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Last week I had a chance to speak as part of a group of panelists at an Opportunity Zone seminar that was sponsored by Rehmann in Traverse City. The panel consisted of Warren Call from TraverseConnect, Lowell Gruman from Boomerang Catapult and myself, while the main speakers were Gina Staudacher & Bill Burdett, attorneys with Howard & Howard in Royal Oak. While I am very familiar with the real estate benefits of investing in an Opportunity Zone, I was excited to learn about the advantages of starting a business in an Opportunity Zone. The ease and benefits to the investor could potentially be greater for new businesses in an Opportunity Zone than for a real estate investment. Since Traverse City has its own Opportunity Zone just south of downtown, both possibilities could be a boon for local businesses, investors and developers.
For those not familiar with Opportunity Zones, these are areas across the country that have been identified as economically distressed areas where the federal government is giving investors tax breaks for investing in these communities. There are 83 counties in Michigan with Opportunity Zones. In Traverse City there is an Opportunity Zone that encompasses a small area within the city limits and a larger area within Garfield Township (click here for a map). These zones were created in 2018 and offer investors a chance to invest capital gains into these disadvantaged areas in exchange for deferring tax on the gains until December 31, 2026 and receiving forgiveness of up to 15% of the capital gains tax owed. In addition to those benefits, any gain in value of the new investment is not taxed if the investment is held for 10 years or longer.
There are numerous requirements that must be met in order to receive these benefits. One of the main requirements is that the funds invested into the Opportunity Zone must come from the gain on a sale of an asset such as stocks, businesses or real estate. The gains must be invested into a Qualified Opportunity Fund (QOF) within 6 months of realizing the gain. While other money can be invested into the Opportunity Zone, only these funds will have the tax benefits mentioned. While it is fairly easy for an individual to establish their own QOF, many investors are pooling money in larger funds and partnering with developers or funding new businesses with the money.
For real estate investments in Opportunity Zones, the property must be purchased and improved within 31 months of the initial investment. The requirement for ‘improvement’ can be met by building a new building on a vacant piece of property or investing an amount equal to or greater than the value of an existing building on the property at the time of acquisition. The greatest benefit to the real estate investor is that the new or improved building can be sold after 10 years and the investor will not pay any tax on the gain of the appreciation of the property. Many investors are forming partnerships with developers in order to pair groups of people with available capital gains with professionals experienced in development projects in order to produce healthy returns on the real estate investment.
Qualified Opportunity Funds can also invest into new businesses that locate in an Opportunity Zone. The potential benefits here may be even greater than real estate investment when you consider the potential increase in value of a successful start-up business and also consider how many businesses fail in their first five years. Think of all the recent public stock offerings for tech start-ups, new apps such as Instagram & Snapchat, and ride sharing companies such as Uber & Lyft, that have occurred this past month. If businesses like these are formed in an Opportunity Zone and have IPO’s after 10 years, the gain in value is not taxed when the business is sold. While these are extreme examples, it is not uncommon for a start-up business to get off the ground with just tens of thousands of dollars invested and be worth hundreds of thousands or millions of dollars ten years later. If the start-up business fails or is worth less than the initial investment when the deferred taxes become due in 2026, the investor only pays taxes on the lesser of the initial contribution or the value of the business at the end of 2026. This safeguards an investor from paying capital gains taxes now and then incurring future losses on a new business venture.
Due to these tax advantages, it is very likely we will see new businesses locating in our Opportunity Zone in the next few years. Boomerang Catapult is deploying capital into many local start-up companies and has indicated that they will be looking for space within the Opportunity Zone for these new companies. Real estate developers who build multi-family, industrial & retail developments will certainly be looking at this area and will now have an additional source of funding for their projects. In order for investors to receive the maximum 15% tax break on their capital gains, they must keep the investment for 7 years before the tax is due in 2026, which means they must establish the QOFs in 2019. Investments held for 5 years will qualify for a 10% tax break which means the funds must be established in 2020 or 2021 to receive the tax break. Because of these short time frames for investment, it is likely we will see a flurry of activity in our Opportunity Zones over the next couple of years.
As this is just a brief overview, investors should discuss all of the requirements in more detail with their legal, tax and financial advisors.
– Dan Stiebel, CCIM
