In 2007, 28-year-old Sean Parker held a personal stake in Facebook bigger than the annual gross domestic product of France. Using his credential as a co-founder of Napster, Parker wrangled a meeting with a young Mark Zuckerberg at a Chinese restaurant in New York in 2004 – and landed a position as Facebook’s first president. When he exited Facebook, Parker became a key investor in Spotify, the music streaming startup. The rest is history. Parker is still in his 30s. Net worth: $2.6 billion.
Parker, now a renowned philanthropist, was a key player behind the creation of Opportunity Zones. He was fascinated by the challenge of rescuing chronically blighted U.S. neighborhoods. He knew that in order to be effective, those investments had to remain stable in those areas – not just turn a quick profit and run. Parker knew that big money – trillions of dollars in investment capital – would be required to effectuate meaningful change in these communities. He didn’t think the answer was a foundation. Instead he opted for an incentive of tax avoidance to attract capital across the broadest possible spectrum of potential investors. It was a novel idea. As usual. That’s how Parker got wealthy.
His idea attracted the support of fellow billionaires like Michael Milken (inventor of junk bonds) and Jim Sorenson (whose Sorenson Media created the digital compression software used by Apple QuickTime, Adobe Flash and YouTube). Facing an increasingly polarized political atmosphere on Capitol Hill, Parker accomplished yet another miracle: He obtained bipartisan support for his Opportunity Zone bill!
Democrats loved the idea of pouring funds into areas of need; Republicans loved the tax cut benefit placed into the hands of state and local governments. U.S. Senator Tim Scott punted the provision through the uprights by obtaining President Donald Trump’s consent to include the Opportunity Zone legislation in the Tax Cut and Jobs Act of 2017 passed in December.
The result was nothing short of spectacular for real estate investors who are willing to hold a real estate investment in an Opportunity Zone for 10 years. How spectacular? If withdrawing 100 percent of your profit tax free at the end of 10 years sounds good, read on.
An Opportunity Zone is defined by the choice of the governors of each state. It must have a poverty rate no less than 20 percent in a census tract and a median income less than 80 percent of the surrounding area. Just last week, the Department of the Treasury issued additional criteria: median family income must be 37 percent below the area or state median and unemployment in the designated Opportunity Zone must be 1.6-times higher than the national average. Up to 25 percent of all eligible census tracts in a state can be selected as Opportunity Zones. As of July, about 8,700 Opportunity Zones have been identified nationally – representing 35 million Americans living in those zones.
The tax benefits are distributed through an approved Opportunity Zone Fund, which must invest its assets in Opportunity Zone projects. Last week’s Treasury Department clarification details that since 70 percent of a business’ tangible assets must be in an Opportunity Zone, the practical effect is that a fund may only need 63 percent of its total assets to be physically located in an Opportunity Zone, not 90 percent as previously thought.
The tax benefits begin immediately. Realized capital gains from any investment (excluding related person transactions) – stocks, real estate, partnership interests, oil and gas holdings, etc. – obtain a deferral of tax payment on that transaction until 2026 when re-invested within 180 days into an Opportunity Zone.
This investment must be made by Dec. 31, 2019, under the current tax code. This deferral of tax on re-invested profits is only the beginning – it gets better.
- If the investor leaves his money in the Opportunity Zone investment for five years, he gets a 10 percent step-up in his basis. In other words, only 90 percent of his profit is taxed.
- If the investor leaves his money in the Opportunity Zone investment for seven years, he gets a 15 percent step-up in his basis.
- But if the investor leaves his money in the Opportunity Zone investment for 10 years, the benefit is a 100 percent step-up in investment basis. Translation: 100 percent of the profit qualifies for full tax exemption.
Can the government pull this lollipop from the hands of investors if the political climate changes (as it might) every two years? No. The investments are not subject to retroactive removal if investors double their investment basis within a period of 30 months. This gives real estate investors enough time to invest substantive infrastructure or improvements to a real estate project.
What are the practical considerations of accessing this “pot of gold” for real estate investors?
Real estate sponsors absolutely can’t consider any equity joint venture that will monetize their investment in anything less than 10 years. This pretty much excludes the investment horizons of opportunistic equity and most real estate funds (typically targeting five- to seven-year monetization horizons). The tax benefits for some life companies and real estate investment trusts may be negligible – leaving them without incentives to invest in Opportunity Zone projects. Further, Opportunity Zone census tracts will be in areas that institutional investors are likely to reject.
The optimal capital profiles for these investments will be high-net-worth individuals, real estate firms trying to shelter “lumpy” capital gains realizations, family offices, and business owners/stock investors seeking to diversify their holdings without incurring significant tax consequences.
Secondly, the Treasury Department has not yet finalized the precise details of these investments. As such, major investment firms will prudently withhold monetary commitments until they are sure of the finality of regulatory constraints. The most recent Treasury regulations still have a 60-day comment period before they are finalized – pushing any realistic deployment of institutional funds into 2019.
Opportunity Zone benefits can be aggregated with other incentives – Enterprise Zones, New Market Tax Credits, tax-increment financing, low-income housing tax credits and Commercial Property Assessed Clean Energy benefits. When you cobble them together, the result can transform a nonincentivized real estate investment into a compelling “gee whiz” opportunity. Aggregating multiple incentives within a single real estate deal can carve a huge positive delta for investment outcomes.
Where do these Opportunity Zones exist in Colorado? Make sure you check at the census tract level – because each county will have tracts that qualify. The state of Colorado map showing those zones is available at https://choosecolorado.com/opportunity-zones/.
You don’t have to be Dorothy to find this pot of gold somewhere over the rainbow!