A Guide to the Opportunity Zones Program for Commercial and Multifamily Real Estate Investors
The Tax Cuts and Jobs Act of 2017 ushered in a variety of changes to the way corporations are taxed, but it also created a new tax incentive program to encourage capital investment in economically distressed areas of the U.S. Via the use of opportunity funds, corporations can attract investment into multifamily and commercial real estate, as well as stock or partnership interests in companies that operate in or do a significant amount of business in an Opportunity Zone.
However, in order to qualify for the tax incentives offered by the Opportunity Zones program, investors must invest through an Opportunity Fund. When investing in real estate, an Opportunity Fund must either invest in new construction or substantial rehabilitation of properties, to ensure the funds are actually being used to improve the area in question. In the case of building improvements, an Opportunity Fund needs to invest more in a building’s rehabilitation than it originally invested in the building’s purchase. In either scenario, all construction and rehabilitation work must be completed within 30 months of a property’s purchase.
Opportunity Funds Hope To Tap A $6.1 Trillion Market
A 2017 analysis estimated that U.S. households and corporations are sitting on $6.1 trillion of unrealized capital gains in stocks and funds. In general, both individual investors and corporations would not want to sell any of these assets to re-invest them, as they would be required to pay capital gains taxes. By instead re-investing these funds into low-income areas, they can help revitalize low-income areas across the U.S. Unlike the Low-Income Housing Tax Credit (LIHTC) program, which is limited to a specific amount each year, Opportunity Zones are actually written into new IRS regulations, meaning there is no limit to the tax incentives which investors can claim under the program.
How Opportunity Funds Work
As we mentioned previously, investors must invest through an Opportunity Fund in order to qualify for the tax incentives offered by the Opportunity Zones program. An Opportunity Fund is a partnership or corporation which plans to invest a minimum 90% of its assets in Opportunity Zones. Opportunity funds permit investors to avoid paying taxes on recent capital gains until December 31, 2026.
If an investor keeps their money in an Opportunity Fund for at least 5 years prior to December 31, 2026, they will reduce their deferred capital gains tax liability by 10%, while if they keep funds in for seven years before that date, they can reduce their tax bill by 15%.
In some cases, investors may even reduce their tax liability to zero on any profits they generated by investing in an Opportunity Fund, though they will need to hold their investment in the fund for at least 10 years in order to qualify. In addition, it’s important to realize that Opportunity Funds can self-certify, meaning that they do not specifically need to be approved by the government.
The Opportunity Zone Creation Process
After the Tax Cuts and Jobs Act was passed in 2017, the governors of U.S. states and territories (and the mayor of Washington, DC) were allowed until April 2018 to nominate census tracts to become Opportunity Zones. In order to be eligible to become an Opportunity Zone, an area needs to meet IRS income requirements, including:
A minimum poverty rate of 20%
A median family income of:
Non-metropolitan areas: Less than or equal to 80% of the statewide median family income
Metropolitan areas: Less than or equal to 80% of the statewide median family income or the overall metropolitan median family income (whichever is greater)
No more than 25% of census tracts in each of these qualified areas can be nominated. Another 5% of the census tracts in a qualifying area may also be eligible, given that they adjoin a current Opportunity Zone, and that the median family income in the area is not more than 125% of the median family income in the adjoining Opportunity Zone.
As a result of this nomination process, approximately 12% of the census tracts in the U.S. are now Opportunity Zones, which adds up to approximately 8,700 census tracts around the U.S.
The Largest Opportunity Funds
Right now, there are quite a few large Opportunity Funds on the market, each of which invests in a slightly different group of assets. Some of the largest include:
Caliber Tax Advantaged Opportunity Zone Fund, LP: Planning to deploy $500 million of capital in Arizona, Colorado, Nevada, Texas, and Utah, Caliber’s fund focuses on affordable housing, commercial real estate, hospitality development, mixed-use development, multifamily and single-family residential, and student housing.
Allagash Opportunity Zone CRE Fund I: With plans to deploy $500 million of capital in Virginia, North Carolina, and Maryland, the Allagash Fund focuses its investments in commercial real estate, workforce housing, affordable housing and multifamily residential housing.
Cresset-Diversified QOZ Fund: Looking to generate $500 million of capital commitments, Cresset’s fund plans to invest in all 50 states, in asset groups including low-income housing, self-storage, parking, and even relocating existing businesses into Qualified Opportunity Zones.
EJF OpZone Fund I LP: Managed by EJF Capital, EJF OpZone Fund I LP also plans to raise $500 million of capital nationwide to focus on investments in the affordable housing, mixed-use development, commercial real estate, workforce housing, student housing, and multifamily residential sectors.
EquityMultiple Opportunity Zone Fund: Much like the EJF OpZone Fund I LP, EquityMultiple’s Opportunity Zone Fund is attempting to raise $500 million of capital nationwide to invest in commercial real estate, multifamily residential properties, affordable housing, workforce housing development, mixed-use development, and student housing.
Opportunity Zones and the Low-Income Housing Tax Credit (LIHTC) Program
Earlier, we mentioned the differences between the Opportunity Zones and LIHTC tax incentive programs, and, while these programs are different, they may also be able to be combined for an even greater tax benefit. However, in practice, LIHTC and Opportunity Fund investors are often very different in nature; LIHTC investors are often banks, which cannot own equity investments— and therefore do not generate any capital gains that can be offset by the Opportunity Zones tax incentive. However, for high net worth individuals and certain investing partnerships, combining these two programs could be highly effective. In general, though, this will have to result from new construction, as it’s unlikely that an LIHTC property rehab would cost more than the price of acquiring the property in the first place (as is required for the Opportunity Zones program).
Investors looking to fund LIHTC properties in Opportunity Zones may also benefit from utilizing HUD multifamily loans, such as the HUD 221(d)(4) loan for the construction and substantial rehabilitation of multifamily properties. HUD multifamily loans offer between 87-90% LTV for affordable properties and a reduced mortgage insurance premium (MIP) of 0.45% (as opposed to 0.65% for market-rate projects). Plus, the HUD 221(d)(4) loan offers a fixed rate 40-year loan term (with an additional 3-year construction period).
For eligible properties, LIHTCs and Opportunity Zone tax credits can also be combined with rental assistance demonstration (RAD) properties — though this is only likely to occur in limited circumstances— such as in RAD demolition and reconstruction projects, which are only a small percentage of all RAD conversions.
Financing Multifamily Properties in Opportunity Zones
While we just mentioned HUD multifamily financing, it’s far from the only way to finance multifamily properties in Opportunity Zones. Other common multifamily loan options include Freddie Mac and Fannie Mae Multifamily financing, however, Fannie and Freddie do not offer ground-up construction loans; only property rehabilitation loans and refinancing. For ground up construction, many investors/developers may wish to obtain a short-term bank construction loan, and then refinance into longer-term fixed-rate financing such as a 5-7 year CMBS loan or a Fannie Mae or Freddie Mac multifamily mortgage. They may also want to refinance with a HUD multifamily loan, such as the HUD 223(f) loan for property acquisitions and refinances.