Opportunity Zones Boost Real Estate Prices as Investors Rush In

Real estate investors are rushing to take advantage of the 2017 tax overhaul’s opportunity zone tax breaks—and may risk shooting themselves in the foot by propping up prices in already-hot urban markets.

“There are funds that have raised $500 million and they have timelines to make investments, so they’re out competing against each other, driving the prices wildly up,” Paul Wilner, a CPA and partner at Grossberg Co. LLP in Bethesda, said at a June 27 New York University conference in Washington. “Which speaks to the bad economics of the whole thing—because you’re going to way overpay for something just to avoid tax and lose your money.”

The end of 2019 marks a major deadline for investors seeking to use the 2017 tax law provision to shelter 15% of their profits from stocks and other investments, particularly from real estate, from taxes. In return for the tax break, they must hold their investments in mostly low-income opportunity zone census tracts for seven years, under tax code Section 1400Z-2.

With two tranches of IRS proposed regulations on the books, they’re no longer waiting around.

“There’s a critical mass of informed investors now” who are ready and willing to dive in, Brian O’Connor, a partner at the law firm Venable LLP in Washington, said at the same event. “I’m assuming that’s having a dramatic effect on real estate prices.”

A June study from researchers at the Massachusetts Institute of Technology’s Center for Real Estate and the Netherlands’ Maastricht University School of Business and Economics supports that assumption. While designation of the nearly 9,000 census tracts for the tax breaks didn’t affect all property prices, it resulted in a 14% price hike for properties slated for redevelopment and a 20% increase in the prices of vacant development sites, the study said.

While many of the tracts are in low-income areas, some have ignited criticism of the tax breaks, which opponents characterize as a giveaway to real estate investors in already-overheated markets. An arts district in downtown Los Angeles qualified, for example, as did swaths of downtown Brooklyn and the New York City borough’s relatively pricier Williamsburg neighborhood.

Many investors and tax professionals advising on the deals say 80% to 90% of the opportunity zone projects that they’ve seen are real estate-focused and predominantly in urban areas. This may be in part because the first round of proposed regulations (REG-115420-18) from the Internal Revenue Service, issued in October, mainly outlined the rules of the road for real estate opportunity zone developments.

Tight Turnaround

Investors specializing in real estate face a bit of timing whiplash this year if they want to qualify for one of the program’s key perks.

Unlike other capital gains eligible for the tax breaks, such as those from stocks, only the net amount—not the gross amount—of an investor’s gains under tax code Section 1231, which stem from property such as real estate, can be used to fund an opportunity zone project.

So in its most recent batch of proposed rules for the incentives (REG-120186-18), released in April, the IRS required that such investors wait until the last day of the year to tally up their net Section 1231 gains and plug them into an opportunity fund.

But Dec. 31, 2019, is also the final day to invest and still be able to shield 15% of the gains from tax after holding the investment for seven years.

“This is going to be a bad year-end for a lot of people,” Steve Schneider, a partner at Baker McKenzie in Washington who specializes in real estate tax, said at the conference. “You have to make your investment that same day before the stroke of midnight, because your full 15% step-up requires an investment before 12/31/2019.”

That deadline is stoking a rush to buy up property in the zones, O’Connor said.

“There’s going to be more and more bidders as more and more funds have been formed, and they have this capital they need to invest in certain time frames,” he told Bloomberg Tax. “They want to get the benefit of the seven years. There are going to be a lot of incentives to move forward before Dec. 31.”

Already, investors have formed 136 funds with more than $29 billion in investing capacity, according to a list compiled by the accounting and advisory firm Novogradac & Co. LLP.

Still, Schneider said, that’s unlikely to turn most investors away. Even if they miss this deadline, they’ll still get to avoid tax on 10% of the gains if they hold the investment for five years, he noted.

“You’re still getting 10. I don’t think that’s going to stop people,” he said, adding that he thought the IRS could have written more investor-friendly proposed rules in this respect, and that he planned to “talk to them” about it.

Along with those benefits after five and seven years, the law allowed investors in the census tracts chosen for the incentives to defer tax on their gains for eight years, and pay no tax on any appreciation in the investment after 10 years.

Bill on Its Way

The IRS updated its FAQ on the tax breaks on June 24 to reassure investors who funneled their Section 1231 gains from the 2018 tax year into opportunity zone projects before Dec. 31, 2018, as long as they didn’t go over their net amount for 2018.

But the FAQ update said nothing about investors looking to use such gains cropping up in 2019.

“We have these dilemmas,” Wilner said at the NYU conference. “You have mechanical questions of ‘How do I fund it by Dec. 31 and get it into good qualified property, drop it into a lower-tiered partnership, have the partnership get qualified under the working capital safe harbor, and all the other things you have to do that all have to happen instantaneously on Dec. 31 at midnight?’”

The original authors of the opportunity zone legislation, Sens. Cory Booker (D-N.J.) and Tim Scott (R-S.C.), are looking at extending the deadline by a year, to the end of 2020, for the 15% reduction in gains subject to tax after seven years.

Scott told Bloomberg Tax in mid-June that he and Booker were ironing out their different approaches, but that they intended to introduce a bill before the August recess.

Shafron “Shay” Hawkins, a former Scott staffer who initially announced that legislation in April before leaving the senator’s office to form a lobbying group for opportunity zone investors, said at a May conference in Washington that budget issues wouldn’t be a concern.

“A lot of investment has actually been held up because of the regs, so we don’t expect a lot of revenue impact,” said Hawkins, a co-founder of the Opportunity Funds Association.

But Schneider wasn’t so sure.

“I mean, where are you going to get the money for that?” he told Bloomberg Tax during the June 27 event. “I think it’s going to cost you a lot. We’ll see how it’s scored.”