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

Throughout Houston, many areas have the ‘Opportunity Zones’ designation. In fact, there are a total of 150 Houston O-Zones. Texas Governor Greg Abbott believes that these 150 Opportunity Zones can boost local communities. Especially the areas most affected by Hurricane Harvey. In brief, Gov. Abbot would like to see billions of investment dollars flow into Houston. Additionally, there are O-Zone investment opportunities in other parts of Texas like Dallas-Ft. Worth and San Antonio.

Some specific Houston Opportunity Zones that could benefit from an influx of investments are New Caney, Downtown Houston, and East Downtown Houston. What’s more, a number of industries could potentially benefit from these designations – real estate development, manufacturing, restaurants, and service business, among others.

2. There is a Houston Opportunity Zones Map

Opportunity Zones map snapshot, showing Fort Worth areaThe Treasury Department has designed these Opportunity Zones to spur investment in economically-distressed communities. Because of this, the parts of Houston hit the hardest by Hurricane Harvey could experience significant improvement from O-Zone investments.

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

The blue highlighted areas indicate designated Opportunity Zones. As you can see, this map shows many blue sections in and around Downtown Houston and East Downtown Houston. Consequently, these highlighted areas indicate places where investors could 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 O-Zone Projects

Below are four 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.

The Cameron

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

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

Commercial real estate can only be Qualified Opportunity Zone property if it, either: was not subject to use during the five years prior to acquisition or it becomes substantially improved property (rehab expenses = cost plus $1) within 30 months of it being acquired.

In order for the IRS to consider real estate (and cash used to do the rehab) as qualified property during the 30-month rehab period, the taxpayer must have a documented plan of rehabilitation. This plan would include:

  1. all construction drawings for rehab,
  2. timeline for completion of projection with milestones, and
  3. other written materials to support that the intention is to rehabilitate the building into qualified opportunity zone property.

the taxpayer must have a documented plan of rehabilitation

Without the plan of rehab, any cash held by the QOF intended to be used to rehab the building would not be considered a qualified asset. In addition, it is likely the real estate itself would not be considered a qualified asset.

Penalties for Unqualified Assets in an Opportunity Zone Fund

The penalty for an unqualified asset in an Opportunity Zone Fund is equal to the underpayment rate for estimate taxes which changes monthly. An entity receives this penalty on a monthly basis for each period the 90% qualified business property test is not met. Overall, the IRS bases the penalty on the amount by which you miss the 90% test.

So, if the QOF has $1,000,000 of total assets and $300,000 of them are qualified opportunity zone property, then the penalty is levied on $600,000 of “miss”. The underpayment rate is currently 5% (changes every three months based on Treasury rates). So, the penalty would be roughly $2,500 per month ($15,000 for 6 month testing period).

An investor would effectively lose the initial tax benefit after about 12 months worth of penalties.

Our advisory’s analysis says that investors would effectively lose the initial tax benefit after about 12 months worth of penalties. Remember, the QOF only provides a deferral of taxes. This means the levied penalty on gross miss is not a hypothetical tax. So, the effective penalty rate on the deferral is significantly higher.

The tax on $600,000 of gain would be roughly $144,000. A 12-month penalty on a $600,000 miss would be $30,000. So, the effective penalty rate on the deferred tax is roughly 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

As Houston continues its post-Harvey recovery, many people hope that Houston’s Opportunity Zones will boost many local communities. For example, Governor Abbott says there is the potential for billions of investment dollars to flow into Houston.

Ready to learn more about investing in Opportunity Zones? Read CXRE’s Opportunity Zone Fund Guide for Texas. Then, for additional details on Houston commercial real estate investments, Contact Us today.

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

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