Capital gains tax benefits attract investors and critics
- April 29, 2019
On Major League Baseball’s Opening Day in March, property owners, bankers, entrepreneurs and city officials gathered at the Beacon Theatre in downtown Hopewell for a workshop on opportunity zones, a new addition to the federal tax code that has the real estate community abuzz.
For officials like Charles Dane, Hopewell’s assistant city manager, the opportunity zone workshop was a chance to highlight development opportunities around town while showcasing completed projects.
“We’re equally excited about the opportunity-zone legislation because we think that’s that next sacrifice bunt or whatever to move the runner up,” Dane said at the workshop.
For members of the business community, the Hopewell workshop was a chance to see how they could leverage the newly created tax benefit. Rama Gara, president of Papi Naidu LLC, had a table display with information on 17 acres of undeveloped land for sale in one of Hopewell’s opportunity zones.
“I want to meet with the developers, the bankers, the businessmen that are looking for an opportunity to develop in Hopewell,” Gara says. “Because of the opportunity zone, the developers can get great tax benefits.”
Enacted in December 2018 as part of the Tax Cuts and Jobs Act, opportunity zones offer investors the chance to defer and reduce taxes on capital gains. To be eligible for the tax benefits, their capital gains have to be invested in low-income census tracts that have been designated as opportunity zones. More than 8,700 census tracts in the U.S., including 212 in Virginia, have been officially identified as opportunity zones.
The investments have to be made through qualified opportunity zone funds. The money can go toward acquiring commercial real estate, opening a new business in an opportunity zone or expanding a business in an opportunity zone.
Even as they’ve generated excitement, opportunity-zone rules have raised plenty of questions. The Treasury Department and Internal Revenue Service have been clarifying regulations surrounding opportunity zone investments.
Kristen Dahlman, a senior policy analyst at the Virginia Department of Housing and Community Development, says the main requirement for real estate investments to be eligible for opportunity-zone tax benefits is that the property be located in a designated opportunity zone. More questions remain about what investments in businesses would qualify for opportunity-zone benefits.
“It’s the low-hanging fruit,” Dahlman says of opportunity-zone real estate investments. “It’s something that’s tangible.”
The purpose of opportunity zones is to encourage economic development in low-income neighborhoods by offering tax benefits to investors. The idea of offering tax benefits to investors to build wealth for residents of low-income communities is a familiar one with both supporters and critics.
U.S. House Majority Whip Jim Clyburn, a South Carolina Democrat, has said opportunity zones mainly benefit investors, though he later appeared to walk back his criticism of the program.
Mehrsa Baradaran, a corporate law professor at the University of Georgia, has argued tax benefits for investors aren’t enough to reverse the forces that created low-income communities in the first place.
Others, however, say opportunity zones have hit a rare sweet spot. There are no caps on investments in opportunity-zone funds, and the tax benefits are open to any investor with capital gains.
Proponents also argue the flow of capital to low-income neighborhoods will lead to more stable housing and jobs. U.S. Sen. Tim Scott, a Republican from South Carolina, who included the zones in the Tax Cuts and Jobs Act, has said opportunity zones are working across the country.
Many localities, however, aren’t waiting around to see how the debate plays out. Instead, they are fine-tuning their development pitches to investors.
“Fund managers can invest their dollars anywhere,” says Sean Washington, a business development manager with Norfolk. “So, it’s localities’ responsibility to market themselves.”
Similar to Hopewell, Norfolk is taking a proactive approach to opportunity zones. The city has hosted sessions providing general information on the zones and another session focused on how the tax program can be used to boost redevelopment in the St. Paul’s area of Norfolk.
One key program benefit is that opportunity zone fund investments held for at least 10 years become tax free. (This benefit does not apply to the original capital gains, which are only eligible for a deferral or a reduction).
