What Opportunity Zones Are and The Benefits of Investing in them

Eric Barvin

Where is the next opportunity? It's the million- or (multimillion-) dollar question.

Here's our snapshot of the current multifamily real estate investment situation:

The market continues to escalate, and it is getting harder to make the numbers work at current prices. Most recent multifamily real estate purchases have been completed by sponsors (general partners) who are fee-driven, using high levels of debt to finance project at sky-high valuations that do not reflect the real risk. Rent growth is slowing and expenses are increasing. These factors could bring new opportunities in the next few years, if sponsors are unable to hit their pro-forma projections and cannot refinance their high leverage loans upon maturity.

Admittedly, this isn't the prettiest picture for the investment business. Our goal is to buy properties that will appreciate in the future and bring a reasonable cash flow in the present. There will always be one-off deals that make sense, but it's proving more difficult to make investments work, particularly with escalating interest rates.

That being said, we see a new opportunity within the new "Tax Cuts and Jobs Act" (TCJA).

A key part of the TCJA, which garnered bipartisan political support, is the Investing in Opportunity Act, which provides special benefits for investments made in geographies designated as "Opportunity Zones." Opportunity Zones (OZs) are areas that each state and city have nominated for redevelopment, with the approval of the federal government. These zones are in low-income areas that are to be reenergized by practical investment. Under this new law, investors can obtain tax relief by investing in a qualified OZ property.

Below we will discuss in detail what OZs are and the benefits of the unique opportunities for future wealth appreciation that we believe are offered by investment in an OZ.

What Are Opportunity Zones?

In March 2018, the US Treasury agreed to designate certain census tracts throughout the country as Opportunity Zones (OZs). This was done to generate private investment in distressed areas, stimulate economic revitalization, and boost job creation. Over 8,700 OZs were created in the US. In Texas, there are more than 600 OZ census tracts across 145 counties.

In order to qualify as an OZ, a census tract must meet the following requirements:

  • There must be a poverty rate of at least 20%

OR

  • A median family income of:
    • No more than 80% of the statewide median family income, for census tracts outside of metropolitan areas
    • No more than 80% of the greater statewide median family income, or the overall metropolitan median family income, for census tracts within metropolitan areas

According to these requirements, the downtown and urban areas of most major cities qualify as Opportunity Zones. For instance, in Houston, all of Downtown, Midtown, and parts of the Medical Center are OZs.

These above income requirements sound fairly bleak, but like most investments the details are important. For example, an area where many students live could be designated as an OZ, because student incomes are frequently very low. Or an industrial area could be deemed an OZ, due to the small number of residents, and the fact that those who do live there have low incomes. Often the edges of an OZ lie alongside a thriving economic area. For example, in Las Vegas, one side of Las Vegas Boulevard (the Vegas Strip) has been designated as an OZ, while the other side of the street has not. While one needs to be selective, there are some excellent potential investment opportunities within Opportunity Zones.

NOTE: THE ABOVE DESCRIPTION APPLIES TO STATE OF TEXAS RESIDENTS. RESIDENTS OF OTHER STATES, AND OPPORTUNITY ZONE INVESTMENTS IN SOME OTHER STATES, MAY NOT ALLOW CAPITAL GAINS DEFERRAL ON STATE INCOME TAX, OR MAY HAVE A DIFFERENT TAX TREATMENT WHEN THE INVESTMENT IS SOLD. PLEASE CONSULT YOUR TAX ADVISOR IN THE STATE IN WHICH YOU RESIDE.

Benefits of Investing in OZs

When an investor sells an appreciated asset that they have held for more than one year, such as stocks, bonds, or real estate, they realize a capital gain. This is a taxable event. But under the Opportunity Zone program, if an investor reinvests any part of that capital gain into an Opportunity Zone Fund, the payment of the capital gains tax that is invested is deferred until 2026, and could be reduced or eliminated entirely.

