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 might 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 have the potential to defer and reduce this tax. Furthermore, where highly appreciated equities are concerned, creating a potential income stream for investors is not necessarily an issue. As common stock, more often than not, it may not have provided 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.
This material and views are prepared solely by the author and does not necessarily represent the views of the it’s affiliates. Statements concerning financial market trends are based on current market trend, which will fluctuate. Projections are inherently limited and should not be relied upon as an indicator of future results. Historical figures and performance are not indicative of future results. This is for informational purposes only and does not constitute an offer to buy or sell any investment.
DST 1031 properties are only available to accredited investors (typically have a $1 million net worth excluding primary residence or $200,000 income individually/$300,000 jointly of the last three years) and accredited entities only. There are risks associated with investing in Delaware Statutory Trust (DST) and real estate investment properties including, but not limited to, loss of entire principal, declining market value, tenant vacancies and illiquidity. Diversification does not guarantee profits or guarantee protection against losses. Potential cash flows/returns/appreciation are not guaranteed and could be lower than anticipated.
Because investors situations and objectives vary this information is not intended to indicate suitability for any particular investor. This information is not meant to be interpreted as tax or legal advice.
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