By John Waters

October 29, 2018

Business and civic leaders alike have reason to celebrate the Treasury Department’s proposed regulations for investment in so-called “opportunity zones.” Released one week ago, the regulations clarify two new sections of the tax code enacted as part of the 2017 Tax Cuts and Jobs Act, both of which aimed to spur economic investment in historically distressed or impoverished communities. The early consensus among interested professionals is optimistic, as the regulations make it easier for private equity investors to defer taxes on capital gains by funding investment in opportunity zone funds. In that way, the intent of the program — “to create a brighter tomorrow for communities that have been left behind,” in the words of Sen. Tim Scott — stands a real chance of succeeding. Certainly, the benefits to real estate investors in particular are obvious and substantial. And still an important question remains to be answered: whether the flow of capital will pour predominantly into gentrifying urban neighborhoods already attractive to investors, or if small towns and rural communities also will be rejuvenated by new investment?

But first some background on the program. The tax benefits of an opportunity zone investment operate in two phases. In the first phase, any individual — including a “C” corporation, “S” corporation, REIT, or trust, to name a few — can roll over capital gain from an unrelated asset into a “qualified opportunity fund” within 180 days of the asset’s sale. The individual can see a 10 percent reduction in his tax bill on the capital gain if he holds onto the investment for five years, or a 15 percent reduction if he holds on for seven years. The second phase allows the opportunity fund investor to eliminate his tax exposure on the new investment altogether. Specifically, if the individual holds onto the qualified opportunity zone investment for a period of 10 years, then any gains realized on that investment are tax-exempt. The particulars, of which there are many, are laid out in Internal Revenue Code Sections 1400Z-1 and 1400Z-2.

Real estate experts compare these new provisions to Internal Revenue Code Section 1031, commonly called the “like-kind exchange.” Traditionally a boon to real estate investors who hold property for productive use or investment, 1031 states that no gain or loss is recognized on the exchange of “like kind” properties. The upshot is that both 1031 and the opportunity zone provisions allow investors to defer capital gains taxes by reinvesting proceeds.

The early data shows that real estate investment is up across the country. One source reported that 2018 sales of development sites in opportunity zones nationwide are up 80 percent compared with the first three quarters of 2017. And future projections coming from the White House are even bolder. “I think there’s going to be over $100 billion dollars in private capital that will be invested in opportunity zones,” said Treasury Secretary Steven Mnuchin.

Now, of the roughly 8,700 census tracts that affect some 35 million, many (if not most) of the opportunity zones encompass areas near large population centers. Take a look at the nationwide map of opportunity zones here. But, recent reporting in my home state of Nebraska shows both small and large markets taking advantage of the program. Just last week, a $300 million neighborhood redevelopment project was announced in an historically underserved segment of Omaha’s north downtown neighborhood, promising to transform previously neglected warehouses and historic buildings into housing and work spaces. The project has already attracted a homegrown tech company as its first tenant. Separately, in a nearby city of some 6,000 people, developers and city councilmembers are equally excited about a plan for redevelopment of the city’s “market street” area, which includes “turning a former grain elevator into an outdoor entertainment space.” Both the Omaha plan and the small-city plan are spearheaded by private investment. Both the Omaha plan and the small-city plan tackle redevelopment of areas that lie in the middle of opportunity zone districts.

Much remains to be seen about this program. For one, the draft regulations must undergo 60 days of public comment before being finalized sometime next spring. Many investors are waiting on a second round of IRS guidance to clarify ambiguities, especially about an investment fund’s flexibility to buy and sell assets. However, early indications from private investors and public leaders illustrate the program’s potential to spark activity in historically distressed or neglected communities.

This article was originally published on realclearmarkets.com.

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