hit $250 billion.
What’s more, to take full advantage of the tax benefits that money would have to be deployed by the end of next year. That is a short time window to invest such hefty amounts. The window is growing ever tighter by the day, too, because the Internal Revenue Service and Office of Management & Budget have yet to issue final guidelines to investors for how the program will work.
“This is going to be a big part of my business over the next two years,” said Rick Barnes, principal of Massachusetts-based CIC Realty.
The brokerage firm is seeking to list $200 million in qualifying properties to market to its national database of investors and fund managers. In the 138 zones in Massachusetts, Barnes said the most likely properties to benefit would be investment-ready opportunities in zones along Massachusetts’ transit-oriented corridors going into Boston.
“For investors, this is a unique opportunity to capture a generous break on capital gains taxes, while investing in real estate that stands to benefit from a broader government mandate for growth,” Barnes said.
The provision also stands to benefit under-served and oft-overlooked investment markets across the country.
“More sophisticated money is sorely needed in rural areas,” said Robert Dunn, an industrial broker with The Stump Corp. in North Carolina. “In a rural market there is a finite amount of money available, and it tends to be controlling, not risk taking. The concept of sophisticated money seeking deals in opportunity zones has the potential of doing significant good in otherwise ignored places.”
Barnes and Dunn are not alone in their instincts that the provision could be a game changer. Brokers across the country at the very least are revising listings to tag properties included in opportunity zones. Many are basing their entire pitch around the opportunity.
Opportunity zones are designed to spur economic development by allowing investors to defer tax on any prior gains through 2026, so long as the gain is reinvested in a “Qualified Opportunity Fund.” In addition, if the investor holds the investment in an opportunity fund for at least 10 years, there would be no tax on any new gain from the investment in the opportunity fund.
The tax code now encourages private capital to invest in eligible low-income rural and urban communities across the U.S. called Opportunity Zones. States are starting to tack on additional incentives. Legislation proposed in Ohio would provide a 10 percent state tax credit on investments greater than $250,000 in qualified Ohio opportunity funds. In fact, a third of U.S. states are actively considering opportunity zone incentives.
Such tax benefit incentives have investment fund managers and equity funds poring through their pipeline of certified deals searching for properties in opportunity zones suitable for new opportunity funds, said James Hanson, president and chief executive of New Jersey-based Hampshire Real Estate Cos. Hanson oversees the operation and investment activities of the Hampshire companies and its funds. The firm is actively exploring the creation of qualified opportunity funds.
Under the law, funds could be set up as single-purpose entities or general funds to invest in several properties in several markets.
Hanson estimates Hampshire currently has a pipeline of potential of eligible deals with an all-in cost of about $250 million.
The deferral of a 15 percent capital tax is welcome, even better though, is the fact that there would be no tax on the new gain, Hanson said. However, the catch is that the deal has to make sense regardless of the tax benefit. History is littered with failed property deals undertaken primarily for a tax break, he said. If history repeats itself, the same could happen again in some of the deals that arising from the new opportunity.
Virtua Partners, a private-equity real estate investment firm based in Phoenix, was one of the first out of the gate this summer with a fund that seeks to take advantage of the newly created program. The investment firm is seeking to raise $200 million from investors.
“The first deals to get done will be those with the lowest risk, highest returns,” said Derek Uldricks, president of Virtua Capital Management. “You don’t make an investment just for the tax benefit. You have got to like the deal.”
Virtua Partners is also one of the first out of the gate to undertake an opportunity zone fund project. It has completed a rezoning in Tempe, Arizona, for a 90-unit apartment project. Tempe City Council unanimously approved the 3.6-acre rezoning for multifamily development. The 16-month construction of the 90-unit apartment complex is scheduled to break ground in the first quarter of 2019.
That time frame also fits into another aspect of the tax law provision. As enacted, the law specifies the investment be used for a new development or, in the case of an existing property, the asset must be “substantially improved” within any 30-month period following acquisition of the property. To be treated as “substantially improved,” the additions or improvements to the property must be equal to or greater than the acquisition cost.
The “substantially improved” provision is one of the many parts of the provision that have yet to be clearly defined. Unknowns of the program have firms such as Hampshire, Virtua and others still approaching the starting gate in what could be a sprint to the 2019 finish line. It also is currently holding back investors from signing over their money to such funds.
So while the first opportunity zone deals are starting to show up, the bulk of the flow will probably come in a surge starting late this year and peak throughout next year. If the estimates of how much money could be pumped into opportunity zones hold true, it would amount to anywhere from 16 percent to 46 percent more in commercial property sales than the $542 billion spent in 2017.
Editor’s Note: This the first of five parts on new Opportunity Zone tax benefits designed to boost investment in economically distressed communities.
Part I: Investment Overview
Part II: Potential Roadblocks
Part III: Emerging Projects
Part IV: Unintended Consequences
Part V: A Successful Effort — So Far