Note: This article reflects zoning policies in effect as of November 1, 2019. These policies are slated for review and updates in January of 2020. We will update this article as needed.
The Demand for Urban Residential Property Is High
Good news for landlords: the demand for urban residential property is and has remained high for quite some time. Studies have pointed to dozens of causes for this sustained level of demand, from an ever-increasing population to an older generation choosing apartment living in retirement. We ourselves have discussed at length how financial trends and employment opportunities have shaped Millennials as a substantial and continuous source of renters. Compounding the issue, as demand has remained high, housing supply has failed to keep up, resulting in a steep shortage in some markets.
Constructing inventory from scratch can be expensive, difficult, and slow. What’s more, in an urban living space, empty plots of land rarely exist. Building from the ground up typically requires that you tear something down to the studs, and unfortunately, demolition isn’t cheap. A real opportunity is available for developers to respond to this intense demand for living space by using what’s already out there.
Opportunity zones offer an incredible opportunity for the savvy investor to develop a commercial property portfolio in urban (and non-urban) locations while enjoying significant tax savings. There’s a lot to know about the rules and regulations that govern them— a web that is made only stickier by the ever-evolving nature of these policies — but understanding the basics doesn’t have to be impossible. Let’s break down what landlords need to keep in mind so they can get the most out of their real property investments.
Opportunity zones offer an incredible opportunity for the savvy investor to develop a commercial property portfolio in urban (and non-urban) locations while enjoying significant tax savings.
What Are Opportunity Zones?
In short, opportunity zones are economically distressed areas that have been identified by the government for the Opportunity Zone program. The IRS provides a few different ways for you to view a list of opportunity zones. Those who invest capital gains made from the sale of other assets into “Qualified Opportunity Funds,” or funds designated solely for investment in these zones, can defer and potentially reduce taxes on those gains. Investors looking to participate must invest their capital gains into a Qualified Opportunity Fund within 180 days of the sale of an asset. How long and how much an investor can save on taxes through opportunity zones depends on how long the investor maintains ownership of the opportunity fund investment and whether the investor reinvests the gains made from the sale into another Qualified Opportunity Fund. In essence, the longer the investor owns the project, the more savings the investor can claim up to a point — 10 years.
Opportunity Zones May Bring Economic Development to Impoverished Areas and Opportunities to Landlords
Those who follow tax and financial news and trends closely are undoubtedly familiar with opportunity zones. The Tax Cuts and Jobs Act of 2017 opens specific, government-identified, impoverished areas in every region of the country to economic development by offering developers incentives to invest. This includes various tax benefits and tax deferrals on their capital gains, a potential windfall for the savvy real estate mind. If you plan to engage in commercial development, anytime soon, we strongly encourage you to dig deeper into this subject.
What Are Opportunity Zones All About?
The whole idea behind opportunity zones is that they give investors an incentive to develop projects that could help lift communities out of poverty. Whether opportunity zone projects ultimately have that impact remains to be seen. For those in the renting business, investing in underdeveloped land or vacant buildings is a chance to expand portfolios and give willing renters more options on the market. Investing in opportunity zones in particular gives landlords a chance to develop projects in areas that may eventually have an economic resurgence, and potentially contributing to community good.
What Are the Relevant Rules, Dates, and Deadlines of Opportunity Zones?
Again, how much an investor saves by investing in an opportunity zone is defined by how long the investor maintains ownership of the investment fund. If an investor sells the opportunity zone fund investment within 5 years, then the original gains plus any incremental gains made from the opportunity zone investment are taxed. If the investor sells the investment and reinvests the gains into another opportunity zone project, the taxes are deferred again according to opportunity zone rules. If the investor sells the investment between 5–7 years after the initial investment, the taxable gain is reduced by 10%. If the investor sells the investment 7–10 years later, the taxable gain is reduced by 15%.
There is a time-based limit to these tax incentives. At the end of the year in 2026 (December 31, to be exact), capital gain tax is assessed on that original gain regardless of whether the investor sold the opportunity zone fund investment. This means that investors looking to get the most tax savings from the program want to make those investments by the end of 2019, so the clock is ticking!
What’s more, not all buildings or projects qualify for an Opportunity Fund. Opportunity Fund investments need to represent substantial improvement of an existing building or an entirely new construction. If you decide to go the route of substantial improvement, you must invest more in the improvement of the building than you paid to buy the building. And in either case (improvement or ground-up construction), the development must be completed within 30 months of purchase.
The Bottom Line
Opportunity zones are rules- and regulations-laden, but landlords looking to increase their portfolio and capitalize on the adaptive reuse of buildings or chances to build a new may find prospects in their local opportunity zones. Whatever they end up doing, they should consult a tax professional or an attorney to help them determine if opportunity zones are right for them and their plans. If landlords decide to go for it, an attorney can help them navigate the procedural web, manage changes to policy, and identify and realize key tax benefits.