Are Opportunity Zone Benefits All They Promise?

There is a frenzy around opportunity zone investments and the capital gains tax benefits that come with them, but for commercial real estate investors and developers, 1031 exchanges will likely provide better tax benefits. That is because there are mitigating circumstances to receiving the tax benefit from the qualified opportunity zone. Bryan Shaffer, principal and managing director of George Smith Partners, has outlined five reasons why the tax benefits of opportunity zone investments might not be as advantageous as expected.

First, Shaffer says that the capital gain must be reinvested, and he calls this the most “misunderstood” aspect of the qualified opportunity zone feature. “The most misunderstood part of qualified opportunity zone investments is that you only receive the tax benefits if the investment comes from a capital gain that is reinvested. New money receives no tax benefits,” Shaffer tells GlobeSt.com.

Second, the capital gains tax benefit works better for the large capital gains earned by corporate, stock, bond and casino investors. “Most corporate, stock, bond, and casino investors who make a large gain have to pay capital gains tax. Therefore, these are the most likely types of investors that are going to invest in QOFs,” he says. Real estate investors on the other hand receive better benefits through a 1031 exchange. “Because of the 180-day reinvestment rule for both QOFs and 1031 exchanges, managers of high-net-worth capital and investments banks are more likely to have clients with this type of gain, so they will most likely put together this type of investment fund,” adds Shaffer. “A standalone real estate investment fund would be more likely to attract co-investors who know people with large capital gains.”

The third reason Shaffer lists as a mitigating circumstance for receiving the opportunity zone tax benefit is that the returns must be significant enough to invest. “Unlike an EB5 investment, where the investor receives U.S. citizenship, the QOZ investor only receives a tax benefits of around 200 to 400 basis points,” he says. “So, it is unlikely that someone who needs a 20 percent IRR would be willing to accept an 8 percent IRR only because of the tax benefits. It is more likely that that 20% IRR investor would accept a 16 percent or 17 percent return. Therefore, there is incentive for capital to come to QOZs and QOFs, but the returns still need to be strong.”

Fourth, qualifying investments must meet specific requirements. The legislation requires the project must be in an IRS-designated qualified opportunity zone; a tangible property used in a trade or business; and acquired through a cash purchased on or after January 1, 2018. Finally, the property must be “either new construction that is not put into use until after the purchase of the property or ‘substantially improved’ after purchase of the property, which requires that the costs of constructing, renovating, or expanding the property during any 30-month period beginning after the date of the acquisition of the property must exceed 100% of the adjusted basis of the property at the start of the 30-month period,” says Shaffer.

Lastly, Shaffer says that not all funds are considered legitimate, making it imperative to vet the qualified opportunity zone fund—especially considering the number of funds that have emerged. “Many groups may falsely claim to have huge QOFs or capital, so it’s very important to vet every investment representative and fund before investing,” he says. “This legislation is so new, and errors can have huge negative impacts on investors and their taxable gains. In addition, the IRS and Treasury Department are still finalizing some of the rules, so it would be wise to wait until that process is complete before taking the plunge.”