HOUSTON OPPORTUNITY ZONE FUND GUIDE
THE 2019 QUALIFIED OPPORTUNITY ZONE FUND GUIDE
FOR TEXAS COMMERCIAL REAL ESTATE INVESTORS
Signed into law on December 22, 2017, the 2017 Tax Reform Reconciliation Act (the Act) includes a new tax incentive program. What’s more, Houston opportunity zone fund commercial real estate investors can benefit from this program. Internal Revenue Code Subchapter Z, which covers Opportunity Zones, seeks to promote investments in certain economically distressed communities. However, Subchapter Z is also highly complex. To this end, our research team assembled the following 2019 Qualified Opportunity Zone Guide designed for Texas commercial real estate investors.
Please be aware that we are not accountants or attorneys, and this is not advice. As a result, we encourage you to seek the professional advice of a Certified Public Accountant (CPA) and Licensed Attorney.
On a basic level, the Opportunity Zone Program allows investors to inject capital into certain low-income communities. By design, the proposed outcome is to promote long-term economic growth through a variety of investment vehicles. Furthermore, investors may also receive significant tax benefits, such as:
- A. Tax deferral for capital gain invested in a qualified Opportunity Zone fund.
- B. Elimination of up to 15% of the tax on capital gains invested in the qualified Opportunity Zone fund.
- C. Potential elimination of tax when exiting a qualified opportunity fund investment.
On top of all the original regulations, the Treasury Department issued additional proposed regulations and other guidance on October 19, 2018. Certain highlights of these proposed regulations are:
- A. Almost all capital gains qualify for deferral.
- B. The Opportunity Fund must hold at least 90% of its assets in qualified Opportunity Zone property.
- C. In general, the deferred capital gain amount must be invested in a Qualified Opportunity Fund to qualify for deferral. Specifically, the investment entity must be treated as a corporation or partnership.
In addition to the proposed supplemental regulations, the Treasury and the IRS issued an additional piece of guidance. Rev. Rul. 2018-29 provides guidance to taxpayers in participating in the qualified Opportunity Zone incentive. Specifically, it highlights the “original use” requirement for land purchased after 2017 in qualified opportunity zones. In the end, this ruling addressed and resolved questions as to how a 00 Fund could “substantially improve” land.
In addition, assuming a taxpayer holds a Qualified Opportunity Zone Fund investment until December 31, 2026, the gain subject to tax is either:
- the lesser of the fair market value of the property at the time of the event or
- the original deferred gain
For this reason, taxpayers will need to value their interest in the Qualified Opportunity Zone Fund in order to receive the correct gain. Moreover, this incentive may also be used as a complementary investment tool for those who are also receiving NMTCs or Low-Income Housing Tax Credits.
ABOUT HOUSTON OPPORTUNITY ZONES
Ideally, Opportunity Zone investments will stimulate economic growth and transform certain parts of Houston. Governor Abbott believes that Houston’s Opportunity Zones represent billions of dollars in potential investments. In light of this, here are a few things to know about Houston’s Opportunity Zones:
- Houston has 150 Opportunity Zones.
- These areas will keep the O-Zone designation for 10 years.
- Texas Governor Greg Abbott has specifically highlighted areas impacted by Hurricane Harvey.
- The Rice-Kinder Institute for Urban Research created a Houston Opportunity Zones Map.
If you are interested in Houston Opportunity Zone investment opportunities, contact CXRE today.
In general, a good rule of thumb for life is don’t spend more money than you make. This is true if for individuals as well as corporations.
As a real estate investor, you should have a handle on how much money you have, how much you’re spending, and what your assets are worth. In order to keep track of these and other things, a good accounting system is crucial.
Good accounting practices allow investors to increase efficiency and streamline operations. In contrast, poor accounting practices make operations harder and slower. Not only that, but not tracking your real estate investment finances could lead to financial hardship.
As the saying goes, death and taxes are the only two certain things in life. For real estate investors and owners, taxes are an unavoidable part of life. Not only that, but so are new tax codes change.
A commercial real estate investment broker is expected on top of tax code changes for 2019 to best advise their clients. However, if you own a Houston commercial real estate investment, you should also stay current on tax laws and code changes. Not being aware of tax code changes could hurt you in the long run.
Houston’s Southwest Freeway is the busiest freeway in Texas and one of the nation’s busiest stretches of freeway. Also known as US-59, the submarket lies between Uptown and Greenway/Upper Kirby. It winds its way through Sharpstown on the way to Sugar Land. However, the area is more than a `pass-through’
Not only does it have plenty of office space, shopping, restaurants, entertainment, and healthcare, but it is also near Rice University, the Museum district, and West University Place.
OPPORTUNITY ZONES TAX BENEFITS SIMPLIFIED
Investing in Opportunity Zones happens through qualified Opportunity Funds (O-Funds), the designated O-Zone
investment vehicles. The main Opportunity Zones Tax Benefits are:
Deferred Capital Gains Tax – You can sell current assets to invest taxable capital gains into O-Funds. Do this within 180 days of selling your assets and you avoid paying capital gains tax (at least until an O-Fund is divested or until December 31, 2026).
