The Impact of Opportunity Zones on Tax Credit Housing Development
The federal Opportunity Zone program has generated a lot of excitement among investors and the real estate industry since it was created as part of the 2017 Tax Cuts and Jobs Act. The Opportunity Zone program seeks to be a catalyst for development in the neediest communities.
HUD recently issued a notice announcing a series of incentives for affordable multifamily owners investing in Opportunity Zones (OZs). With regard to Federal Housing Administration (FHA) mortgage insurance for sites in OZs, the FHA will reduce application fees for certain affordable housing programs in OZs and designate a team of underwriters to speed up the processing of those applications. Fees for properties with at least 90 percent of units eligible for Section 8 or Low Income Housing Tax Credit (LIHTC) residents will be reduced by two-thirds. HUD estimates the changes will spur approximately $100 million investment in OZs.
In addition, earlier this year, HUD released another notice aimed at encouraging LIHTC sites in OZs. The notice announced the expansion of an LIHTC pilot program to encourage Opportunity Zone investments. According to the announcement, the pilot program will expedite FHA mortgage financing for projects with equity from the LIHTC program. The pilot will now be available to LIHTC projects that are either “new construction or substantial rehabilitation,” whereas the previous version was restricted to properties applying for mortgage refinancing.
The average wait time for a project with LIHTC funding to be approved for an FHA mortgage is at least 90 days, according to HUD. The pilot program should shorten that timeline to 30 or 60 days for qualifying projects, depending on whether they apply for the expedited approval process track or the Standard Approval Process track. The text of the notice briefly but specifically mentioned that the new program was meant to encourage Opportunity Zone investing.
Thus far, HUD has been active in incentivizing affordable housing development in OZs. This may be, in large part, due to HUD Secretary Ben Carson being named chairman of the White House Opportunity and Revitalization Council, a group that includes representatives from 13 federal agencies. The Council will coordinate federal efforts relating to Opportunity Zones and work to prioritize such neighborhoods for grant funding, loan guarantees, infrastructure spending, and other federal initiatives.
At the Council’s signing ceremony, Carson said the mission of the Council is to “jumpstart the development in urban and rural communities through the creation of Opportunity Zones.” He added, “The Treasury Department estimates that the Opportunity Zone legislation could attract over $100 billion in private investment, which will go a long way to spur on jobs and economic development.”
The IRS is still promulgating regulations and guidance around the program. How these regulations are shaped and what corresponding state and local government incentives are offered to developers and investors will greatly affect the development of affordable housing in these Opportunity Zones and, consequently, how many LIHTC sites are built within them. As the program develops, and if the number of LIHTC sites expands within these zones as a result, all professionals in the LIHTC industry should understand the basics of the federal Opportunity Zone program and keep tabs on how the latest guidance may affect investments in OZs.
Program Background and Impetus
The Opportunity Zone program was created through the Investing in Opportunity Act, which was included in the Tax Cuts and Jobs Act enacted in December 2017. In bipartisan support of the program, more than 100 legislators sponsored the bill across both houses of Congress. With its passage Congress approved the designation of Opportunities Zones, which are economically depressed communities characterized by high poverty and subpar employment opportunities.
The Opportunity Zone program was created to stimulate private investment in Opportunity Zone communities in exchange for capital gain tax incentives. The importance of these designated areas comes from the tax benefits associated with qualifying investments in them, which, in theory, will help transform these economically blighted communities into areas of opportunity for their residents. Instead of dedicating taxpayer money to developing thousands of low-income census tracts across the U.S., this program aims to stimulate the investment of the estimated $6.1 trillion of unrealized private gains held by U.S. households. In exchange for investing in communities within qualified Opportunity Zones, investors can access capital gains tax incentives both immediately and over the long term.
Unlike existing programs designed to encourage private investment in low-income areas through tax advantages, the Opportunity Zone program is much more flexible and less reliant upon government agencies to function. Existing programs, such as the New Markets Tax Credit (NMTC) program and LIHTC program, are subject to annual Congressional approval and/or tax credit allocation authority. Because the tax credit system limits the number of credits issued each year, it inherently limits the number of investors who can participate, and therefore the amount of money that can be invested into the development of a community under the program.
Opportunity Zones don’t operate through a tax credit program. Instead, Opportunity Zone designation and investment are governed through Internal Revenue Code sections. The passage of the bill established two new Internal Revenue Code sections, which outline the Opportunity Zone program: IRC Sections 1400Z-1 and 1400Z-2. IRC Section 1400Z-1 governs Opportunity Zones, and IRC Section 1400Z-2 governs Opportunity Funds.
Designating OZs and governing them in this way removes any limitation on the number of Opportunity Funds that can exist, making them more the product of an entirely new IRS rule that changes the tax treatment of capital gains than the subject of a more traditionally structured tax credit program. And unlike existing programs designed to stimulate private investment in low-income communities, Opportunity Funds can self-certify without the need for approval from the U.S. Treasury Department. This means that Opportunity Funds are managed entirely in the private market with the administration of the funds falling solely on the shoulders of fund managers rather than government agencies or investors.
Most important, there is no cap on the amount of capital that can be invested into qualified Opportunity Zones through the program, and hence no pre-designated limit on the extent to which the program may help reshape needy communities.
Creation of Opportunity Zones
Opportunity Zones are created through a nomination and designation process. Following the passage of the new tax reform, governors of U.S. states and territories—as well as the mayor of Washington, D.C.—were given until April 2018 to nominate qualifying census tracts in their jurisdictions for Opportunity Zone designation. Because the Opportunity Zone program is intended to develop economically depressed areas, there are restrictions on which census tracts can qualify for designation. To qualify for nomination as an Opportunity Zone, a census tract must meet the following low-income requirements as defined by Internal Revenue Code Section 45D(e):
- A poverty rate of at least 20 percent; or
- A median family income of no more than 80 percent of the statewide median family income for census tracts within non-metropolitan areas or no more than 80 percent of the greater statewide median family income or the overall metropolitan median family income for census tracts within metropolitan areas.