There are 3 federal tax benefits available when investing in a qualified Opportunity Zone Fund:

  1. Capital gains tax deferral: If you invest your realized capital gains into an Opportunity Zone Fund, you can defer the tax due on those capital gains until you sell your interest in the fund, or December 31, 2026, whichever comes first. You must pay your capital gains into an Opportunity Zone Fund within 180 days of the sale, so for example, if you realized a capital gain in August 2018, you have until the end of January 2019 to invest those gains in an OZ Fund to be able to defer the payment of the capital gains tax. If the gain was on the sale of a property within a partnership, the rules are slightly different, and it is possible that the period to invest those gains is longer than 180 days.
  2. Step-up in basis: If you hold your investment in the Opportunity Zone Fund for at least 5 years before December 31, 2026, you can reduce your tax liability on the deferred capital gain invested in the Opportunity Fund by 10%. If you’ve held it for at least 7 years before December 2026, your tax liability is reduced by another 5%, or 15% in total. This means that an investment in any Opportunity Zone Fund that is made prior to December 31, 2019, and held through December 2026, will be eligible for the 15% step up in basis.
  3. Capital gains tax elimination: If you hold your investment in an Opportunity Zone Fund for 10 years or more, you will not pay any capital gains tax on that OZ Fund investment when it is sold.

The concept of deferring and reducing capital gains tax is similar to that of a 1031 like-kind exchange, but it has significant advantages. Here are some of the ways that investing in Opportunity Zone Funds is better than a 1031 exchange:

  • You can transfer the profits of the sale of any kind of asset (stocks, personal property such as art, private companies, etc.) to an Opportunity Zone Fund, unlike a 1031 exchange, which only allows you to do a like-kind exchange for real estate. With a 1031 exchange, the real estate purchased also has to be of greater value than the total proceeds received on the real estate sold.
  • With an Opportunity Zone Fund, you can choose to transfer only your personal gains to the Fund. You can retain the initial capital investment on the item you sell, before investing in the Opportunity Fund. For example, you invested in a partnership that has bought an antique car, and that asset has been sold for a gain. You can take the gain and move it into an Opportunity Fund, regardless of the choice of the other members of the partnership, and keep the original cost of the antique car to invest elsewhere. You don’t need to reinvest the original capital, only the funds that would be considered as capital gains by the IRS. With a 1031 exchange, you can't remove your original capital, or abandon the partnership.
  • With today’s inflated stock values, it is really very easy to harvest those gains to transfer funds from stocks into an Opportunity Zone investment. For example, you bought Apple stock at $50, but is it now worth $150. You can sell the stock at $150, and harvest the $100 per share long-term capital gain to invest in an Opportunity Zone Fund. And the next day you can buy as much of that $150 per share Apple stock that you want, to reinvest in Apple. The 30-day rule many of us are familiar with only applies in harvesting a stock loss, not a gain.

How Do You Invest in OZs?

In order to invest in an Opportunity Zone and enjoy the tax breaks that come with it, investors have to use a qualified Opportunity Fund.

An Opportunity Fund must:

  • Be certified by the US Treasury
  • Hold at least 90% of its assets in a Qualified Opportunity Zone investment
  • Invest only in real estate, businesses, and business assets that are located in an Opportunity Zone
  • Invest in the construction of new buildings, or substantial improvements to existing buildings
  • If the fund is renovating existing property, it must invest more in the cost of improvements than it paid to buy the building
  • Complete the development or renovation of the building within 31 months of the investment in the Opportunity Zone Fund

Moving Forward

The Barvin Group intends to take advantage of this tax break by buying raw land and building new area-appropriate multi-family projects in Opportunity Zones. Currently, we are under contract to purchase a piece of land in the Texas Medical Center which is within an OZ, and we will build our first new multifamily development project. It’s located close to another property we own, the future Texas Medical Center-3 campus, and is in walking distance to the light rail.

We plan to finalize the purchase of that land in January 2019, and then reach out to Opportunity Fund investors shortly thereafter. Depending on permissions, our plan is to start construction later in 2019, with completion of the project projected for 2020. We will send more information in the near future. Note that, at this point, we will be raising Opportunity Funds on a property by property basis rather than creating a single fund to own multiple assets.