Opportunity zone pioneers must account for uncertainty

Firms are scrambling to capitalize on the new investment opportunity, but the language and definitions in the legislation still need more clarity.

The early bird catches the worm, so the saying goes.

But it is important that the worm is identifiable before the bird has a good chance of catching it. This week saw Bridge Investment Group add its name to a growing list of private equity real estate firms bent on capitalizing on one particular worm: US opportunity zones.

The Salt Lake City, Utah-based manager has already gleaned more than $500 million of potential investments for a wide range of property types that portend to fit in these state-circled areas of the country.

Under the new opportunity zone program, passed under the 2017 Tax Cuts and Jobs Act, taxpayers qualify for benefits when making investments in designated areas. Investors can qualify for a deferral and partial reduction in the inclusion of taxable income for capital gains that were reinvested into designated zones. Those holding the investment for at least 10 years may qualify for a permanent exclusion from taxable income on capital gains related to the sale or transfer of an investment.

The US Department of the Treasury and Internal Revenue Service added opportunity zone designations for the latest four states on June 14, bringing the total number of zones to 8,700 across the country. It was the final designation round, meaning there are now opportunity zones designated in all 50 states, the District of Columbia and five US territories. Geographies range widely from rural areas to urban centers, and the market opportunity is large: there is an estimated $6.1 trillion of unrealized capital gains that qualify for the investments, according to the Washington, DC-based thinktank Economic Innovation Group.

Unsurprisingly, several firms have launched, or announced plans to start, funds focused around opportunity zone investments. New York-based RXR Realty is reportedly seeking $500 million for the strategy, and venture capital firm Revolution has launched a direct real estate platform that will include opportunity zone investments. Normandy Real Estate Partners, which focuses on investments in the northeast and mid-Atlantic region, is also reportedly raising an opportunity zone fund targeting $250 million.

However, the legislation is still in its infancy and the Treasury Department and IRS will need to give more detailed guidance before these firms can invest with certainty that they know the rules of engagement.

A qualified opportunity fund is defined as an investment vehicle organized as a corporation or partnership with the intention of investing in a qualified opportunity zone property. One initial concern is that a limited liability company may not be eligible to receive qualified opportunity fund status, even if it would be classified as a corporation or partnership for federal tax purposes.

A qualified opportunity fund must also pass a 90 percent asset test, wherein the fund shows that 90 percent of its assets are qualified opportunity zone property. An asset would qualify if its original use began with the fund or if the asset, which was purchased after December 31, 2017, has been substantially improved over a 30-month period. It is unclear whether land would be considered “original use” or whether it could be considered substantially improved through construction. In the case of a property being part land and part building, for instance, would substantially improving the building alone be enough?

In addition, local municipalities may add their own restrictions and rules to encourage specific types of property investments. For example, they can impact the way real estate investments will be made in the opportunity zones through zoning restrictions and permits.

Investment managers will need to be ready to react quickly to any updates to the legislation and they will want to be flexible with their strategy. Potential changes to the legislation and additional rules imposed by local municipalities must also be accounted for in the underwriting of assets.

The tax benefits presented by the policy are certainly attractive to investors, but opportunity zone investment pioneers will face the challenge of interpreting vague rules and coming up with strategies that account for the risk posed by these uncertainties.

To contact the author of this opinion piece, email lisa.f@peimedia.com