As the old saying goes, “in real estate, you make your money when you buy.” But, the investor usually doesn’t actually get paid any money until they sell. Here is an illustration of how this might work: The investor “buys right” by buying an underperforming property below market value. Then, the investor puts in their own effort to get the property back in good shape either by resolving deferred maintenance issues or by filling vacancies and raising rents to market rate. Suddenly, the increased revenue that the property generates means that the resale value of the property has significantly increased. (The value of commercial real estate is based upon the “cap rate”, which is calculated using the net operating income (NOI) of the property. A higher NOI results in a higher sales price for the property.) A typical real estate entrepreneur’s plan usually includes an exit strategy where the property is sold, the proceeds are used to pay back lenders, and the entrepreneur keeps the difference.
When this strategy works, the investor is delighted. Until… Uncle Sam gets involved. Suddenly, the investor is faced with the responsibility of paying capital gains tax on the real estate. Capital gains tax is the tax paid on the profit realized on the sale of the asset, which is the difference between the basis that the taxpayer has in the property and the selling price. “Making money when you buy” usually implies paying below market value for the real estate, which means relatively small basis in a piece of property, which is now worth significantly more. This leaves the investor with a big gap between what they have in the property versus what they end up selling it for.
1031 Exchange
Savvy real estate investors have been using a tax regime called the “1031 exchange” to avoid paying capital gains taxes for almost 100 years. In order to encourage taxpayers to re-invest their money, the Revenue Act of 1921 provided for relief through deferral of capital gains when the sale proceeds are used to purchase a “like-kind” asset. This allows real estate investors to put off paying capital gains tax if they roll the proceeds over to be used to purchase more real estate. However, there are some rules. The new property must be of equal or greater value, meaning the investor can’t use a 1031 exchange to purchase a less expensive property. Also, there is a timing window which requires the purchase of the new property to happen within 180 days. The investor must complete the transaction and take legal and equitable title of the replacement property on or before the 180th day, or the 1031 exchange can’t be used and capital gains tax applies. This sometimes results in real estate investors rushing into a purchase that might not be a good business decision just to avoid the capital gains hit.
Opportunity Zones
Because the mechanics of the 1031 exchange can be problematic, investors have been clamoring for alternative ways to mitigate the effects of capital gains. The government listened by creating a new tax program called “opportunity zones.” The Tax Cuts and Jobs Act of 2017 allows certain investments in lower income areas to have tax advantages. The purpose of the opportunity zones program is designed to put capital to work that would otherwise be locked up due to an investor’s unwillingness to trigger capital gains tax.
Opportunity zones are generally low-income areas designated by each state. In order to qualify for the tax benefit, the investor needs to significantly improve the opportunity zone property, which requires an investment that at least doubles the original basis in the property. Capital gains taxes are deferred for investments reinvested into properties in these zones and, if the investment is held for ten years, all capital gains on the new investment are waived!
Clearly, this can be an extremely powerful tool for real estate investors. However, opportunity zones aren’t a one-size-fits-all approach either. The biggest obstacle is the geographical requirement, which prevents the benefits from being available for properties that are outside the designated opportunity zones. The type of investors that can use opportunity zones is also limited. The law requires that the fund looking to invest in the opportunity zone holds at least 90% of its assets in such properties.
Whether it is because of these requirements, or unfamiliarity and confusion related to the new law, the effect of opportunity zones has been negligible. Many of the tax breaks that have been given out through the opportunity zones program may have occurred anyway. And whether opportunity zones have had the intended result of rebuilding impoverished areas is also in question, due to displacement from gentrification.