Equity & Capital Gains: How to Reduce Your Taxes via Opportunity Zones
Considered one of the most exciting developments for investors in recent memory, Opportunity Zones establish a new connection between private capital and low-income communities across the U.S. The program is designed to spur economic growth and job creation by providing tax incentives for investors to reinvest capital gains into these communities. With estimates that U.S. households and corporations are sitting on more than $6 trillion in unrealized capital gains1, the program has significant potential to drive powerful change in distressed communities while creating attractive opportunities for taxable investors.
Opportunity Zones: Background
The Opportunity Zones concept first gained traction in 2015 when Jared Bernstein (economic adviser to Vice President Biden) and Kevin Hassett (now chairman of the Council of Economic Advisers for President Trump) authored a white paper for the Economic Innovation Group, a Washington research and advocacy group.2 The idea matured into a bill led by Senators Cory Booker (D-NJ) and Tim Scott (R-SC) that garnered enough bipartisan support to become a provision in the recent Tax Cut and Jobs Act of 2017.
Sen. Booker detailed his motivations for supporting the initiative as follows:
The American economy would be far better off if every community could realize its full entrepreneurial potential. But barriers stand between too many communities and access to the capital needed to generate economic growth and opportunity. In an era of capital moving overseas or going towards uses that don’t maximize opportunity for most Americans, our bipartisan legislation will help lower these barriers and jumpstart economic development and entrepreneurship by stimulating the flow of investment into the communities that need it most, from Camden to Newark and beyond.3
After the Tax Cut and Jobs Act of 2017 went into effect, the U.S. Department of the Treasury certified Opportunity Zones based on nominations by governors, who were allowed to nominate up to 25% of their qualifying low-income community (LIC) census tracts. For a census tract to meet the definition of an LIC, it generally must have a poverty rate of at least 20% or a median family income of less than 80% of the metropolitan area or state median. Governors were also able to nominate a small number of census tracts adjacent to LICs.
Opportunity Zones have now been designated in all 50 states, the District of Columbia and five U.S. territories.4 Altogether, there are more than 8,700 Opportunity Zones, encompassing a range of urban, suburban and rural communities. Opportunity Zones are home to more than 31 million Americans, with locations evenly split between high-, medium- and low-density areas.5
The average Opportunity Zone (excluding U.S. territories)6
- Poverty rate: 29%—Nearly twice the national rate
- Median family income: $42,400—Nearly 40% lower than the national level
- Non-white minority residents: 56%.
Investing in Opportunity Zones
Investments in Opportunity Zones must be made through Qualified Opportunity Funds, which are vehicles that invest a certain percentage of their assets in designated Opportunity Zones. Investments made through a Qualified Opportunity Fund are required to be equity investments in businesses or real estate within an Opportunity Zone. Real estate investments are generally subject to a “substantial improvement” requirement, where the Qualified Opportunity Fund must invest a certain minimum percentage of its capital on improving the property within 30 months of the purchase date. As a result, real estate Qualified Opportunity Funds are expected to target primarily development and rehabilitation projects. For example, a fund could invest in a ground-up development of a mixed-use project that includes new street retail and workforce housing.
Investors may reinvest capital gains from any recently sold investment—including the sale of stocks, bonds, a private business, or real estate—so long as the gains are rolled into a Qualified Opportunity Fund investment within 180 days of the sale. Investors who reinvest capital gains into these funds can receive meaningful tax breaks, as described below. It’s important to note that investments into a Qualified Opportunity Fund do not need to be made solely from capital gains; a fund can pool eligible capital gains and other capital. However, only investments of qualifying capital gains are eligible for the Opportunity Zone tax benefits.
Savvy investors may recognize some similarities between Qualified Opportunity Funds and like-kind real estate exchanges under Internal Revenue Code Section 1031. There are, however, several key differences. Unlike the 1031 exchange program — which has long been used to defer real estate-related taxable gains — Opportunity Zone rules allow investors to reinvest any gain, not just the gain from the sale of real estate assets. Additionally, Opportunity Zone investment requires no intermediaries: Investors can hold gains on their own and still benefit from any part invested into a Qualified Opportunity Fund within 180 days. Finally, an investment in Qualified Opportunity Funds allows investors to permanently eliminate capital gains on their Qualified Opportunity Fund investment, rather than just deferring through 1031 exchange.
