The Advent of Opportunity Zones

March 22, 2019

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 Brad Alexander of McGuireWoods Consulting.

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 Mark Williamson.

“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 Greg Riegle.

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 initial guidance came out, excitement gave way to scrutiny. Working through the nitty-gritty 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?” Williamson asked.

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 Williamson.

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.]