Opportunity Zones provide a new way for investors to mitigate and ultimately avoid taxation of capital gains. It might just be the greatest tax incentive ever created.
Click the play button above to listen to our conversation.
- Why Opportunity Zones may be the single greatest tax incentive ever created.
- The three Opportunity Zone tax benefits that apply to capital gains.
- A step-by-step example of how a taxpayer with a $10 million gain can benefit from rolling it over into a Qualified Opportunity Fund.
- The geographic limitations of investing in the 8,764 Opportunity Zones.
- The policy theory behind the creation of the Opportunity Zones legislation.
- The opportunity that the run-up in the equities market has created for Opportunity Zone investors.
- An approximation of the size of the Opportunity Zone marketplace.
- Examples of three Qualified Opportunity Funds that are seeking investor capital.
Featured On This Episode
- Jimmy Atkinson on LinkedIn
- OpportunityDb: Opportunity Zones Database
- Opportunity Zones Podcast
- Economic Innovation Group (EIG)
- Sean Parker
- New Markets Tax Credit Program
- Low Income Housing Tax Credit
- Andy Hagans: As Key OZ Deadline Approaches, Will Q4 Set A QOF Record?
- OZ Pitch Day
- Urban Catalyst Fund II
- Caliber Tax-Advantaged OZ Fund
- Hall Labs Opportunity Fund
About The Alternative Investment Podcast
The Alternative Investment Podcast covers new trends in the alternate investment landscape. Hosts Jimmy Atkinson and Andy Hagans discuss diversification opportunities in the alts universe, including direct investments, DSTs, opportunity zones, private equity and more.
Andy: Welcome to the third episode of The Alternative Investment Podcast. I am your host, Andy Hagans, and I have Jimmy Atkinson here with me. And today, we are talking about the single greatest tax incentive ever created, right? It’s gonna knock your socks off if you haven’t heard of this. So, Jimmy, let’s not keep everyone in suspense here. What is the single greatest tax incentive ever created?
Jimmy: Well, thanks, Andy. Thanks for having me back on the show. Happy to be here with you again, as always. I think that the single greatest tax incentive ever created is Opportunity Zones. So that’s gonna be the topic of discussion on today’s episode.
Andy: Okay. Opportunity Zones, and you know what? Real quick, before we dive into the wonderful world of Opportunity Zones, I think we need to introduce you a little bit more because you’re not only my co-host at The Alternative Investment Podcast, but you also host an Opportunity Zones Podcast, and you’re also the founder of the Opportunity Zones Database. So could you just tell us a little bit about that?
Jimmy: Yeah. Briefly, I founded the Opportunity Zones Database at opportunitydb.com a little over three years ago. It’s an educational resource for Opportunity Zone stakeholders. And we have some capital matchmaking events a few times a year also where we match investors who have capital gains with qualified Opportunity Zone funds that are looking to raise capital. And then as you mentioned, I’m also the host of the “Opportunity Zones Podcast,” where I interview an expert in the industry every week.
Andy: Got it. So let’s talk about, for a minute before we dive into funds and all the moving pieces, what are Opportunity Zones?
Jimmy: Yeah. So let’s first talk about the tax benefits of Opportunity Zones because I like to lead with that first, and then I’ll zoom out and tell you more about the tax policy, right? So, but first of all, the Opportunity Zone tax benefits, and I should start by saying that this is a capital gain tax benefits. So the investor in this Opportunity Zones program needs to have a capital gain in order to be eligible. And it could be a capital gain from anything. It could be a capital gain from the sale of real estate or the sale of assets in your brokerage account, stocks, bonds, mutual funds, ETFs, could be from the sale of crypto assets. I know a lot of people have low-cost basis gains from Bitcoin, could be from art or any other type of collectible, really any type of gain that you can consider.
If you take that gain after you recognize it or after you realize it, I should say, there’s three benefits that you get from then taking that gain and rolling it over into an Opportunity Zone investment. Benefit number one is a deferral period. You get to defer recognition of that capital gain until December 31st, 2026. So that’s essentially, we’re recording this late in 2021. At this point in time, it’s roughly a five-year interest-free loan from the federal government. Benefit number two is a reduction in the amount of capital gains that you recognize. When you do go to recognize the gain eventually at year-end 2026, you get to reduce the amount of gain by 10%. And then benefit number three is complete elimination of capital gains tax liability on any of the gains in the subsequent Opportunity Zone investment after a 10-year holding period. So I’ll stop there. Those are the three main benefits. Andy, I don’t know if you wanna ask a follow-up question, but I have an example that I can walk through people with real numbers if you’d like.