Basis Step-Ups – Basis step-ups increase your rolled-over capital gains: A five-year O-Funds holding brings a 10% basis step-up. A seven-year O-Funds holding brings an additional 5% (15% total).
Fewer Limits – Finally, there are fewer limits on O-Fund investments. There are no limits on the amount invested, the type of taxes you avoid, how much tax you avoid, and the amount of time that gains can compound tax-free.
Tax-Exempt Potential – Holding O-Funds investment for at least 10 years lets them grow tax-free AND you are exempt from paying capital gains.
SPURRING INVESTMENT AND
CONNECTING WITH COMMUNITIES
Opportunity Zones have the potential to spur investment and development in Houston. Furthermore, investing in Opportunity Funds connects investors to communities with real needs. In addition to the benefits to the people of Houston, Opportunity Zone investments offer tax benefits to investors.
For additional information on investment opportunities in Houston and in Texas, contact CXRE Group today.
Qualified Opportunity Zone Funds (QO Funds) must be formed as partnerships (LLCs that are taxed as partnerships would be acceptable), or corporations. QO Funds can invest in income-producing real estate located in an Opportunity Zone, such as an apartment complex, shopping center, or office building.
In order to meet the criteria of a QO Fund, 90% of the assets held by the vehicle on the last day of the fund’s taxable year and the last day of the first six-month period of the fund’s taxable year) must be qualified opportunity zone property (QOZ Property) within a QO Zone and the QO Fund must have acquired the property after December 31, 2017.
QOZ Property can be qualified opportunity zone stock (QOZ Stock), qualified opportunity zone partnership interest (QOZ Partnership Interest). or qualified opportunity zone business property (QOZ Business Property).
CAPITAL GAIN DEFERRAL
Specifically, subchapter Z provides incentives for investments in qualified opportunity zones (QO Zones) by means of temporary capital gain deferrals and ultimately permanent exclusion from gross income of capital gains, if certain requirements are met.
Under the new law, any gain from the sale or exchange of property by a taxpayer to an unrelated person, that is invested in a qualified opportunity fund (QO Fund), as defined below, within 180 days of the sale of that property is excluded from gross income until the earlier of the date the investment in the QO Fund is sold or December 31, 2026.
The law requires only the gain to be reinvested into the QO Fund, not the total proceeds, which is different than other tax deferral tools such as like-kind exchanges. The gain deferred can be any gain (e.g., short-term, long-term, ordinary and Section 1231 gains) in connection with the disposition of property.
The taxpayer’s basis in the QO Fund is initially zero but will be increased by 10% of the deferred gain if an investment is held for 5 years and increased by an additional 5% if the investment is held for 7 years. Therefore, if a gain on the sale of property is reinvested in a QO Fund within the required timeframe, taxpayers may be able to decrease the taxable portion of the originally deferred gain by 15% (an overall basis step-up of 15%) if the investment is held up to 7 years.
CAPITAL GAIN EXCLUSION
For investments held for at least 10 years, the taxpayer will recognize no capital gain income on the appreciation of the asset from the time of the initial investment in the QO Zone through the sale of the investment (note they still will be required to pay tax on the initial gain used to fund the investment into the QO Fund).
Where the taxpayer invests both capital gain proceeds and cash from other sources into a QO Fund (fresh capital), the Act specifically states that the investment will be treated as two separate investments of which only the capital gain proceeds will be eligible for the 10-year capital gain exclusion (and basis boosts).
The following is a timeline of the mechanics of investing into a QO Fund:
Property is sold for a gain (example: publicly traded stock) for $150 which is comprised of $50 of cost basis and $100 capital of gain
Within 180 days, the $100 of gain is reinvested into a QO Fund
Taxpayer receives a step up in basis in connection with the original $100 of gain of $10 (10%). That is, now they will recognize a gain of no more than $90 from the original $100 of gain.
Taxpayer receives a step up in basis in connection with the original $100 of gain of an additional $5 (5%). That is, now they will recognize a gain of no more than $85 from the original $100 of gain.
Tax on deferred gain of $85 is due (Assuming the fair market value of the interest in the fund is greater than $85).
Taxpayer would not owe any tax related to post acquisition appreciation on the interest in the fund
QUALIFIED OPPORTUNITY EXAMPLE ECONOMICS AND
COMPARISON TO OTHER INVESTMENTS
The following presents an investor’s after-tax funds available under different scenarios, assuming various holding periods, annual investment appreciation of 7%, and a long term capital gains rate of 23.8% (federal capital gains tax of 20% and the net investment income tax of 3.8%):
Investing in an QO Fund vs. Standard Stock Portfolio with a capital gain of $100 reinvested in 2018
INVESTMENT IN A STOCK PORTFOLIO / INVESTMENT IN A QO FUND
|HOLDING PERIOD||APPRECIATION RATE||TOTAL TAX LIABILITY $||AFTER TAX FUNDS $||TOTAL TAX LIABILITY $||AFTER TAX FUNDS $||DIFFERENCE IN AFTER TAX ANNUAL RATE OF RETURN|
Taxpayer purchased Amazon stock in 2016 for $50 which is worth $150 in 2018. Taxpayer sells the stock and receives $150 in cash of which $50 is returned to the taxpayer and $100 is invested in a QO fund. The investor holds the investment in the 00 Fund for 10 years.