“This tax incentive is unlike anything I’ve ever seen,” Jenny Connors, a partner at the law firm Williams Mullen, said at the Hopewell workshop. “It has garnered more attention than all of the tax credits combined. It is much more user friendly.”
Connors added that Virginia did a good job of picking strategic areas to designate as opportunity zones. Localities recommended census tracts to the state, which then nominated the tracts for official designation at the federal level. To be eligible, census tracts had to have a poverty rate of 20% or a median family income that is 80% of statewide median income based on U.S. Census data. That meant that 901 of Virginia’s census tracts were eligible to become opportunity zones. States were only allowed to nominate up to 25% of their eligible zones.
In nominating its zones, Virginia balanced evaluating census tracts with the most need and those with the most likelihood of future investment, Stephen Moret, president and CEO of the Virginia Economic Development Partnership, said in an email. Connors, the Williams Mullen lawyer, notes that Virginia’s opportunity zones are in places that are either already developing or are on the cusp of development. Such is the case for a deal in Scott’s Addition in Richmond, one of the hottest real estate markets in the state.
John B. Levy & Company raised the equity and debt used in opportunity-zone financing for The Summit, a 166-unit multifamily project under construction in Scott’s Addition. John Levy, the company’s president, says the $35 million project was attractive even without opportunity-zone tax benefits.
“The [opportunity zone] just added a little polish to an already really strong deal,” Levy says, adding he is planning more multifamily, opportunity-zone deals in Virginia. “We’re quite excited because this gives a tax incentive to real estate investments that really has never existed before.”
Scott’s Addition shares a census tract that stretches east across Virginia Commonwealth University and the Carver neighborhood. The poverty rate for the census tract in 2015 was estimated at 37.2%; in 2016 it was 31.1%; and in 2017 the poverty rate was estimated to be 36.8%, according to U.S. Census data.
Councilwoman Kimberly B. Gray represents Richmond’s Second District, which includes the Scott’s Addition opportunity zone where the Summit apartment project is under construction. Gray thinks opportunity zones can spur development in blighted areas, but she thinks there hasn’t been enough focus on increasing home ownership in areas of Richmond where some residents are being priced out.
“I would like to see the policies shift in favor of ownership,” Gray says. “Instead of wealthy developers cycling rental properties that age out in 20 to 30 years and then we’re back at the drawing board tearing down old decrepit buildings and then rebuilding for rental.”
The managers of other opportunity zone funds with Virginia ties echo Levy’s enthusiasm about the program.
“You’re bringing capital into underserved areas,” Neal Wilson, Arlington-based EJF Capital’s co-founder and chief operating officer says. “How else is that going to happen if you don’t at least provide an incentive?”
EJF Capital is raising a targeted $500 million opportunity zone fund that has committed to two out-of-state projects so far. The projects include a hotel in Oakland, Calif., and a logistics warehouse facility in South Carolina.
“The areas that were in the designated opportunity zones provide really interesting investment opportunities from a real estate perspective,” says Wilson. “We do think the Northern Virginia multifamily housing area is a particularly interesting area because of the mismatch between demand and supply in workforce housing.”
Allagash Opportunity Zone Partners is another opportunity zone fund with Virginia ties that’s raising $500 million. The fund, which has offices in Ashburn and New York, is focusing on real estate deals.
Tony Barkan, Allagash’s CEO and co-managing principal, says multifamily housing has been the darling of the institutional investment community for 20 years and should have compelling returns for opportunity-zone investors looking to protect their realized capital gains. Barkan says Allagash will focus on the mid-Atlantic region, with up to two-thirds of its portfolio expected to be based in Virginia.
The key for these deals is that they were already attractive to begin with, says Jamie Canup, a tax partner at the Hirschler law firm. The opportunity-zone tax benefits just give people on the fence about a deal more reason to move forward with it, Canup says.
“The tax benefits basically goose it up,” Canup says. “But if a deal isn’t interesting to begin with, then I think the tax benefits aren’t going to make it into a good deal.”