The Tax Cuts and Jobs Act passed by Congress in December 2017 included many changes to the tax code. One was the creation of "opportunity zones": state-designated and U.S. Treasury-approved areas where "new investments, under certain conditions, may be eligible for preferential tax treatment."
Opportunity zones are specifically designed to incentivize investment in economically distressed communities and, for investors, they offer some intriguing and potentially significant financial benefits.
For advisers, understanding the potential benefits of opportunity zones, and appreciating when they do and don't make sense as an investment, is critical.
(More: Fervor over 'opportunity zones' heats up)
Broadly speaking, the opportunity-zone provision allows investors to defer taxes on a gain from the sale of an asset. There are some similarities between the
tax benefits of opportunity-zone investments and those available under a 1031 exchange — where investors can defer capital gain and depreciation recapture taxes from a property sale if they reinvest the proceeds in a replacement property. But there are some significant differences as well.
While a 1031 exchange only permits tax deferral on the sale of investment real estate, opportunity-zone benefits apply to the sale of a range of assets, including
real estate, a business or highly appreciated stock, and thus are potentially beneficial to a wider range of investors.
Opportunity zone real estate developments may offer a higher internal rate of return than investments in existing stabilized assets, but the nature of a development project means that investors aren't going to receive any cash flow for the first few years of the investment.
Additionally, after the initial deferral, investors have an opportunity for two modest step-ups in basis: 10% if the investment is held for five years and 15% after seven years (if the five- and seven-year periods end prior to Dec. 31, 2026).
If the investment in the project is held for 10 years, however, there are no capital gains or depreciation recapture taxes on that investment. This makes the longer-term IRR potential for opportunity zones, both pre- and after-tax, look attractive, but investors with liquidity needs or flexibility preferences inside of that 10-year time horizon should think carefully. The fit for an opportunity-zone investment should be evaluated on an investor-by-investor basis.
While there's no limit to how many 1031 exchanges an investor can execute — preserving the ability to continue deferring taxes until death — the initial gain deferred upon an investment in an opportunity zone becomes taxable on Dec. 31, 2026.
Certain product sponsors plan to return some capital through the refinancing of a project's construction loan to help with tax payments. Nonetheless, investors should keep enough liquid assets available to pay future taxes and not rely on a potential sponsor distribution. Additionally, because opportunity zones allow 180 days to reinvest, compared to just 45 days in a 1031 exchange, they can be a great option for investors who missed the chance for a 1031 exchange.
Advisers and investors alike should be careful not to let the tax tail wag the investment dog. Evaluate the quality of every investment independently, and don't make any decisions solely for tax benefits.
But for investors who have realized a substantial gain (and incurred a substantial tax bill), opportunity zones provide a chance to reinvest and allow those assets more time to make money — an appealing alternative to writing a large check to the government.
(More: A new tax break for impact investing has arrived)
Tim Witt serves as director of research and due diligence officer for Livonia, Mich.-based Concorde, a broker-dealer registered with Finra.
