As the longest economic expansion in United States history encounters increased volatility, investors with a defensive mindset are wondering whether it’s time to sell stock or other appreciated assets and realize some profits. But an even more difficult question for many is how to reinvest the proceeds. After a decade of record returns, some tough questions on taxes will likely arise. One potentially tax-friendly alternative gaining attention recently is opportunity zone funds.
What are opportunity zones?
Opportunity zones are a category of investments created under the Tax Cuts and Jobs Act. The goal is to incentivize private investors to invest in qualified assets in low income communities by offering tax benefits linked to capital gains that are triggered by the sale of stock, certain sales of real estate, or some flow through holdings.
The potential tax benefits fall into three categories:
- Deferral: The first benefit enables investors to defer the obligation to pay tax on gains triggered by a sale of appreciated assets to Dec. 31, 2026. This is a deferral only – the tax still has to be paid on the gain — and it can’t be rolled forward like some other programs in real estate that are lifetime exchanges.
- Exclusion: The second tier of benefits allows investors to potentially take a “haircut” on their tax obligation. Depending on how long the investor has been invested in an opportunity zone fund, he or she might be able to shave off 10% of the gain when the tax is paid on the 2026 tax return.
- Step-up in basis to fair market value: The third benefit, and the one that has created the most attention, is the possibility of avoiding tax on the appreciation that grows within the opportunity zone fund if the investor stays in the fund for at least 10 years.
As with most tax benefits, “the devil’s in the details,” and opportunity zones are no exception. Opportunity zone investments are subject to a list of special IRS regulations which investors must check off to qualify for the tax benefits. Key items include:
- Location: The property must be in a designated zone to qualify. There are over 8,700 zones across the United States and territories. Designations are based on low-income census tract data selected in 2018, and they don’t change over period of the designation, even if the boundaries of an individual census tract are redefined in future census releases.
- Qualified asset: At the fund level, 90% of the assets must be a “qualified asset,” which means either real property in a zone or investment in an underlying business (not necessarily involved in real estate) that qualifies similarly. For the property itself to qualify, it must either be “new to the zone” — meaning new or something that has been vacant for a specified period of time and brought back — or something that has been substantially improved. “Substantial improvement” is defined as making improvements that double the basis of the property over a 30-month period.
- Business requirements: The rules require operation of some sort of a trade or business. Things like triple net leases without active conduct of business don’t qualify. Related party restrictions must also be considered.
- Timelines for investing: There’s a 180-day clock for investing a gain in an opportunity zone fund. And then the fund itself has another timeline for when money must be put into property or a business. If it’s put into a business, then the business has a timeline must follow to get the project completed. When the first clock is started depends on the type of investment that triggered the gain. Since individual circumstances differ, it’s important that investors work with tax advisors to ensure the fund has structured the project correctly.
Assessing the investment potential
While opportunity zone investments can offer attractive tax benefits, they should be treated like any other real estate investment in terms of fundamentals. These are typically opportunistic investments that carry a lot of risk. An opportunity zone program doesn’t make a bad deal good; it makes a good deal better. Investors need to feel confident that they would have invested in it anyway and treat the tax savings as just an added benefit.
Opportunity zone investments should be investigated like any other opportunistic real estate investment along with a couple of additional factors:
- Location: It’s critical to understand fully the specific zones the fund targets. Opportunity zones are not created equal. Some are located near vibrant, expanding central business districts in cities while others are in deep rural areas with different economic prospects. Investors need to understand the inherent risk that comes with the locations chosen for the fund.
- Track record of the fund manager: The ability and track record of the investment fund manager are potentially more important than they would be with other investments because managers and investors will be partners for the next 10-plus years. A fund manager could be an experienced developer, but do they have a track record of holding properties for this long? Do they have an asset management infrastructure that goes beyond the traditional developer’s 3-7-year hold period of “fixing and flipping?” It’s critical that the manager can hold the property over the long term and manage it through the first couple of lease rolls. The majority of the tax benefit comes from that the property’s appreciation upon ultimate exit. This requires a manager that can not only create value through the development but maintain and enhance that value over the entire investment period.
Plante Moran investment advisory team
Given the risk and complexity of real estate and opportunity zone investing, it’s important to have a multidisciplinary team of advisors evaluating and advising on investments. Plante Moran has a multidisciplinary team of real estate, tax, and wealth management experts who evaluate opportunities and can pull in resources from anywhere within the firm to benefit clients.
To find out more about real estate as an alternative investment, give us a call.