The taxpayer can defer the taxes owed on the $100 of gain until 2026. Further, because the investor will hold the asset for at least 7 years, a basis step-up of $15 would be applied and this the tax due will be $20 ($85 times 23.8%) in 2026. Since the investment was held for 10 years, there will be no further tax due on the appreciation of the original $100 investment.
Total Tax: $20
After-Tax proceeds: $176
Effective Tax Rate on original and QO Fund investment 10.2% ($20 divided by $196 of ending value)
Effective after-tax annual return: 5.8% (7% assumed annual return less tax leakage)
Assume the same facts as in example 1, but the investor only holds the 00 fund investment for 7 years. As in example 1, the investor can temporarily defer the tax owed on the original stock sale and will receive the same 15% step-up in basis.
Thus, the investor will owe the same $20 in tax in the year of sale ($85 times 23.8%) based on the original capital gain; however, unlike example 1 because the investment in the QO Fund was not held for 10 years there will be no exemption from the appreciation on the investment.
If we assume that the investment grows 7% annually, then the taxpayer will owe an additional $15 ($61 of gain times 23.8%) of tax upon exit.
Total Tax: $35
After-Tax proceeds: $126
Effective Tax Rate on original and QO Fund investment 21.7% ($35 divided by $161 of ending value)
Effective after-tax annual return: 3.3% (7% assumed annual return less tax leakage)
Assume the same facts as in example 1, but the investor only holds the 00 fund investment for 5 years.
As in example 1, the investor can temporarily defer the tax owed on the original stock sale but will receive only a 10% step-up in basis. Thus, the investor will owe $21 in tax in the year of sale ($90 times 23.8%) based on the original capital gain.
However, unlike example 1 because the investment in the 00 Fund was not held for 10 years there will be no exemption from the appreciation on the investment.
If we assume that the investment grows 7% annually, then the taxpayer will owe an additional $10 ($40 of gain times 23.8%) of tax upon exit.
Total Tax: $31
After-Tax proceeds: $109
Effective Tax Rate on original and QO Fund investment: 22.1% ($31 divided by $140 of ending value)
Effective after-tax annual return:1.8% (7% assumed annual return less tax leakage)
What Makes an Opportunity Zone?
Governors of states and territories and the mayor of Washington D.C., nominated potential census tracts within their jurisdictions as Opportunity Zones. In areas with less than 100 census tracts, 25 census tracts were eligible.
To date, there are over 8,700 Qualified Opportunity Zones in every U.S. state and D.C. What’s more, there are O-Zones in five U.S. territories – the Virgin Islands, American Samoa, Guam, Northern Mariana Islands, and Puerto Rico (the entire island is a designated Opportunity Zone).
Opportunity Zone Criteria
As stated above, becoming an Opportunity Zone requires nominations. However, to receive an Opportunity Zone designation, a tract it has to be economically distressed. In addition, tracts need to meet several low-income requirements criteria (outlined by IRS Code Section 45D(e)):
- Minimum 20% poverty rate OR
- Median family income of:
- Less than 80% of statewide median family income for non-metropolitan census tracts
- Less than 80% of greater statewide median family income OR the overall metropolitan median family income
Overall, 25% of census tracts in a given jurisdiction were eligible for nomination. What’s more, another 5% were eligible, providing they met both of the following criteria:
- Census tracts directly adjacent to a low-income O-Zone
- Median family income less than 125% of the median family income (relative to the adjacent QOZ)
Based on these criteria, almost 60% of American neighborhoods were eligible for nomination. Yet only 12% of all census tracts received the designation.
If done correctly, it may be possible to defer capital gains taxes for 7 years. Subchapter Z provides incentives for investments in qualified opportunity zones (QO Zones) by means of temporary capital gain deferrals and ultimately permanent exclusion from gross income of capital gains, if certain requirements are met.
Governors of each state proposed census tracts. You can use our searchable map to see if a specific address is inside of an Opportunity Zone.
There are 150 opportunity zones throughout the greater Houston, Texas area.
Qualified opportunity zone funds can invest in office buildings, RV parks, retail center, multifamily apartments and even the stock of business located inside of an Opportunity Zone.
An eligible partnership or corporation must self-certify by completing Form 8996 (Qualified Opportunity Fund) with its federal tax return. This return must be filed in a timely manner, taking into account any extensions. For more details, consult the Form 8996 instructions.
No. You don’t need to live, work, or operate a business within the Opportunity Zone.
Click here for a full listing of all Texas Opportunity Zones.
The 11-digit census tract numbers (GEOIDs) can be found using the U.S. Census Bureau’s Geocoder.
Still have questions? Visit the IRS Opportunity Zones Frequently Asked Questions page to learn more.