3 Things You Didn’t Know About Houston’s Opportunity Zones Locations – Revised for Q3 2019

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Houston’s Opportunity Zones

It’s true that many real estate investors have heard of Opportunity Zones. Yet many might not know exactly what they are. Briefly, Opportunity Zones (a.k.a. ‘O-Zones’) are designated investment areas. Specifically, these are originated with the 2017 Tax Cuts and Jobs Act. Overall, the objective of these Zones is stimulating economic growth in these designated areas. In general, O-Zones are either distressed areas, economically depressed areas, or both.

If taken advantage of, real estate investors could potentially transform certain areas of Houston. This is especially true for places which were impacted by Hurricane Harvey. Not only that, but O-Zones will retain their Opportunity Zones designations for a decade. However, one of the greatest aspects of O-Zones for real estate investors is the potential tax benefits from these investments.

3 Things To Know About Houston’s Opportunity Zones Locations

Even if know that Houston has O-Zones, you may now know the details. Below are three things you might not know about Houston’s Opportunity Zones.

Opportunity Zones Investment - capital gains with CXRE timeline of 10 year period.

1. Houston has 150 Opportunity Zones

All around Houston, many neighborhoods and areas have the ‘Opportunity Zones’ designation. In fact, Houston has a total of 150 O-Zones. In fact, Texas Governor Greg Abbott believes that Houston’s Opportunity Zones can boost each local community. Especially in the areas which were most affected by Hurricane Harvey. Briefly, Gov. Abbot wants to see billions of investment dollars flow into Houston’s O-Zones. In addition, other parts of Texas, like Dallas-Ft. Worth and San Antonio, have O-Zone investment opportunities 

Some specific Opportunity Zones that could benefit from an influx of investments in Houston are Downtown Houston, New Caney, and East Downtown Houston. On top of that, several industries could possibly benefit from O-Zone designations – real estate development, manufacturing, restaurants, and even service business.

2. There is a Houston Opportunity Zones Map

Opportunity Zones map snapshot, showing Fort Worth area

Per the Treasury Department, Opportunity Zones are designed to spur investment in economically-distressed communities. Due to this, Houston areas hit hardest by Hurricane Harvey could experience major improvement from O-Zone investment.

Texas Governor Greg Abbott submitted the state’s 628 Opportunity Zone designations to the Treasury Department in March 2018. As outlined above, 150 of these O-Zones are in Houston. To help real estate investors and brokers, CXRE Research Team posted the following Opportunity Zone Map. (the following map previously published by Rice: Houston Opportunity Zones Map).

The map’s blue highlighted areas indicate the designated Opportunity Zones. As you can see, it shows numerous blue sections near Downtown Houston and East Downtown Houston. As a result, the highlighted areas are places where investors could potentially invest their capital.

3. There Are Tax Benefits for Investing in Houston O-Zones

Opportunity Funds (O-Funds) are the primary vehicle for investing in Opportunity Zones. In particular, new investments in these areas could qualify for tax benefits under certain conditions. Qualified O-Funds offer the following tax benefits to investors:

  • Deferred Capital Gains Tax —Sell current assets and invest the taxable capital gains in Opportunity Funds. Do this within 180 days of selling the assets to avoid paying capital gains tax (until the fund is divested or until December 31, 2026).
  • Basis Step—Ups – Increase rolled-over capital gains:
    • 5-year O-Funds holding produces a 10% basis step-up
    • 7-year O-Funds holding produces 5% more (15% total)
  • Tax Exempt Potential — Hold Opportunity Funds for 10 years – they grow tax-free and are exempt from capital gains
  • Fewer Limits — O-Fund investments have fewer limits than other investments. There are no limits on:
    • The amount invested
    • How much tax you avoid
    • The type of taxes you avoid
    • The amount of time that gains compound tax-free
Chart depicting the left-side rows of Deferred Gain, versus top columns of years reinvested into QOF.
Example Mechanics of investing into a QO fund, timeline left to right from year 1 to year 10.

Check out the Ultimate Opportunity Zone Guide for Houston Commercial Real Estate Investors Here.

Current and Upcoming Houston Area O-Zone Projects

Below are five projects in the development which lie within one of Houston’s 150 O-Zones:

The Preston

Hines has plans to develop The Preston. Once completed, the 373-unit luxury tower will be Downtown Houston’s tallest residential development. Construction began in March and the project should be completed sometime in 2020. Due to its location in a Houston Opportunity Zone, Hines will receive favorable tax benefits from this project.

Over the past few years, Downtown Houston has made a concerted effort to attract more residents. Because of this push, the number of Downtown residents grew from about 3,800 residents in 2013 to over 9,000. Downtown Houston would like to see this number continue to rise, with possibly as many as 30,000 residents by 2040. The Preston fits nicely into Downtown Houston’s plan to become more residential and will add new units to attract even more residents.

