There has been much talk of Opportunity Zones since their creation by the Tax Cut and Jobs Act of 2017. Their purpose is to spur economic development in distressed areas by encouraging long-term investments through substantial tax breaks. More than 8,700 areas in the U.S., encompassing ±10% of the U.S. population and ±12% of the land were designated as Qualified Opportunity Zones (QOZ). As of April 17, 2019, the U.S. Treasury issued new regulations to stimulate more investment in QOZs as many investors were waiting on the sidelines due to some ambiguous language in the Tax Cut and Jobs Act of 2017.
Do you have capital gains (either on paper or a cash distribution) or plan on having them either from the sale of real estate, stock, or some other investment? If you don’t, unfortunately, you will not be able to benefit from Opportunity Zones. If you do, you understand that capital gains tax will cut into your return. Once you receive your capital gains you have 180 days to invest those gains into a Qualified Opportunity Fund (QOF) either as a corporation, partnership, or LLC. 90% of a QOF’s funds must be invested in a Qualified Opportunity Zone (QOZ). This consists of investment in either a QOZ Business Property (real estate) or in the purchase of stock, partnership interests, or LLC interest in a QOZ Business. Investment of infrastructure and start-ups in QOZs is also permitted. There are many more requirements for the QOZ Business and QOFs that will raise money to invest is a multitude of properties and business, selling shares to investors with capital gains. Given the context, this article focuses on the QOZ Business Properties.
There are approximately either in place or under construction 1.9 million multi-family units, 960 million square feet of office space, and 180 million square feet of self storage space. Focusing just on the self storage, as a percentage of total space, properties in OZs that are in place or under construction represent 11.4% of total self storage space. An additional 12 million square feet of self storage space is planned or proposed in opportunity zones.
Self storage is a popular use in QOZs as redevelopment of underutilized properties (which, oftentimes, happen to be in QOZs) has been a very hot trend in the industry over the past few years.
So you have a QOF and you invested your capital gains in a property in a QOZ within the 180 day time limit. If your QOZ Business Property is improved with a building that you intend to convert to self storage, congratulations! Your reward is that another time limit has begun!
You now have 30 months to make a “substantial improvement” to the property. What is the substantial improvement? You must double the value of the improvements on the land. For example, you buy a vacant building for conversion for $1 million. Your friendly neighborhood appraiser values the property at the purchase price and allocates $200,000 as the land value. Since the improvement value is $800,000 you must invest at least $800,000 into the property within 30 months. Having appraised many self storage conversions, at least in the Midwest, the renovation and conversion costs almost always far exceed the acquisition costs of the improvements.
If you purchased vacant land for ground up construction of self storage, the substantial improvement rule doesn’t apply. Some argue that most investors will opt for ground up construction because of this, however, with the popularity of self storage conversions, if you have capital gains to invest, converting in an opportunity zone is a no brainer.
So now that your QOF has a QOZ property and it has been converted to self storage within 30 months, what are the tax benefits everyone is so excited about? Well, as appraisers love to say, “It depends.” It comes down to how long you keep the investment. Here are the three tax incentive benefits:
Going back to our example, where the initial capital gains were $1 million. Instead of paying capital gains taxes when earned, by investing in a QOF, you get to defer taxes until either you sell the QOF or Judgement Day; in this case known as December 31, 2026. So, the first benefit is deferring capital gains tax payment until the end of 2026.
The partial forgiveness of the initial capital gains depends on how long you hold the investment in the QOF. If you hold for longer than 5 years, there is a 10% exclusion of the deferred initial gain. If you hold on to your investment for longer than 7 years, this exclusion is bumped up to 15% of the deferred initial gain. In other words, after 5 years you only owe capital gains taxes on $900,000 (90% of $1 million) of your initial capital gains; and likewise, after 7 years you would owe capital gains taxes on $850,000 (85% of $1 million) of your initial capital gains.
Particularly astute readers will note a potential problem. Since Judgement Day comes on December 31, 2026, if an investor wants to fully maximize the incentives offered by an QOZ, they only have until December 31, 2019 to invest their capital gains into a QOF and purchase a QOZ property. What are you waiting for? Buy that QOZ property before it’s too late!
Hyperbole aside, even if you make an investment in a QOZ after December 31, 2026, you can still enjoy the 5 year, 10% exclusion on the initial capital gain, and that isn’t even the best part! If you hold on to your QOZ converted self storage facility for 10 years you get 100% forgiveness on all additional capital gains! Continuing our example, you decide to sell your converted self storage facility after 10 years and your friendly neighborhood appraiser values it at $5 million. Assuming that you invested prior to December 31, 2019, you already paid 85% of your initial capital gains tax in 2026. Therefore, you will pay no new capital gain taxes on the $4 million of additional (new) capital gains after the 10+ year hold. This can have a massive impact on an investor’s return.
If you don’t have capital gains to make the initial investment, you can’t take part in this program limiting participation of many investors. You also have to make sure that you invest those capital gains in a QOF and invest in a QOZ property. While you can defer the initial tax on capital gains until you sell the property, if you don’t hold for at least 5 years you get none of the other benefits. Since the primary benefits of an OZ investment are dependent on an investor’s actions long after the purchase and are not transferable to potential buyers, any increase in value due to a property being in a QOZ from the initial investor’s perspective would be considered Investment Value as opposed to Market Value. Investment Value is defined as:
The value of a property to a particular investor or class of investors based on the investor’s specific requirements. Investment value may be different from market value because it depends on a set of investment criteria that are not necessarily typical of the market.
In conclusion, Opportunity Zones potentially offer a great way for an owner to boost their ROI by mitigating their taxes on capital gains. This can have a large impact on investment value and given the booming trend of self storage conversion of troubled or vacant real estate (often in QOZs) taking advantage of these incentives makes a good deal of sense. Even with the government’s April 17, 2019 regulations making investing in QOZs easier; due to the restrictions in-place, limiting the investor pool, as well as considering that the magnitude of the tax benefit largely fluctuates based on the investor’s future actions and are not transferable to potential buyers, it does not have an impact on the Market Value of self storage properties.