Andy: Sure. And I just wanted to reiterate that point that you can invest the capital gain from anything into an Opportunity Zone or Opportunity Zone fund. So that makes it so much broader. So much of a program, more potential investors versus a 1031 exchange, where it only applies to that capital gain from the sale of investment real estate, right? I mean, that’s why I am an Opportunity Zone investor myself. I never actively manage an investment real estate property personally. So I never had a capital gain that was generated from that type of investment, but like many investors, I have all sorts of different capital gains, some smaller, some larger. So, for me, Opportunity Zones were applicable and a great opportunity whereas the 1031, I can recognize, like, that’s an awesome tax program that people could take advantage of, but it’s not applicable to me.
Jimmy: And I’m in the exact same boat as you are. I have gains elsewhere outside of real estate that I wanna put to work now in this Opportunity Zone program. And if we’ve got some time, I’d like to actually walk through a specific example with real numbers so we can actually see how the math works on these types of returns. Yeah. So, in my example, let’s consider a taxpayer that has a $10 million gain this year, and we’ll assume the current capital gains tax rate at the federal level is 23.8%. We’re gonna ignore state taxes just to keep it simple. I’m in Texas anyway, so we don’t have state taxes here on income or capital gains. But normally, that $10 million gain would get reduced down to a $7.62 million net after the taxpayer pays this $2.38 million tax liability the following April, right? Instead, that investor takes his full $10 million gain or any portion of it. But typically, if you wanna get the full tax benefit, take the full gain amount.
Within 180 days of gain recognition, that taxpayer rolls over that amount into a newly created investment vehicle called the qualified opportunity fund that then invests that capital into Opportunity Zone property. So, in the case of our $10 million investor, the three benefits again are one, a deferral period. He essentially gets a $2.38 million interest-free loan for Uncle Sam for the next five years. Now, one important caveat here is the rate that he pays when he does go to recognize the gain in 2026, the 2026 tax rate is going to apply. So there is some tax rate risk there if rates end up going up, and all indications are that they will, that is one consideration to keep in mind. Although I believe that tax rates going up could be to this investor’s benefit in the long run and you’ll see why when we get the benefit number three. But first, benefit number two, the amount of gain that the investor has to recognize at the end of 2026 is reduced by 10%. So instead of recognizing a $10 million gain in our example, the taxpayer’s gain goes down to $9 million. So he pays a capital gain tax on an amount of $9 million. And again, that’s at the 2026 rate. So, one important note here is that the investor needs to make sure that he or she does have some liquidity when that tax eventually comes home to roost.
Benefit number three is the big one here. This is really the reason why we’re doing this episode is because of this unbelievably great tax incentive, which says that so long as you hold your qualified opportunity fund investment for at least 10 years, you get to pay zero tax on capital gains realized from that investment. So it’s tax-free growth within the Opportunity Zone investment. So, let’s say, for example, that $10 million investment made in 2021, by 2031, 2032, maybe you hold it for longer than that, maybe late 2030s, 2040s even, let’s say it appreciates to $50 million. So, a 5X return, pretty good. Normally, you’d owe a huge tax bill on a $40 million gain, but instead, you’re able to because you invested through this new investment vehicle, the qualified opportunity fund, when you go to dispose of that asset, you are able to take a cost basis step-up to fair market value at the time of disposition. So essentially, you have zero capital gain to recognize. So that’s why I think that if the tax rates do end up going up over time, this benefit actually becomes more valuable if you think about it.
Andy: Absolutely. I mean, so the fact that you can plow any capital gain going in, it’s not limited to just real estate, and then if you hold it for 10 years, you get that step-up basis when you come out without paying capital gains tax on the increase in value within the QOF, within the fund, within the OZ investment. That’s simply amazing.
It’s almost too good to be true. And then you look at the fine print and you’re like, “Oh, nope, it’s all true.” Of course, I mean, there is a catch, the Opportunity Zone itself, right? So a limitation of an OZ versus, like, a 1031 exchange is the real estate in an OZ fund has to be located within an Opportunity Zone or, I guess, there’s some other ways they can qualify, right? But there are a lot of different real estate properties that just are not in an Opportunity Zone.
