The advent of
opportunity zones offers players in the finance and real estate communities a new way to
enjoy tax incentives while helping economically distressed areas.
It’s an intriguing proposition that sounds like a win-win. But will it be?
Members of McGuireWoods’ national opportunity zone development team offer some thoughts on the nascent program and what it could mean for
investors and project developers.
Why do opportunity zones matter?
The program, stemming from the Tax Cuts and Jobs Act of 2017, could provide
major tax breaks to investors who re-invest capital gains into
disadvantaged communities via
qualified opportunity funds. Final regulations are pending, but those with large capital gains or long
horizons stand to benefit the most, said
Investors looking to minimize capital gains taxes may find that opportunity
zone tax incentives achieve their financial objectives, said McGuireWoods’
Dan Chung. However, when trying to maximize their tax benefits, investors must be
careful to evaluate the long-term financial feasibility of any substitute
investment in an opportunity zone project, urged
“The now designated zones logically encompass a number of markets where our
firm has well established real estate, tax and fund formation experience
and reflect a wide diversity of real estate investment opportunities,” said
Why do opportunity zones matter to institutional investors, such as
large energy companies, real estate firms, high-net-worth
individuals and family offices?
Anyone who expects to have tax management issues after selling capital
gains assets — including the wealth management and bank groups that advise
such investors — is going to be interested, Williamson said.
Given that opportunity zone incentives offer new avenues for tax deferral,
investors are evaluating them against the tried-and-true option of using
Internal Revenue Code Section 1031 “like-kind” exchanges for real property
holdings, Chung explained. “These investors are watching what funds are
doing in the opportunity zone space before moving forward.”
Why do opportunity zones matter to private equity funds?
While some capital gains investors might make direct investments in
opportunity zone projects, Williamson said that most activity will come
through syndicated private equity deals that aggregate various investors’
capital gains and create funds that seek out specific projects.
A recent public hearing is expected to generate a second set of proposed
regulations later this year. “When the
came out, excitement gave way to scrutiny. Working through
yielded vital questions such as, ‘What does the exit strategy look like
when the fund invests in multiple projects?’ ” said Chung.
Also, and more fundamentally: “What happens to the capital gains investment
if the funds don’t qualify as opportunity zones? And if the project goes
bad — a very real risk in economically distressed areas — what happens?”
Execution risk also is an issue, noted Riegle and
Doug Lamb. With community development financial institutions already circling many
opportunities to invest in lower-income areas, it may be difficult for new
investors to find viable projects to bankroll, they said. As Lamb noted, on
top of the customary credit concerns investors might find in such areas,
there are many timing tensions between the statutory framework and common
project delivery schedules that may affect deployment of the capital or
dampen the attractiveness of such an investment to large investors who
aren’t looking to contribute $1 million to $2 million, but rather 10 to 20
times as much.
Coordinating these efforts for a successful outcome is by no means
insurmountable so long as the deal team possesses the requisite unique
skills, Williamson said. He also cited corollary concerns: “How do managers
get five or six investors to bring enough cash to the table to create a
sufficiently diversified fund? Will investors balk at being lumped together
with peers whose investment return profiles may differ?”
Why do opportunity zones matter to sponsors/project developers?
Developers are hungry to match their projects with the capital that private
equity can provide, despite some lingering uncertainty about specific deal
structures and timing until the proposed regulations are finalized, said
Under the proposed regulations, capital gains contributed to new “ground
up” real estate projects or substantial renovations to existing properties
should qualify for the opportunity zone tax benefits. So, too, would
capital gains flowing into non-real estate business projects located within
an opportunity zone, but the rules on investing in qualifying businesses in
an opportunity zone get more complicated and will be further refined by the
final regulations, Williamson added.
“Developers also are trying to determine whether opportunity zones will
actually help reduce the cost of capital for projects,” Lamb said. “We
could see a mix of market participants who are unfamiliar with each other’s
business models and risk appetites. That would make it challenging to
arrange capital and place a premium on the abilities of everyone involved.”
Other questions abound, including the relationship between opportunity
zones and existing tax credit plans under federal and state law,
Mark Kromkowski said. “Can new credits be combined with incentives already in place? Some
fund managers who already started looking at qualified deals will try to
shoehorn them in via a qualified opportunity zone fund structure. We expect
hundreds of new specialized funds to be formed in 2019.”
Alexander said, “The biggest thing to watch is that these areas often have
low levels of economic activity for one or more real business reasons.
Investors really need to be careful to pick projects that have a good shot
at working given the tougher economic fundamentals.”
[UPDATE: A public hearing in February generated a second set of proposed regulations on April 17, 2019.]