A new opportunity in Opportunity Zones? Yes, but keep this in mind.
As you might imagine, as community-focused bankers we have taken interest in this year’s launch of Opportunity Zones, a federal program intended to spur economic development in distressed counties, cities, and towns around the country.
“OZs” were established by an act of Congress last year to encourage long-term investments in struggling, low-income urban and rural communities by providing tax benefits to investors in the form of deferring, reducing, or altogether avoiding capital gains taxes. They’re akin to 1031 exchanges for real estate, where an investor can sell a property and reinvest the proceeds to defer the taxes (though, unlike 1031s, OZs allow investors to reduce or avoid capital gains).
OZs are lower-income census tracts – typically, communities with poverty rates of at least 20 percent, or median family incomes no greater than 80 percent of the surrounding region. OZs are established by each state and territory’s governor or chief executive; Virginia includes 212 opportunity zones in rural, urban, and even suburban areas.
The Economic Innovation Group, a bipartisan public policy organization that helped develop Opportunity Zones, estimates a pot of $6.1 trillion in capital gains in the U.S. will be eligible for reinvestment. We cannot reasonably expect all of that cash to flow into OZs, yet if only a fraction of it did, that would still one of the largest development initiatives in U.S. history.
There’s a lot of wait-and-see when it comes to Opportunity Zones, and at Virginia Community Capital we have been spending the past few months helping educate our partners and stakeholders on the possibilities of this new investment tool. Some of our clients have shovel-ready projects in OZ census tracts and are looking for investors, and we view Opportunity Zones as one possible, additional element in the capital stack to bring these and other new projects to life.
What do OZs mean for investors?
OZs have the chance to transform communities while providing preferential tax treatment and shelters for investors.
Here’s how it works: Say you sell a stock, interest in a business, or a piece of property today. If you reinvest your capital gains in an Opportunity Zone within 180 days, you’ll defer taxes until you exit the OZ fund or until Dec. 31, 2026. If you hold the OZ investment for seven years, you can step up your basis investment for capital gains by as much as 15 percent, lowering the amount you’ll owe in taxes.
And if you hold the investment for 10 years, the basis will rise to the fair market value – erasing entirely the gains on top of the initial investment.
For a small business or real estate project, OZs may be a tool that will allow banks and their partners to get deals done more quickly. There is certainly excitement and interest in knowing that there may be fresh capital available for real estate developments and business investment, but like any new investment vehicle, it is important to do your research and understand the potential challenges and limitations.
Next steps: Do your due diligence.
To get your money into an OZ, you’ll need to find or set up or find a Qualified Opportunity Fund, or “O-Fund.” These will be established by anyone from large institutions to individual investors; skilled investors will know how to find them or set one up. OZ investors will self-certify that they meet certain qualifications through a form that the IRS is expected to release in October.
Still, investors must approach an O-Fund as they would any business, Wall Street, or real estate vehicle, and do their due diligence: Get to know the management team operating the fund, any fees, review the pro forma, and take time to learn about the community into which your dollars would flow. Not all zones promise a return, and like any investment, there is risk in losing your principal and gains.
We take a cautious but informed view of Opportunity Zones, and want to ensure our partners are educated on the opportunity and the restrictions to avoid any trouble down the road. Like many, we await clear rules from the U.S. Treasury and Internal Revenue Service to better understand the regulations and potential pitfalls of this new reinvestment incentive. We expect that guidance by end of October.
Our hope is that our partners can leverage the benefits of an Opportunity Zone to align with their mission to create vibrant neighborhoods and improve the quality of life in their communities.
Stick with us as more information becomes available about this new opportunity. And if you have questions, reach out to us anytime.
Bill Greenleaf is senior vice president and team manager of Virginia Community Capital’s real estate lending team. He holds an M.B.A. in finance from the Kelley School of Business at Indiana University.
Adam Northup is an advisor to Virginia Community Capital with expertise in strategy development, financial planning and analysis. He holds an M.B.A. from the University of Virginia Darden School of Business.