Jimmy: Yeah. That’s absolutely right. So that’s one of the limitations of Opportunity Zones is it needs to be located in an Opportunity Zone. So maybe I should back up and explain a little more about what Opportunity zones are if you’re ready for me to dive into that topic now.
Andy: Go for it.
Jimmy: Yeah. So Opportunity Zones were created out of the Tax Cuts and Jobs Act that was signed into law at the end of 2017. And then the Opportunity Zones themselves were created…the actual geographic boundaries of the zones were created in the summer of 2018. And what they are is they are low-income areas designated at the census tract level and they exist all over the country. In total, there are 8,764 of these census tracts that have been designated as Qualified Opportunity Zones.
Andy: And you have the census tract number memorized for each of those 8,000 zones, correct?
Jimmy: I do. Yeah, yeah. Right. I think it’s like a 10-digit number. So no, I don’t have all of the census tract numbers memorized, but you can find out all those census tract numbers at opportunitydb.com. So, but getting back to my larger point, the area that’s covered by all these Opportunity Zones is it covers a pretty large area of the country. They exist in every state. They exist in Washington, D.C. They exist in Puerto Rico and all the other overseas territories. And roughly 35 million people reside in these areas. It covers roughly 12% of the landmass of the United States. And getting into what these Opportunity Zones are, so the geographic limitation, you’re absolutely right, Andy, your investment in real estate within Opportunity Zones. And by the way, this isn’t just a real estate play. You could also qualify for Opportunity Zone tax benefits through investing in operating business within Opportunity Zones as well. But the fact of the matter is, these real estate properties or operating businesses do need to be physically located in these Opportunity Zones, which are by and large, low-income census tracts. So that’s one of the catches here and that kind of gets into the tax policy behind Opportunity Zones. If you’d like me to go into that for a few minutes, I can provide some context.
Andy: What’s the political theory, what’s the philosophical theory that led to these being created?
Jimmy: Yeah. So this legislation was actually first crafted before Trump even took office and ended up signing this into law as part of his big Tax Cuts and Jobs Act at the end of 2017. It was originally drafted several years earlier when President Obama was in the White House. It has really broad bipartisan and bicameral roots. It’s supported by both sides of the aisle, and both the Senate and Congress had numerous co-sponsors on this provision that ended up getting packaged into the much larger Tax Cuts and Jobs Act. And the context or the background that led to this was the uneven recovery that this country experienced coming out of the Great Recession of 2008/2009. Many of the nation’s wealthiest zip codes rebounded very nicely, recovered pretty quickly, whereas the bottom quintile or the bottom quartile of neighborhoods or zip codes around the country really struggled to ever really get back on their feet. And it led to more inequality across the nation.
So EIG, the Economic Innovation Group was one of the catalysts of this program that spearheaded the effort to get this legislation drafted. One of the original founders of this program is actually Sean Parker of Napster fame, and one of the first employees at Facebook. And what he wanted to do and what this group wanted to do when they crafted this legislation, knowing that humans respond to incentives, they wanted to create not simply another government tax credit program like New Markets Tax Credits, but they wanted to incentivize private capital to flow into these traditionally distressed or economically underserved communities. So that’s a huge distinction between Opportunity Zones and more traditional tax credits like Low-Income Housing Tax Credit or New Markets Tax Credit, which is a government program where you have to cut through a bunch of government bureaucratic red tape and go through a central agency to get approved and get granted these different types of tax credits.
This is simply more of an open market type system that allows for pretty easy creation of different Opportunity Zone investments that can flow into these low-income type census tracts all over the nation and creating this amazing tax incentive for people like you and me, Andy, and other individuals out there who may have big capital gains who want to maybe take some money off the sidelines. Maybe you’ve seen what your stock portfolio or your real estate investment portfolio has done over the last decade or so. I don’t know what the Dow Jones has done since it bottomed out during the crash a decade or so ago, but go ahead.
