Area Development
Opportunity Zones (OZs), a product of the Tax Cuts and Jobs Act of 2017, are designed to stimulate new investment in low-income communities nationwide. The program enables investors to harvest capital gains and defer payment of federal gains tax by investing those gains as equity into a “new activity” within an OZ within 180 days. A new activity will generally take the form of a real estate development, but it could include an operating company as long as the funds can be traced to funding the new activity.

{{RELATEDLINKS}}Under the new tax law, each state selected 25 percent of its low-income census tracts, as defined under the New Markets Tax Credit program, to be OZs. States were also able to designate up to 5 percent of tracts contiguous to low-income tracts as qualifying areas. The OZs will remain fixed from the date of designation through the close of the tenth calendar year and can be quickly identified on mapping websites.

Investor Incentive
Investors initially benefit from deferral of capital gains tax, which effectively becomes an interest-free loan from the federal government to fund approximately 20 percent of the OZ investment. The capital gains tax on the original investment is due at the earlier of the disposition of the OZ investment or with the federal tax return covering Dec. 31, 2026. The capital gains tax on the original investment is reduced 10 percent if the OZ investment is held for five years and another 5 percent (15 percent in total) if held seven years or longer. The greatest incentive though is to hold the OZ investment for 10 years, which results in no capital gains tax on the new OZ investment, including the potential for no recapture of depreciation taken during the 10-year holding period.

{{SIDEIMAGE1}} Expanding the Pie
Though the tax benefit accrues to the investor, developers planning projects within OZs can share in the benefit through careful attention to the investment structure. Developers seeking OZ capital can target cash returns and tax attributes (e.g., depreciation losses) between classes of investors that consist of OZ investors, non-OZ investors, those that can (or cannot) use passive losses, and the general partner (developer) through special allocations in the operating agreement. A carefully structured operating agreement will “expand the pie” by allowing the developer to retain a greater share of cash and/or tax losses, while OZ investors experience greater after-tax returns — the classic win-win.

The OZ tax benefit accommodates a shift of cash returns and tax losses toward the developer, while still enhancing the yield for OZ investors. Savvy developers will need to offer a reasonable combination of cash returns and appreciation to attract OZ investors. Given the current capital gains tax rate, investors will not take excessive risk or substantially inferior cash returns and participation in appreciation to simply capture the deferral and reduction benefit on the original gain. They will need to see potential to take depreciation (to the extent allowed) and participate in the appreciation of the investment to benefit from the elimination of gains on the new OZ investment.

In the following example, investors eligible for OZ treatment achieve an internal rate of return (IRR) 45 percent higher than investors not qualifying for OZ benefits, and this is before value-engineering the structure to specially allocate depreciation.On October 19, 2018, the U.S. Treasury released regulations that will guide governance and implementation of OZs. The regulations answered many questions but left several important open questions.

Expanding the Pie
Expanding the Pie
Important Takeaways
After-Tax IRR
After-Tax IRR
Open IssuesOpportunity Zones have the potential to attract more than $50 billion of capital to low-income communities to stimulate job creation and revitalization. Like all other forms of tax-driven incentives, the devil will be in the details, which will influence the actual efficacy of the program’s intent