We’re spending a lot of time at the moment on Opportunity Zones (OZ) and probably will until the end of the year. The rules, as currently designed, are such that investors who can allocate realized capital gain before the end of the year pick up an extra tax benefit.
And tax benefit is the name of the game with OZ. The concept was included in the Tax Cuts & Jobs Act passed at the end of 2017 with the intention of spurring more development in low income, economically challenged areas around the country. The law attempts to do that by encouraging investors to take capital gain that’s been realized on other assets and allocate that gain to OZ. Investors have 180 days to allocate to OZ (with some nuance for when the clock starts ticking) once the gain has been realized. The carrot for doing so = tax benefits.
Step 1: buy into OZ property; often real estate but can be other assets like an operating business. Step 2: develop that property by spending at least as much to improve the property as was originally used for the purchase. Step 3: hold that property for a long time. Do that and you can avail yourself of the major tax benefits on offer which fall into three buckets:
Deferring payment of the capital gains tax previously realized
Paying less capital gains tax (than would have otherwise been owed) when it comes time for the deferred tax payment to be made
Avoiding capital gains tax on the OZ investment itself if held for more than 10 years
Assuming an investor remains invested in OZ, the capital gains tax will come due with the 2026 tax year. And by remaining invested for more than five years, achieving a 10% reduction in the amount of previously realized gain.
It’s a highly technical program. Multiple rounds of regulation have been issued by the IRS, requiring calibration and re-calibration by OZ experts. With the rule tweaking complete, asset managers have moved quickly to create vehicles that can benefit from those rules. We saw significant activity at the end of 2019 (with its own deadline) and we’re seeing significant activity today ahead of a 12/31/2021 deadline.
Real estate developers have been particularly active. And many of our clients are already active real estate investors and so OZ is a natural extension of that activity. Some of our clients have sufficient scale to put together their own OZ program with help from attorneys, CPAs, and administrators. In those cases our support is very much at the strategic level. Other clients need to rely on the development and management expertise of real estate OZ sponsors. Some sponsor programs are national in scope; others focused and local. In these cases our support involves performing due diligence on sponsors and helping clients make decisions about how much they’re willing to allocate to OZ and with whom.
Our diligence puts a lot of emphasis on development capabilities and track record. We need to have a high level of conviction that the project(s) can be successful in their own right - the OZ tax benefits are really just icing on the cake. We also need to have conviction about the sponsor’s ability to keep their program in compliance with the complex OZ rules.
And while we see examples of sponsors who are effectively soaking up much of the OZ benefits for themselves, we have been able to find sponsors who take a more balanced approach while checking the critical development, management, and compliance boxes.
Our clients typically have most of their wealth concentrated in their business. Away from the business, there’s a tendency to hold a lot of cash plus gravitate to the tangible nature of real estate. With the right guidance, or with the right sponsor, OZ can be a natural extension of that activity.