Opportunity Zones Tax Benefits
Investors who reinvest capital gains through a Qualified Opportunity Fund can capture significant tax benefits. At a high level, Opportunity Zone investments have the potential to generate more than double the after-tax profits compared to a standard taxable portfolio.7
Opportunity Zone investments offer three unique and compelling tax advantages. Investors can:
- Defer taxes on capital gains reinvested in a Qualified Opportunity Fund until December 31, 2026 or the date on which the Opportunity Zone investment is disposed of, whichever is earlier.
- Reduce the amount of deferred taxes owed by up to 15%. The basis for capital gains reinvested in a Qualified Opportunity Fund is increased by 10% if the Opportunity Zone investment is held for at least five years, and by an additional 5% if held for at least seven years; as such, the amount of deferred taxes can be reduced by up to 15%.
- Eliminate tax on capital gains from the Qualified Opportunity Fund investment if it is held for at least 10 years.
Quantifying the tax benefits
Taken together, these benefits can materially improve an investor’s total tax liability and investment return. Holding an Opportunity Zone investment for 10 years is estimated to generate 300-400 basis points higher after-tax annual returns and twice the after-tax profits compared to a standard taxable portfolio appreciating at the same rate.
For example, consider an initial pre-tax gain to invest of $1 million. With a 10-year holding period and an appreciation rate of 10%, a standard portfolio would generate an after-tax IRR of 5.4% (equaling after-tax profits of $687,000 or a 1.7x profit multiple), while an Opportunity Zone investment would generate an after-tax IRR of 8.8% (equaling after-tax profits of $1,391,000 or a 2.2x profit multiple).8
Cadre’s Approach to Investing in Opportunity Zones
As with any real estate investment, investing in Opportunity Zones carries certain risks. Given the economic disparity between Opportunity Zones and other areas, we believe the need for thoughtful market and partner selection is especially critical. The regulatory outlines of the program also require an experienced team to ensure the combined success of the underlying real estate investments and the Qualified Opportunity Fund structure. At Cadre, we invest using a strategy of proactive market selection, working with top-tier operating partners, and serving as an active fiduciary for our investor partnerships. We believe the optimal Opportunity Zone investment strategy and deal structure align with our existing approach. Through our Opportunity Zone program, we offer investors the following unique advantages:
- Efficient Diversification – Access a series of Opportunity Zone investments with data-driven diversification across select markets and alongside experienced operating partners. We seek to avoid the risks associated with single asset, market, or developer strategies.
- Experienced Investment Team – While the program’s tax benefits are highly attractive, investments must be grounded in the merits of the real estate. The Cadre team brings over $50 billion of collective transaction experience at top tier investment firms, including ~$10bn of development experience across the U.S. We co-invest in each opportunity alongside our investors and actively manage all of our assets.
- Experienced Operator and Developer Network – We have developed a pipeline of actionable opportunities within our target Opportunity Zone markets, driven by our network of over 300 local operating partners. These relationships provide us with a unique sourcing advantage across Opportunity Zones, as well as local market development and repositioning expertise.
- Single-Asset Fund Structure – Since inception, we’ve focused exclusively on structuring single-asset funds, which we believe is the optimal structure for gaining exposure to Opportunity Zones. This structure has also encouraged discipline without a broad, multi-asset fund mandate. We have reviewed over 200 Opportunity Zone transactions to date and committed to just 5 deals.
Next Steps for Interested Investors
- Economic Innovation Group, https://eig.org/news/opportunity-zones-tapping-6-trillion-market
- Bloomberg Businessweek, https://www.bloomberg.com/news/articles/2019-01-04/will-opportunity-zones-help-rich-poor-or-both-quicktake
- The Daily Beast, https://www.thedailybeast.com/cory-booker-and-tim-scotts-bipartisan-plan-to-wage-a-smart-war-on-poverty
- IRS, https://www.irs.gov/newsroom/opportunity-zones-frequently-asked-questions
- IRS, https://www.cdfifund.gov/Pages/Opportunity-Zones.aspx and Economic Innovation Group, https://eig.org/news/opportunity-zones-map-comes-focus
- Economic Innovation Group, “The State of Socioeconomic Need and Community Change in Opportunity Zones”, Kenan Fikri and John Lettieri, December 2018
- https://cadre.com/investing-with-us/opportunity-zones/ – no specific source/calculation cited
- https://cadre.com/assets/pdf/Cadre_Opportunity_Zones.pdf – Assumes long-term capital gains tax of 23.8% (federal capital gains tax of 20% and net investment income tax of 3.8%), no state income tax and annual appreciation of 7% for both the standard portfolio and the Opportunity Fund investment.