Tax opportunity knocks for investors in lower income areas
Funds could target older industrial buildings as well as redevelopment of other properties in new ‘opportunity zones’
Conversations are heating up around Opportunity Zones, touted as one of the most significant developments for the real estate sector from 2017’s tax overhaul (‘Tax Cuts and Jobs Act of 2017’), which created federal tax incentives for investors in around 8,700 newly-created Opportunity Zones around the country.
Opportunity Zones are in areas of the country which, in the current period of economic expansion, have not seen the level of business creation or real estate development seen in markets like downtown San Francisco, New York, Chicago, Los Angeles, Seattle or suburban Washington, DC. There are 879 zones in California, including 63 in the Sacramento Metropolitan Statistical Area (MSA) which includes some downtown, in midtown and throughout West Sacramento.
How it works
The program allows any person or entity with a capital gain event, whether from the sale of stocks, bonds, real estate or other asset, to qualify for favorable tax treatment of that capital gain and future gains by investing in an Opportunity Zone. The funds are placed in an Qualified Opportunity Fund (QOF), which can be comprised of just one investors funds, and then invested in projects or businesses within Opportunity Zones.
Typically, investors would roll over proceeds from a sale into a “like kind” property in order to defer any capital gains, a long-established and widespread process under the IRS Code called a 1031 ‘Like Kind’ (or ‘Starker’) Exchange. A 2015 study found that like kind exchanges made up at least 5 percent of all real estate market transactions. (In recent years, 1031 exchanges have come under increased scrutiny but they remain a standard capital gains tax deferral tool today.)
New capital gains above initial investment are tax-free
In contrast, the Opportunity Zone program allows an investor to recognize a capital gain and defer tax on that gain if the proceeds are invested in a QOF within 180 days of the initial sale and deployed to a project within the given timeline. The QOF is the vehicle used to invest in any projects or businesses in an Opportunity Zone. In addition to deferring any capital gain, investors can also receive a 15 percent exclusion on capital gains tax from the initial gain if the investment is held in the QOF for at least seven years, 10 percent if held for at least five. Here’s the icing: any new capital gains above the initial investment will be tax free.
There’s one caveat: investors don’t have long to take advantage of the tax deferral; at present, the deferral window closes in 2026.
Industrial redevelopment fits well into program parameters
Clearly though, QOFs have the potential to spur new development opportunities especially for investors who may have held their current real estate investments for several years and want to defer or reduce a substantial capital gain. The program has no restriction as to property type but because the program requires investors to double the basis of their investment, this program is particularly suited to substantial redevelopment or ground-up development opportunities.
Industrial submarkets in Sacramento are ripe with Opportunity Zones including the entire Power Inn submarket along with swaths of North Sacramento, South Sacramento, McClellan and West Sacramento. Pair that with strong market fundamentals and continued projected growth in the industrial sector, and the potential is strong for investment in Sacramento.
The opportunity zone program is not the only federal program designed to spur investment in communities that have struggled to attract private capital. The New Market Tax Credit (NMTC) program has been around since 2000 and, as the names suggests, provides tax credits for investors against their federal tax obligations in return for providing capital to community development entities which then invest in real estate projects or businesses in low-income communities. The program has so far provided tax credits of around $23 billion to more than 4,800 projects. A couple of years ago I helped use the program as part of a creative financing stack to develop an industrial building to be used as affordable manufacturing space in San Francisco’s Design District at 150 Hooper Street.
The Opportunity Zone program though could result in even greater investment in low-income communities because of its beneficial capital gains tax treatment. Potential investors and advocates are providing feedback and input almost as we speak as regulators try to clarify new rules released this spring to try and capture the investment interest and use the momentum for growth.
That said, any investor should seek the advice of a tax professional before making the decision to pursue such an investment. The first thing any tax expert would tell you, which we as real estate professionals echo, is that no investment in real estate should be made on the basis of tax considerations alone. While the tax breaks should be factored in, the investment probably won’t be a success unless it also makes sound economic sense. That’s why having a trusted real estate advisor with knowledge of the local market is critical in any real estate investment process.
About the author
Abbie Wertheim is a Senior Associate broker in JLL’s Sacramento office with over fifteen years experience in urban industrial infill development. Prior to joining JLL she was Director of Policy and Real Estate at SFMade, a nonprofit supporting San Francisco’s manufacturing and ‘maker’ sectors.