25 Jul 2019
There has been much talk of Opportunity Zones since their creation by the Tax Cut and Jobs Act of 2017. Their purpose is to spur economic development in distressed areas by encouraging long-term investments through substantial tax breaks. More than 8,700 areas in the U.S., encompassing ±10% of the U.S. population and ±12% of the land were designated as Qualified Opportunity Zones (QOZ). As of April 17, 2019, the U.S. Treasury issued new regulations to stimulate more investment in QOZs as many investors were waiting on the sidelines due to some ambiguous language in the Tax Cut and Jobs Act of 2017.
Do you have capital gains (either on paper or a cash distribution) or plan on having them either from the sale of real estate, stock, or some other investment? If you don’t, unfortunately, you will not be able to benefit from Opportunity Zones. If you do, you understand that capital gains tax will cut into your return. Once you receive your capital gains you have 180 days to invest those gains into a Qualified Opportunity Fund (QOF) either as a corporation, partnership, or LLC. 90% of a QOF’s funds must be invested in a Qualified Opportunity Zone (QOZ). This consists of investment in either a QOZ Business Property (real estate) or in the purchase of stock, partnership interests, or LLC interest in a QOZ Business. Investment of infrastructure and start-ups in QOZs is also permitted. There are many more requirements for the QOZ Business and QOFs that will raise money to invest is a multitude of properties and business, selling shares to investors with capital gains. Given the context, this article focuses on the QOZ Business Properties.
There are approximately either in place or under construction 1.9 million multi-family units, 960 million square feet of office space, and 180 million square feet of self storage space. Focusing just on the self storage, as a percentage of total space, properties in OZs that are in place or under construction represent 11.4% of total self storage space. An additional 12 million square feet of self storage space is planned or proposed in opportunity zones.
Self storage is a popular use in QOZs as redevelopment of underutilized properties (which, oftentimes, happen to be in QOZs) has been a very hot trend in the industry over the past few years.
If you purchased vacant land for ground up construction of self storage, the substantial improvement rule doesn’t apply. Some argue that most investors will opt for ground up construction because of this, however, with the popularity of self storage conversions, if you have capital gains to invest, converting in an opportunity zone is a no brainer.
So now that your QOF has a QOZ property and it has been converted to self storage within 30 months, what are the tax benefits everyone is so excited about? Well, as appraisers love to say, “It depends.” It comes down to how long you keep the investment. Here are the three tax incentive benefits:
Going back to our example, where the initial capital gains were $1 million. Instead of paying capital gains taxes when earned, by investing in a QOF, you get to defer taxes until either you sell the QOF or Judgement Day; in this case known as December 31, 2026. So, the first benefit is deferring capital gains tax payment until the end of 2026.
Since the primary benefits of an OZ investment are dependent on an investor’s actions long after the purchase and are not transferable to potential buyers, any increase in value due to a property being in a QOZ from the initial investor’s perspective would be considered Investment Value as opposed to Market Value. Investment Value is defined as:
The value of a property to a particular investor or class of investors based on the investor’s specific requirements. Investment value may be different from market value because it depends on a set of investment criteria that are not necessarily typical of the market.
In conclusion, Opportunity Zones potentially offer a great way for an owner to boost their ROI by mitigating their taxes on capital gains. This can have a large impact on investment value and given the booming trend of self storage conversion of troubled or vacant real estate (often in QOZs) taking advantage of these incentives makes a good deal of sense. Even with the government’s April 17, 2019 regulations making investing in QOZs easier; due to the restrictions in-place, limiting the investor pool, as well as considering that the magnitude of the tax benefit largely fluctuates based on the investor’s future actions and are not transferable to potential buyers, it does not have an impact on the Market Value of self storage properties.
