Stimulating Development in Low-Income Areas

Avison Young Principal Jay Maddox details the tax code provisions that incentivize long-term investment in specific geographic areas across the country.
Jay Maddox

Buried in the massive Tax Cuts and Jobs Act enacted in December 2017 is a new set of tax incentives intended to stimulate long-term investment in specific geographic areas across the country—Opportunity Zones. The tax benefits are only available if the funds are invested in a ground-up project or will be used to substantially improve an existing property. Simply investing funds in an existing property is not sufficient.

Under the Opportunity Zones program, newly organized qualified opportunity funds (“QO Funds”) must invest 90 percent or more of their capital in real estate projects located in designated, qualified low-income areas (“QO Zones”).  Virtually every state already has, or is in the process of establishing QO Zones, and more than 3,000 QO Funds have been established.

Tax Advantages for Investors

The tax benefits are similar to the existing 1031 Exchange rules, but they go further:

  • Similar to a 1031 Exchange, taxable capital gains from the sale of a property may be deferred by reinvesting within 6 months into a QO Fund. The taxable gain is deferred until the date that the investment in the QO Fund is sold or Dec. 31, 2026 (whichever comes first).
  • Long-term holding is incentivized by an automatic 10 percent step-up in investment basis for investments held in a QO Fund after 5 years, with an additional 5 percent step-up after 7 years. So, 15 percent of the taxable capital gain for an asset held for 7 years or more would be automatically tax-exempt. If the QO Fund investment is held for 10 years or more, the investment basis is stepped up to the fair market value of the property on the sale date, thereby eliminating any tax liability on the appreciation of the asset.

How Projects qualify

In order to qualify, a project must meet the requirements determined by the “Original Use Test” or the “Substantial Improvement Test.” 

Under the Original Use Test, the original use of the property must be tied to the newly created QO Fund. For example, a ground-up project on vacant land that had no prior economic use would satisfy the test.

The Substantial Improvement Test requires a major improvement of an existing property within 30 months of the acquisition date. Specifically, the additional investment must equal or exceed the QO Fund’s initial acquisition basis. 

Investment Considerations

Like most investors, QO Funds seek economically viable investments using commonly accepted valuation and risk-return metrics. They also want strong sponsors with local expertise, which may be a challenge given that the program is designed for economically disadvantaged areas.  This may result in projects being developed by sponsors not based in the QO Zone.

By definition, QO Zone projects will involve significant development and construction risks compared to investing in existing projects in established areas.  The big unknown at this early stage is whether the tax advantages will outweigh the risks. 

Most private equity funds that invest in risky development and value-added projects have a short term, high yield investment strategy, and they don’t need tax benefits. Since the program is designed to attract long-term investment, the investor pool will likely be limited to high-net-worth individuals and family offices who have the flexibility to stay in the project and want the tax benefits.

The Opportunity Zones program may emerge as an important economic development tool and stimulate investor demand for such projects. Developers will need to balance the risk-return considerations, tax advantages and availability of capital when evaluating whether or not to take advantage of the program.