Andy: If I could just jump in, I think that’s a great point and I’ve written an article about this on altsdb.com, that I think the second half of this year, we’re talking in 2021, it’s just like the stars have aligned for OZ funds because we have the prospect of tax increases, capital gains tax increases in the future. We’ve also had this incredible run-up in the equities market. So a lot of investors are sitting on like these huge capital gains if they have a taxable investment account. And this is an opportunity to realize those capital gains, but defer the capital gains taxes, right? So, even if you haven’t, you know, already locked into capital gain, if you have the potential to, I think it’s worth looking at OZs, especially in this second half of 2021 as a tax advantage way to lock in that initial capital gain, but defer it and potentially reduce it, and then put it to work for another 10 years in a way that it’s gonna grow tax-free. And I know a lot of other investors are like-minded because I know I’ve been working with you at the Opportunity Zones Database and we’ve had so much investor interest. We’ve seen so much deal flow occurring. So I’m wondering, do you know how much capital is moving in to Opportunity Zones?
Jimmy: Those are some great points, Andy. A couple of thoughts on that. One is you’re absolutely right, there are investors sitting on massive unrealized capital gains. So let me get into that part first. As of the end of 2017, which granted is almost four years removed now, the Treasury Department estimated that roughly $6.1 trillion, I’ll say that number again, $6.1 trillion of unrealized capital gains were sitting on the balance sheets of individual investors and corporations. And again, that’s as of the end of 2017. I can only imagine that number has gone way up since then.
Andy: After the Dow Jones run-up of the last couple of years. Yeah.
Jimmy: Absolutely. The Treasury Department at the time when the legislation was first enacted estimated that $100 billion might flow into this program. I think it’s gonna far exceed that. So far what we have seen based on somewhat limited data is tens of billions of dollars have flowed into the program. Recent UC Berkeley study that got access to some IRS data concluded that nearly $25 billion had been invested by qualified opportunity funds into these Opportunity Zone census tracts. And that’s only as of through the end of 2019. So that doesn’t include 2020, it doesn’t include any numbers from 2021. I wouldn’t be surprised if a few hundred billion dollars of capital flowed into this program over the next few years when it finally sunsets. I believe the last possible date that you can invest in an Opportunity Zone is September of 2027. That’s subject to change, but at the moment, the program is scheduled to sunset. So I think there’s gonna be hundreds of billions of dollars that’ll flow into the program over the next few years.
One other point I wanted to make, Andy, with respect to the massive run-up that we’ve had in the equities market and all of these trillions of dollars in unrealized capital gains, one other reason why an investor may want to consider this type of investment, an Opportunity Zone investment, is if you haven’t done a rebalance of your brokerage account portfolio for the last couple of years or so, you may be really overweighted in stocks, right? Because the stock market’s run up hugely over the last couple of years since it bottomed out toward the beginning of the pandemic.
Andy: Your 60/40 might be an 80/20.
Jimmy: That’s right. And I think this provides you with an incentive not just to capture some really great tax benefits, not just to invest in underserved community that desperately need more capital, but also it gives you the opportunity or the incentive to diversify into a different asset class because most of these Opportunity Zone investments are real estate. So it almost gives…actually I wouldn’t say almost, it absolutely gives investors the opportunity or the incentive to finally put some of their big stock market gains to work in a different asset class, such as real estate. So I think that’s an interesting point I usually like to bring up with potential investors or taxpayers who are considering this program.
Andy: Absolutely. Absolutely. Yeah. And I think we’re gonna wrap this up soon but, Jimmy, I wanted to talk about, so at AltsDb, Jimmy and I and as well as our partner, Michael, we’re the team behind The Alternative Investment Database and our podcast here. And we also operate the Opportunity Zones Database. And at the Opportunity Zones Database, we do three Pitch Days every year, which are a lot of fun. We showcase some incredible funds. And like I said, these have been gaining steam with more and more our investors, as well as more fund sponsors. And Jimmy, I wondered if you could just walk us through a couple examples of OZ investments, right? Because when I just hear real estate investment, that’s sort of a broad, vague term, like, paint a picture of some of the funds that you’ve seen successfully raise capital and do deals recently in the OZ space.
Jimmy: Yeah. So I’ve got three of such investments. I’ve got a single-asset real estate fund, I’ve got a multi-asset real estate fund and then I’ve got an operating business fund. I’ll try to go through these quickly. And all three of these funds we’ve worked with in the past. So full disclosure, these are our clients. I don’t mean this to be a pitch for these funds, I’m merely using these funds as a case study for what I believe are some interesting examples of Opportunity Zone investing. So the first one is the Urban Catalyst Opportunity Zone Fund II, and they are specifically focused on one downtown block in Downtown San Jose, California.