Kayaking under the Hill Street (Jensen) Bridge over Buffalo Bayou, Houston

The Cameron

Acquired by Kaldis last November along with two adjacent parcels, this renewal project will revive a historic 1930s Art Deco-style building. At 60,000 SF, The Cameron was originally built for Cameron Iron Works. Overall, the plan is for a mixed-use development that will house professionals and creatives. Kaldis plans to complete and open the property by fall 2019.

East River/ Midway Sites

Midway’s five-phase 150-acre East River redevelopment project will create a walkable live-work-play community. Located along 6,000 feet of the Buffalo Bayou waterfront, the finished project will have a wide range of amenities. Specifically, the completed development will have almost 9 million SF of Class-A office space, about half a million SF of retail, over 475 single-family homes, 1,400+ multifamily units, and 12 acres of green space.

Currently, this project is in pre-development. However, Midway is already deeply invested into this site and is staking a lot on this project’s future. In addition, the Houston-based developer owns two other nearby properties (on Canal Street and Navigation Boulevard).

Navigation Place

This 1.8-acre tract of land at 2929 Navigation previously had a warehouse, which is now demolished. In April 2018, Houston-based Ersa Grae Corp. broke ground on a single-story, two-building retail development. The group has already signed two tenants:

  • Memphis-based Corky’s BBQ – This location will be Corky’s second in the Houston-area.
  • Allegiance Bank – A 4,500 SF space with a two-lane drive-thru.

Yet Navigation Place still has 9,000 SF of leasable space. A few potential tenants might include another restaurant or service-oriented retail.

Valley Ranch in Porter, TX

Valley Ranch, Porter

A map of the Valley Ranch community – courtesy of Valley Ranch

Not all of great Houston’s Opportunity Zones are located near the urban core. About 25 miles northeast of Downtown Houston is Porter, an ideal North Houston Opportunity Zone. Many people consider Porter and the surrounding areas to be the third best Opportunity Zone in Texas, behind only Downtown and East Downtown Houston. Located at the intersection of I-69 (US-59) and the Grand Parkway, the area is a straight shot to Downtown Houston.

At the moment, the main development taking advantage of Porter’s Opportunity Zones is Valley Ranch. This 1,400-acre master-planned community is a new ‘village’ being developed by The Signorelli Co. is one of Texas and Oklahoma’s leading real estate developers. Once completed, it will have residential areas, retail, offices, healthcare facilities, and entertainment.

Opportunity Zones Program

Opportunity Zones are covered by IRS Code Subchapter Z. As outlined by the IRS, these regulations promote real estate investments in certain areas. Furthermore, one of the program’s main goals is long-term economic growth in these communities and neighborhoods.

In brief, the Opportunity Zones program enables investors to invest capital into low-income and/ or distressed communities. In exchange, investors in a qualified Opportunity Zone fund may also eligible for the following tax benefits:

  • A. Tax deferral for capital gain
  • B. Eliminating up to 15% of the tax on capital gains
  • C. Possible elimination of tax when exiting the investment

In addition to the program’s original regulations, the Treasury Department released additional guidance on October 19, 2018. Some of these proposed regulations include:

  • A. Almost all capital gains qualify for deferral.
  • B. At least 90% of and Opportunity Fund’s assets must be held in qualified Opportunity Zone property.
  • C. To qualify for deferral, the capital gain must be invested in a Qualified Opportunity Fund. Also, the investment entity will be considered a corporation or partnership.

Additionally, if a taxpayer holds their Qualified Opportunity Zone Fund investment until December 31, 2026, the gain subject to tax will be either:

  • the original deferred gain OR
  • the lesser of the property’s fair market value at the time of sale

3 Important Things to Know about Investing in Opportunity Zones

Below are three important technical aspects of Opportunity Zone investment to be aware of:

Forming a Qualified Opportunity Zone Fund

Investing in O-Zones requires a Qualified Opportunity Zone Fund (QO Funds). These funds must be either partnerships or corporations. Once formed, QO Funds are able to invest in Opportunity Zone property. However, a QO Fund, 90% of the assets must be QOZ Property (qualified opportunity zone property). In addition, the property after should have been acquired after December 31, 2017.

Tax Benefits of Qualified Op-Funds. Timeline from Sales of Property, Reinvestment QOF, +5 years @ 010% step-up on deferred-gain, 5% on 7 year or higher, and exchange/sale after 10+ year (FMV)
O-Funds Have Fewer Limits

O-Fund investments have fewer limits than some other investments, specifically regarding certain benefits. For starters, O-Funds have no limits on the amount you invest. What’s more, there are also no limits on the types of taxes you can avoid, how much tax you can avoid, and the amount of time that your gains can compound tax-free.

Tax Treatment of QOF investments with 'mixed funds'.

