February 15, 2019
A year ago, the Trump administration rolled out its new Opportunity Zones program, which aims to spur economic development and job creation in designated distressed communities. Buried in the Tax Cuts and Jobs Act, the proposition received very little attention at the time of the announcement, but in the past six months, real estate investors have begun to realize the appeal of this advantageous tax incentive program. As a result, it’s become the new darling of commercial real estate, and, in particular, multifamily.
With this program, investors who hold capital gains due to recent capital events, such as an inheritance or the divesting of a stock, property, or a business, can both defer and reduce their tax liability by reinvesting their capital gains in a new type of investment vehicle called an Opportunity Fund. Such a fund is either a partnership or a corporation that intends to invest a majority of its holdings in one or more of the 8,700 qualified Opportunity Zones.
To stay true to the program’s objective of creating economic growth, there are restrictions regarding the types of investments that qualify. With respect to real estate, Opportunity Funds can only invest in the construction of new buildings or the substantial improvement of existing ones. Thus, property development, including multifamily, is one of the sectors that stands to gain the most from this incentive.
Key Factors to Consider for Multifamily Investments
Investors seeking to take advantage of the Opportunity Zone tax incentive for a multifamily project need to consider a set of factors, including market fundamentals and the duration and complexity of Opportunity Zone investments.
Market Fundamentals
Investors should treat the tax advantage as a bonus, not the driving factor behind their decision to invest in a project. Investors should apply the same market fundamentals for success as they would for any multifamily investment.
These market fundamentals are the strength of the market; the location within the market (including the proximity to transit hubs and jobs); potential rental rates; and past experience with the market and construction type. At our Los Angeles–based development company, Cityview, we focus on urban markets with strong job and demographic growth, along with high barriers to entry on the supply side, and have found that there are many areas in Opportunity Zones that fit our criteria. Developers should treat Opportunity Zones as a tool to expand their existing business in markets where they already have experience developing and stabilizing buildings.
For example, Cityview is currently developing a 296-unit mixed-use project in an Opportunity Zone near downtown Los Angeles. The project benefits from a prime location one block from a major transit hub and a few blocks from the University of Southern California, which has nearly 20,000 employees and roughly 43,000 students. The property is also within a mile of myriad entertainment, shopping, and dining options, including the South Park commercial district, with its massive L.A. Live entertainment complex. The high-quality project was designed to attract millennials and urban dwellers by offering resort-like amenities, including a state-of-the-art fitness center and yoga room, a two-story clubroom, and an expansive sky deck with sweeping views of the downtown L.A. skyline.
Long-Term Investments
The benefits of investing in an Opportunity Fund are immediate, as it allows investors to defer tax on any prior gains reinvested in the fund until the date the investment is sold, exchanged, or until Dec. 31, 2026.
Beyond a temporary tax deferral, investors have much to gain by keeping their investments in qualified Opportunity Funds long term. First, they can benefit from a step-up in basis. Investors become eligible to exclude up to 10% of the original gain from taxation after five years, and 15% after seven years. Additionally, investors who hold their Opportunity Fund investment for at least 10 years can benefit from a permanent exclusion from taxable income of capital gains from the sale or exchange of the investment.
Understanding Complex Regulations
The Opportunity Zones legislation leaves many questions unanswered, and several provisions still require further clarification. In October, the U.S. Treasury Department and the Internal Revenue Service issued proposed regulations aiming to address gray areas of the legislation.
But the regulation governing Opportunity Zones is complex, and it would benefit investors to engage the services of an accounting or law firm for guidance. It’s crucial to work alongside a partner that has an established track record of putting investors first, experience in the market and product type, and a deep understanding of this complex topic.
While the complex nature of the legislation might deter some multifamily developers, many are already incorporating Opportunity Zones in their long-term investment strategy by creating new positions and departments specifically devoted to leveraging this program.
Impact on the Multifamily Sector
As intended by legislators, investors are gearing up to pour billions of dollars into Opportunity Zones that will spur economic growth. In addition to traditional equity and large institutional investors, Opportunity Zones have opened the door to a whole different group of investors. With this new program, small investors and family offices can profit from the same type of quality multifamily deals traditionally reserved for institutional investors.
The Opportunity Zones program signals the beginning of an exciting new chapter for multifamily investing and creates a win-win situation for the communities, developers, and investors involved.
ABOUT THE AUTHOR
Sean Burton is CEO of Cityview, a Los Angeles-based multifamily investment management and development firm. Cityview’s investments have generated more than $4 billion in urban investment across more than 100 projects to date.
