Thanks to the 1031 exchange, avoiding capital gains tax liability on the sale of real property is nothing new to real estate investors. However, the ability to expand upon this and shelter other highly appreciated assets from taxation is a game changer. Therefore, the enthusiasm surrounding opportunity zone programs created by the Tax Cuts and Jobs Act of 2017 is understandable.
Undeniably, the ability to defer and reduce realized capital gains and then avoid taxes on the new investment is compelling relative to traditional real estate investments. However, the surge in land prices that has already occurred in anticipation of this may have already eaten up much of the upside potential in these programs.
Make no mistake, opportunity zone investments have been in the offing for several years awaiting clarification in terms of rules and regulation. In the interim, many of the potential benefits have already accrued to existing landowners with trades and valuations surging in the 8,700 designated low-income neighborhoods selected.
Opportunity Zones are found in 80% of the submarkets and 45% of the zip codes that comprise the top 50 real estate markets in the United States. As such, there is significant risk of excess residential supply being catalyzed in those areas where a large share of opportunity zones are concentrated (New York City, Washington D.C. and other gateway markets along with non-gateway markets such as Raleigh, Austin, Phoenix, Salt Lake City & Las Vegas).
A requirement that investors in opportunity zones double their basis in the building within two and a half years ensures that most deals will be new construction. As such, these programs will provide little or no cash flow through construction and stabilization phases. Depending on the projects size, this could be as long as 5 years.
This is a significant difference between DST programs and opportunity zones. DST properties must be fully stabilized and cash flowing before investment. As such, cash on cash return is immediate and investors are not exposed to development risk as is the case with opportunity zones.
This is why the marketing of opportunity zones is being directed primarily at sellers of equities or private companies. Heretofore, these investors had little place to hide from taxes due on realized capital gains. Now they can significantly defer and reduce this tax. Furthermore, where highly appreciated equities are concerned, creating an income stream for investors is not necessarily an issue. As common stock, more often than not, it did not provide one before.
Finally, the majority of opportunity zone investments are expected to be residential (apartments). Therefore, in those geographic areas of highest opportunity zone concentration, investor concerns regarding excess supply are legitimate. The last time real estate developers were handed tax incentives by the government, things did not end well.
Horror stories of past tax incentivized development bonanzas are rife. The highest profile example being the Economic Recovery Tax Act (ERTA) of 1981, which aimed to spur economic development through the creation of tax shelter opportunities for high income individuals. ERTA was designed to stimulate investment in equipment by accelerating depreciation schedules. Developers hugely amplified this benefit by the use of leverage and a construction boom ensued.
The depreciation schedule for real estate was then scaled back in the mid-80s. However, by that time, development far outpaced actual demand for space, vacancies spiked, and values collapsed. Therefore, any investor should approach government engineered demand with caution and trepidation.
Peregrine Private Capital | Lake Oswego
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Lake Oswego, Oregon 97035