O-Funds’ Tax-Exempt Potential

If you hold O-Funds investment for at least 10 years, they will grow tax-free. On top of that, during that time period, you are required to pay capital gains.

Tax Treatment of Qualified Opportunity Fund Investment, Cumulative Mixed Investment growth over 10 year period

Q3 2019 Opportunity Zone Market Updates

In order to be Qualified Opportunity Zone property, commercial real estate must meet one of the following criteria:

  • It was not in use within the five years previous to its acquisition OR
  • It becomes a substantially improved property within 30 months of it being acquired (rehab expenses = cost plus $1)

However, the taxpayer must have a documented plan of rehabilitation before the IRS will consider real estate (and cash used for rehab) as qualified property during this 30-month rehab period. This plan should include:

  • Construction drawings for the planned rehab
  • A timeline for project completion including milestones
  • Other written materials to support the intention of rehabilitating the property into a qualified opportunity zone property.

The taxpayer must have a documented plan of rehabilitation

Without a clear rehab plan, any of the QOF’s cash which is intended for property rehab won’t be considered as a qualified asset. Furthermore, it is possible that the property itself also wouldn’t be considered a qualified asset.

Penalties for Unqualified Assets in an Opportunity Zone Fund

The IRS charges a penalty for an unqualified asset in an Opportunity Zone Fund. This penalty is equal to the underpayment rate for estimated taxes (this changes monthly). If assessed, the entity must pay the monthly penalty for each period that the 90% qualified business property test isn’t met. Overall, the IRS bases this penalty on the amount by which you miss the 90% test.

For example, if a QOF has $1,000,000 of total assets, yet $300,000 of those assets are qualified opportunity zone property, then the IRS levies the penalty on $600,000 of the “miss”. Currently, the underpayment rate is 5% (this changes every three months based on Treasury rates). In this example, the penalty would be about $2,500 per month (or $15,000 for a 6 month testing period).

Effectively, the investor loses the initial tax benefit after paying about a year of penalties.

Keep in mind that the QOF only provides a deferral of taxes. As a result, the levied penalty on gross miss isn’t a hypothetical tax. Instead, the effective penalty rate on this deferral is significantly higher.

Continuing with the example above, the tax on $600,000 of gain would be about $144,000. Also, a 12-month penalty on a $600,000 miss would be about $30,000. Due to this, the effective penalty rate on the deferred taxes is approximately 21%.

What is a Qualified Opportunity Zone Business?

As noted above, we can consider an investment by a QOF in a QOZB to be “good assets” for purposes of the 90% test. In order for a business to be a QOZB, it must have at least 70% of its assets in a qualified opportunity zone. Furthermore, it must meet a ‘doing business’ test. Specifically, a certain amount of gross income must come from zone or the investment vehicle pays wages to employees within the zone. Since rental real estate receives rent for property located in the zone, it always meets the gross income test.

So, it is really the asset test that is significant. As noted to be a QOZB only 70% of the assets have to be Qualified Business Property.

If the business does not meet this test then it is not a QOZB and therefore the investment at the QOF level in the business would be a “bad asset”. To determine whether real estate is a good asset in a QOZB, the same test discussed above for the QOF owned property applies. (Note: this is not in use for 5 years or substantial improvement in 30 months).

Regarded Entities: Getting Done in Q3, 2019

Because of the lower standard, using regarded entities in our real estate deals is most common. The owners of the entity are generally going to be a mix between the developer, QOF and possibly other investors.

Giving Houston a Boost with Opportunity Zones

Established by the Tax Cuts and Jobs Act of 2017, the hope is that long-term investments will connect capital with communities. As stated above, Governor Abbott believes says there is the potential for billions of investment dollars to flow into Houston. As Houston continues its post-Harvey recovery, many people hope that Houston’s Opportunity Zones will boost many local communities. In the words of Andrew Young (former Mayor of Atlanta):

Too many communities in our great nation feel passed over by economic growth and forgotten by our political leaders. We need a new formula for the public and private sectors to work together to generate new investments, new businesses, and new good-paying jobs in places that have fallen behind. The Investing in Opportunity Act will harness much-needed private capital to flow to more American communities and empower state and local leaders to build a more prosperous future.

Without a doubt, Opportunity Zones are an excellent tool for commercial real estate investment. By investing in O-Zones, commercial real estate investors can help revive and restore Houston, one neighborhood at a time. And not only can investors be a part of real change in Houston, but they can also receive tax benefits.

Learn More About Investing in Houston’s Opportunity Zones

Are you ready to learn more about investing in Opportunity Zones? To help you better understand this great program and its incentives, we have developed resources. For more information, read CXRE’s Opportunity Zone Fund Guide for Texas. Then, to get even more details on Houston commercial real estate investments, Contact Us today. Our professional team can guide you through the entire investment process.

Houston Opportunity Zone Funds - Tax Treatment - Infohgraphic. Check in Full Size; click button banner to see full graphic.

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