Spring 2020's Sudden Spike in Opportunity Zone Activity

What do you get when you combine a shocking worldwide pandemic with a record stock market drop and a stunning increase in unemployment?

You get a lot of uncertainty!

Millions of people—including real estate operators and investors—who don’t know what they don’t know about the future.

This was reflected across all types of investments and asset types, and opportunity zones were not exempt. Like equity markets and other real estate projects, uncertainty and fear caused a significant initial slowdown in opportunity zone investments.

Check out the “Fear & Greed Index” published by CNN. This is based on a number of factors, and generally tracks the emotions of equity investors. The 89% greed rating from January 17^th showed that investors were in the mood to buy. But look at the index from March 6^th—just about seven weeks later.

With all of the panic and general uncertainty in the market, it is no surprise that Opportunity Zone syndicators and fund managers saw a slowdown, as well.

Things seem to have stabilized at the moment. The equity markets have normalized. And there is still a boatload of capital looking for investments. And they are chasing far fewer deals since many would-be sellers are in a wait-and-see mode.

Why Are Opportunity Zones Bouncing Back Quickly?

When the stock market tanked (and when it quickly bounced back), a large number of sellers took their profits and exited. Many of these investors have sworn off investing in the casinos of Wall Street (again) or vowed to at least diversify into real estate. Whatever their motive, years of pent-up capital gains will be due this year.

In real estate, sellers with capital gains have a few powerful options to shelter capital gains.

First of all, they can execute a 1031 exchange. Many real estate investors take this route, and if they can find an asset to exchange into, they will shield capital gains until their next sale at least. Or possibly to the end of their lives where they will typically be permanently sheltered for their heirs.

Real estate investors can also shield tax through investing in a Delaware Statutory Trust. This is a great vehicle for investors who want to shield their gains through a 1031 exchange but don’t want the hassles of owning and operating their next property. This DST path can also work well for those who can’t locate their next property (this happens more than you may think).

The DST allows investors to fractionally exchange into a project that is operated by a professional operator. We have run into so many people in this situation that we are actually launching our own Delaware Statutory Trust this summer.

While 1031 exchanges and DSTs work great for real estate investors, they do not work for those selling stocks or other assets. These investors need other options. And the introduction of Opportunity Zones in the 2017 tax law is the ideal vehicle for many of these investors.

Many exiting the stock market are landing in Opportunity Zone Funds, which we expect could skyrocket in popularity as a result.

What Is an Opportunity Zone?

An Opportunity Zone is a U.S. Census tract with significant economic distress. The goal of the 2017 tax act was to connect meaningful capital with these zones to drive impact by incentivizing investors with better net returns (due to lower taxes).

Opportunity Zones have poverty rates of at least 20% and median family incomes under 80% of the surrounding area. Up to 25% of these zones were nominated as Opportunity Zones by state governors. Nationwide, a total of 8,700 opportunity zones were set up. About 7.9 million of the 35 million residents in these zones live in poverty.

Investor tax breaks are divided into three categories:

Initial tax deferral. When the previously-earned capital gains are channeled into an opportunity zone investment, federal taxes are deferred until the sooner of the end of 2026 or when the investment is sold.
Step-up in basis. Ten percent of the original capital gains will not be taxed if the investment if held for five years. Fifteen percent will not be taxed if the investment is held for seven years.
Capital gains tax exclusion. Federal tax on gains within the new opportunity zone investment will be 100% eliminated if the investment is held for ten years or more.

Check out this awesome visual:

visual capital opportunity zones — *Source: VisualCapitalist.com*

“The ability of Opportunity Zones to bounce back from the impact of a coronavirus-fueled selloff in the financial markets readily attests to the program’s viability and growing investor demand for these tax-deferred real-estate investments,” said BBG Senior Managing Director C. Grant Griffin.

Of course, investments in opportunity zones are not limited to those escaping the stock market. Many real estate investors sheltering gains from prior projects are seeking refuge here, as well.

In May, the federal government announced that your opportunity to shelter taxes through opportunity zones has been extended further. Due to issues arising from COVID, investors with deadlines between April and the end of 2020 will all be extended to December 31, 2020. Operators who are required to complete the 30-month “substantial improvement test” during 2020 will also get an extension. You can learn more about all this and more at the IRS website for Opportunity Zones.

The Bottom Line

One last comment: It is easy to do deals just to get the tax relief. Opportunity Zone deals and 1031 exchange deals are ripe to cause this temptation. My advice is don’t let the tax tail wag the investment dog.

If it’s not a great deal, don’t do it. If it’s not a stellar operator, with a great track record, don’t take the risk. You may save on taxes, but it’s not worth pulling your hair out and losing your principal to get there.

Are you planning to defer taxes through an opportunity zone investment? Have you found good deals?

Tell us more in the comment section below.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.