For all developers / value-add investors on the forum, have you looked at any opportunity zone deals? Given pension funds are not taxed on gains, high net worth LPs seem to be slated for the greatest benefit to these types of deals. Has anyone studied the relative “hit” to LIRR/EM an LP could take in exchange for the perceived tax shelter benefits that investing in an opportunity zone could offer? I’m curious if an LP that might typically want a 17% LIRR could live with lower returns due to the tax shelter. This could make deals that previously required 18-20% project level IRR, very doable at a 15-16% if said LP is good with lower returns; more importantly the sponsor promote could very well remain intact and unchanged from the “typical” return threshold.
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I don’t believe the tax benefits amount to anything of great enough significance to alter an investment decision.
My understanding is that someone would need to hold onto an asset for 10 years to realize any real tax advantage. Even then...it only makes sense if an investor wants the full return of their capital and not 1031 exchange.
For a short or medium term hold...I’m not sure that it provides much more than what you could achieve through a 1031 exchange.
I’m far from an expert on this subject...so please don’t take this as absolute truth. But I don’t think it’s any kind of magical unicorn that’ll change an LPs investment criteria.
Please advise if you think my take is incorrect. I genuinely would like to know if my understanding differs from the practicality of the matter.
I will add that if it’s possible to shift all of the tax savings to the GP side...then you theoretically could make a relative adjustment to the waterfall in favor of the LP to help get them the IRR they desire. That, of course, applies to an institutional investor.
Yes. Depending on the deal profile, the state's tax laws, and the hold period, I have found that OZ deals can increase LIRR by 4.0%-10.0% (or more) over a 10-Year period when factoring in the benefits of the program. A state like California, where we invest out of, has a combined capital gains rate of 37.1% (20% Federal + 3.8% Obamacare Tax + 13.3% California). This provides a significant increase in net proceeds when factoring in the after-tax capital gains that will now be exempt from taxes.
Further, when the initial capital gain is not taxed until 2026, the re-investment has a 7+ year window to compound versus facing a 37.1% Cap Gains rate first and then investing into a new deal (in a non-opportunity zone scenario).
This program has significant benefits depending on what state an investor lives in and their time horizon.
Excellent and helpful response. Check out the report Integra Realty St Louis wrote on the topic. it is brief but helpful
Why not just do a 1031 exchange?
Does this program make sense if you’re a long term investor?
Because a 1031 Exchange only defers a capital gain. The Opportunity Zone Program defers a capital gain (albeit it only until 2026) AND fully exempts you from a capital gain on your Opportunity Zone reinvestment.
The only scenario I would say the 1031 Exchange makes more sense is if you are willing to hold an investment until you pass away, at which point the basis steps up to market value as you transfer the asset to your descendant. (Someone with more tax experience feel free to chime in if I'm missing something here)
Interesting. Mind elaborating on the second part - capital gain exemption on OZ reinvestment? Does this allow an OZ investor to take their distributions from investment #1 and reinvest it into ANY project, or does it need to be another OZ project? Does net gains resulting from the reinvestment / investment #2, have no capital gains applied to those profits?
So, lets run an example that assumes the following:
1. Sale of Original Investment
On July 1st, 2018, Investor sells Apple stock and realizes gain of $250,000
2. Investment Deferred Gain in Qualified OZ Fund within 180 Days On October 1st, 2018, Investor reinvests all of the gain in the OZ Investment.
3. 5-Year Holding Window
After holding in OZ Investment for 5-Years, on October 1, 2023, Investor is entitled to a basis adjustment equal to 10% of the deferred gain ($25,000)
4. 7-Year Holding Window
After holding in OZ Investment for 7-Years, on October 1, 2025, Investor is entitled to an additional basis adjustment equal to 5% of the deferred gain ($12,500) of total basis adjustment of 15% ($37,500)
5. Recognition Event on 12/31/26
On December 31, 2026, if investor has not yet sold the investment, investor recognizes capital gain of $212,500 ($250,000 minus $37,500).
6. Holding Period of 10 Years or More Upon a sale of the OZ Investment, on or after October 1, 2028, the basis in the investors investment will be equal to the fair market value of the investment on the date the investment is sold. Thus, if investor sells the investment for $5,000,000, the basis in the investment will increase to $5,000,000, allowing the investor to exclude the entire $4,750,000 gain in addition to deferring the taxes on the initial gain for ~8 Years (if invested today).
This does a decent job explaining the merits of 1031 vs Opportunity Zones
https://www.linkedin.com/pulse/math-qoz-1031-exchange-gian-starita/
I don't think it's an IRR game anymore when thinking about Opportunity Zone investing. When you're comparing two 10-year hold projects, IRRs become a secondary financial metric. I think long-term investors are driven by two things: cash-on-cash and equity multiples. As others have said, it does give about a 4-6% IRR boost to the project, but it's not that helpful when you're comparing long-term investments. If you think about risk-adjusted return and level of certainty- a shorter term investment is more certain cause there's no big question mark on the exit (which is where a large portion of the return usually comes from).
The benefit from opportunity zones, which is similar to 1031 exchange, is that you get a return on cash that otherwise would have gone to the government. The big difference people miss when evaluating opportunity zones is that they assume that the capital gains investment is coming from a real estate disposition. You have to expand your horizons in thought because in reality, I think one of the big plays for o-zone funds is going to be from stock sales where a typical investor doesn't have a 1031 type investment that they can roll into.
You make the point that O-Zones benefit an investors Cash-on-Cash return. Because the benefit is only to Capital Gains, it has zero impact on ordinary cash flow and therefore has no impact on Cash-on-Cash. However, as you mentioned, it does have an impact on equity multiple due to increased after-tax proceeds.
holeymoley - Great point about the non-like-kind exchange. That is a big difference as well.
PS - Interested to hear others thoughts as to why the 1031 program is superior to the O-Zone program? To me, it seems obvious that the O-Zone program is better.
But cash-on-cash return is different. Consider this scenario:
A stock investor has sold a chunk of his stock portfolio in order to invest in real estate. His sale results in a $5MM capital gain which would be taxed at 30% ($1.5MM). Let's assume he has his eye on two real estate development projects that both have equity needs of $5MM and both projects project $300k/year of stabilized NOI (a 6% cash-on-cash). One is located in an opportunity zone and one is not.
The project that is not in an opportunity zone means that he will need to come up with an additional $1.5MM because he had to write that check for his capital gains tax to the government. Now instead of getting a 6% cash-on-cash, he is getting a 4.6% cash-on-cash (300k/6.5MM).
If instead he invests in the development deal that's located in an opportunity zone, he gets his expected 6% cash-on-cash on the $5MM until 2026.
I work at a LIHTC Fund (Low Income Housing Tax Credits). Opportunity zone investing is primarily a target of Banks (for community reinvestment act requirements) and insurance companies (for yield). One point is being made that you collect Tax credits over 10 years. This is true but the GP&LPs must compliant with Section 8 requirements for 15 years. If any of the lower tier falls out of compliance before the 15 year timeline you are subject to recapture which means you forfit Tax Credits and other benefits.
What? Everything you mentioned (I believe) has to do with LIHTC and nothing to do with Opportunity Zones.
For those reading, disregard his post as it relates to OZ investing.
So what are your favorite opportunity zones?
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