Talk is Cheap: Opportunity Zone Investment Remains Tepid

Posted on Apr 22 2019 - 11:51am by Lance Edwards
Restrictions and lingering questions have stalled the rush of activity that was expected when these tax-based incentives were announced.

 

By Paul Fiorilla  (MultiHousingNews.com Article —  Despite a flurry of attention over the past year on Opportunity Zones, the amount of dollars invested has been limited due to constraints set by the founding legislation and myriad logistical questions that have yet to be answered by regulators.

Treasury Secretary Steven Mnuchin forecasts that $100 billion will ultimately be invested in Opportunity Zone funds, but so far about $30 billion has been placed in funds to date, and only a fraction of that amount has already been invested.

Opportunity Zone capital has “gotten off to a slower start than expected,” said Daniel Kowalski, a counselor to the secretary of the U.S. Treasury department at last week’s ASD Summit 2019 in Brooklyn. Kowalski attributed the slow start to a combination of lack of clarity on the rules and general hesitation on the part of investors.

Anthony Scaramucci, short-lived White House advisor and co-managing director of Skybridge Capital, which is raising an Opportunity Zone fund, characterized the situation in more colorful terms. Investment activity in the segment is akin to “high school sex,” he said at the same event. “Everybody’s talking about it and nobody’s doing it.”

Opportunity Zone funds are investment vehicles created by 2017 tax reform that allows investors to defer taxes on capital gains by investing in designated low-income areas. There are more than 8,700 zones in the U.S. that represent about 12 percent of the land in the U.S. and 10 percent of the population. A wide variety of investments in Opportunity Zones qualify for the tax break, including real estate and operating businesses. But there are drawbacks that have constrained deal flow.

Rules Hamper Business Investments

To be eligible for the tax break as an operating business, the law states that the business must derive at least 50 percent of its revenue from an Opportunity Zone. The idea is to curb tax breaks to businesses that might have an address in an Opportunity Zone but do most of their business elsewhere. The 50 percent income requirement, however, reduces the possible businesses that would qualify to strictly local operations such as dry cleaners or small retail shops, which was not the intent of the legislation. “We want Opportunity Zones to be places where people do business outside the zone,” Kowalski said.

Regulators are in the process of drafting language that would interpret the limits on businesses more broadly, and that guidance could be completed within weeks. There are also attempts to lobby Congress to get the requirements changed to make it easier for businesses to qualify, says Mark Kennedy, chief investment officer of Fuel-LA, a Los Angeles based firm that is working on promoting investments in South Los Angeles. One such idea is to allow businesses that have 90 percent of their staffs located in Opportunity Zones to qualify.

Opportunity Zone capital for businesses is likely to be limited unless the rules are altered. “Without the 50 percent rule being eased, Opportunity Zones will be a pure real estate play,” Kennedy said.

Questions About Real Estate

While commercial real estate is likely to be the largest Opportunity Zone investment category, there are a slew of questions and logistical hurdles that are stifling capital in that sector. One such issue is that investments must represent fresh capital. Investors cannot get a tax break for property they owned in Opportunity Zones before the statute went into effect on Dec. 31, 2017. To get around this, some property owners are selling assets to new firms that they control. Such transactions incur costs and add complexity.

1) A big concern is timing. The law requires that capital must be placed in an opportunity zone fund within six months of the event that created it (such as the sale of stock, property or art, etc.), and 90 percent of the fund must be invested within six months. Given the length of negotiating and closing many property transactions, investors are concerned that it may be difficult to invest within the allotted period. There is a penalty for un-invested funds, although Kowalski said the guidance being written is trying to limit situations where the penalty would apply.

2) Further on the issue of timing, investors have 30 months after a property is purchased to complete capital improvements. The law requires that investors must double the basis of the property to qualify for the tax break. In other words, a building purchased for $1 million would need another $1 million of capital improvements. However, that requires a prompt governmental approval process and cooperation of contractors, matters that are often out of the control of the property owner.

3) Then there’s the question of whether land qualifies as an investment. The legislation is not clear as to whether improvements are required for the purchase of land. Can an investor create a land bank as an investment strategy? That might not make sense given the volatility of land prices and the length of time required to hold an Opportunity Zone investment. But even so, that doesn’t erase the uncertainty about whether such a strategy is allowable.

4) In addition, investors have expressed concern about the logistics of commingled and multi-asset funds. In a fund with multiple investors, what are the implications if investors exit at different times? Likewise, with multi-asset funds, what if the properties are held for different time periods? How would those events be segregated for tax purposes? Single-asset funds are the easiest way to comply with the law, but it also makes it difficult to generate a large amount of deal volume.

These points are just some of the issues that need to be addressed by regulators. The law states that shareholders who keep their investments for five years will pay no taxes on 10 percent of the investment’s gains. After seven years, 15 percent of the gains will not be taxed. Shareholders who hold Opportunity Zone investments for 10 years can avoid paying taxes on all gains.

Kowalski said that guidance is being written with an eye toward giving investors the flexibility needed to encourage capital flow to Opportunity Zones. However the rules are changed or clarified, the complexity involved means that investors without working knowledge of the real estate industry and the targeted markets are likely to struggle to meet the requirements of the law.

Paul Fiorilla is director of research for Yardi Matrix.