Andy: What a block it is.
Jimmy: It is quite a block. It’s adjacent to the city hall, and it’s very close just down the street from Google’s new mega campus, which when it’s completed in the next decade is gonna be Google’s largest campus on Earth. So there’s a lot of growth happening in this area. And interestingly, almost the entirety of Downtown San Jose lies within an Opportunity Zone. So this particular fund is focused on building one mid-rise building or high-rise building, which will be mixed-use multifamily and office. It’s gonna be a $600 million total project cost. They’re raising $200 million of OZ equity for this deal. I think that’s a good example of a fund that is raising money for just one specific identified asset. So when you invest with them, you know exactly what you’re getting.
Now, a second example is the Caliber Tax Advantaged Qualified Opportunity Zone Fund. This is a multi-asset real estate fund. They’re not focused on one specific city in the country or even one specific property type, rather they are focused on the greater Southwest region of the United States. They’re located in Phoenix. So most of their early investments have been in Arizona, but I know that they’re also looking to expand to Utah and possibly New Mexico, and some of the other surrounding states that encompass what they refer to as the greater Southwest region. So when you invest with them, they’ve identified a handful of projects, but they’re still actively looking for additional deals to fill their pipeline. So, in some ways, a little bit about what you’re getting, but the future of the fund’s assets isn’t 100% clear yet. So you’re mostly investing with their team and with their investment strategy. They’re looking to raise $500 million of OZ equity in total. So their projects are gonna be typically in the $25 million to $50 million range if I remember correctly. So they’re probably gonna end up having about 20 or so different deals in their pipeline when all is said and done.
So, to me, that’s an example of a good multi-asset real estate fund. And then finally, third and final example, and then I’ll turn it back over to you, Andy, is the Hall Opportunity Fund. And they are a multi-asset operating business fund that invests in one specific area, the Hall Labs companies. So it’s backed by Hall Venture Partners and the Hall family, which is one of the wealthiest families in the state of Utah. And what this fund invests in specifically is they have a 130-acre accelerator campus located conveniently in an Opportunity Zone in Provo, Utah. The campus actually predates the Opportunity Zones legislation by several decades. They actually have, I think, a 50-plus-year history of doing this in this location. But these days, they’ve realized that, “Well, now we have this Opportunity Zone incentive, let’s create all of these businesses that we’re incubating in our accelerate campus as Qualified Opportunity Zone businesses that we can deploy capital into through a qualified opportunity fund.”
So, investors come into their specially organized qualified opportunity fund. They get access to all of these great underlying companies, many of which are in revenue and many of which are actually profitable already as well. So they’re raising $100 million of OZ equity and that equity ends up getting distributed across their different businesses over time as they grow and hit certain milestones. So that to me is an example of a really good fund that invests in multiple operating businesses.
Andy: Yeah. And it’s amazing that diversity, Jimmy, right, between the individual properties, and frankly, very exciting individual properties or diversified multifamily or really diversified, you know, any subset of real estate. And then you also have the operating businesses. I think it’s so intriguing that an operating business that’s located in an Opportunity Zone qualifies for this, right? So, in a way, it’s not even really limited to just real estate. You also have the potential of all of these operating businesses that happen to be located in Opportunity Zones, and Opportunity Zones cover such a, you know, pretty substantial portion of the United States. It’s just a huge universe and that’s why I’m having so much fun just being a part of it. It really has that boomtown feel like the excitement in the air. So I think it’s a tremendous opportunity. It’s a lot of fun, but more importantly, tremendous tax benefits. According to Jimmy, it’s the single greatest tax incentive ever created. I can hardly give it any higher praise than that.
And Jimmy, I wanna thank you so much for joining me today. It was excellent to allow our listeners to learn more about OZ funds. And I think we’re gonna have more episodes upcoming that talk about OZ funds, as well as all kinds of different Alts, including many kinds of tax advantage Alts. And one last note, if you are a listener and you are enjoying this podcast, I’d love it if you could rate and review us on Apple Podcast, that helps us out a lot. If you are a listener and you’re not enjoying the podcast, just go ahead and forget that I said anything. And Jimmy, I want to thank you for joining me today, and I’ll see you soon, buddy.
Jimmy: Thanks, Andy. Always a pleasure, buddy.