Up to 25 percent of the census tracts of each jurisdiction that met this criterion could be nominated. An additional 5 percent of each jurisdiction could qualify if they met a different set of income and geographic qualifications:
- A census tract that’s contiguous with a low-income Opportunity Zone; and
- A median family income of no more 125 percent of the median family income of the adjacent qualified Opportunity Zone.
Under this scope, 57 percent of all neighborhoods in America were up for consideration as Opportunity Zones, according to the Brookings Institute. The Treasury Department assessed each nominated census tract and certified those that met the program criteria. The Treasury officially certified more than 8,700 tracts as Opportunity Zones in June 2018, constituting roughly 12 percent of all census tracts in the U.S.
Opportunity Zone Investing
The designation of Opportunity Zones is designed to help spur the development of identified communities. In exchange for investing in Opportunity Zones, investors can access capital gains tax incentives available exclusively through the Opportunity Zone program. To access these tax benefits, investors must invest in Opportunity Zones specifically through Opportunity Funds. A qualified Opportunity Fund is a U.S. partnership or corporation that intends to invest at least 90 percent of its holdings in one or more qualified Opportunity Zones.
Because the Opportunity Zone program is intended to stimulate positive growth within designated communities, there are restrictions on the types of investments in which an Opportunity Fund can invest. These investments are called “qualified Opportunity Zone property,” which is defined as any one of the following:
- Partnership interests in businesses that operate in a qualified Opportunity Zone.
- Stock ownership in businesses that conduct most or all of their operations within a qualified Opportunity Zone.
- Property such as real estate located within a qualified Opportunity Zone.
There are rules that govern each of these three investment options. For property such as real estate, the types of real estate investments allowed by the program are limited to ensure that the communities are improved with each investment. Essentially, Opportunity Funds can invest only in the construction of new buildings and the substantial improvement of existing unused buildings. If an Opportunity Fund invests in the improvement of an existing building, it must invest more in the improvement of the building than it paid to buy the building. Whether the building is constructed from the ground up or improved, the development of the building must be completed within 30 months of purchase.
Tax Advantages of Investing in Opportunity Zones
In exchange for following the rules of the Opportunity Zone program and investing in qualified Opportunity Zones through qualified Opportunity Funds, investors can receive substantial capital gain tax incentives immediately and over the long term.
When an investor divests an appreciated asset, such as stocks or real estate, she realizes a capital gain, which is a taxable event. Under the Opportunity Zone Program, if an investor reinvests a capital gain into an Opportunity Fund, she can defer and reduce her tax liability on that gain. Beyond that, she can also potentially receive tax-free treatment for all future appreciation earned through the fund. Together, these tax incentives can boost after-tax returns for Opportunity Fund investors:
- Those who invest realized capital gains into a qualified Opportunity Fund can defer paying capital gains tax for those earnings until April 2027 for investments held through Dec. 31, 2026. Gains must be invested in a qualified Opportunity Fund within 180 days in order to qualify for any tax treatment available under the Opportunity Fund program.
- Those who hold their Opportunity Fund investments for at least five years prior to Dec. 31, 2026, can reduce their liability on the deferred capital gain principal invested in the Opportunity Fund by 10 percent. If the investment is held for a minimum of seven years prior to Dec. 31, 2026, the tax liability can be reduced by 15 percent total.
- Those who hold their Opportunity Fund investment for at least 10 years can expect to pay no capital gains taxes on any appreciation in their Opportunity Fund investment. That’s because Opportunity Fund gains earned from Opportunity Zone investments can qualify for permanent exclusion from the capital gains tax if the investment if held for at least 10 years.
Focus on Multifamily Housing
According to research conducted by FreddieMac Multifamily, market-rate rental housing will be one of the most popular outlets for Opportunity Zones. As of March 8, 2019, it found 105 qualified Opportunity Funds with funds totaling over $19 billion. Of these 105 funds, 70 (representing roughly $15 billion in assets or about 75 percent) have an investment focus of multifamily residential development; however, only eight of these funds focus solely on multifamily housing. Of all funds that have a multifamily investment focus, 28 also have an explicit focus on affordable housing.
The researchers found that Opportunity Zones may experience some increased LIHTC activity, but it’s not likely to be substantial unless additional incentives are introduced. Currently, financial institutions are the primary LIHTC investors, whereas Opportunity Fund investors are more likely to be high-net-worth individuals, managed investment funds, life insurance companies, and mutual funds. Banks will have limited involvement because they are generally not allowed to make equity investments, and, as a result, they don’t have capital gains to reinvest.
There has been much activity from states and state housing authorities to incentivize LIHTC development. For example, the Michigan State Housing Development Authority plans to incentivize Opportunity Zones in the allocation of tax credits. And, recently, Nebraska Governor Pete Ricketts signed legislation giving priority to Opportunity Zones in receiving funds from the state Affordable Housing Trust Fund and other programs. In addition, California Governor Gavin Newsom recently submitted an updated 2019–2020 budget request to include a provision to partially conform state tax laws to the federal tax code for the Opportunity Zones incentive. Newsom’s budget request would make OZ investments in green technology and affordable housing match federal benefits for capital gains reduction and deferral.
There is concern that, in some cases, an Opportunity Zone designation could negatively impact current residents of these areas since there is no established safeguard to prevent displacement of current residents. Even for communities that could benefit from this investment, viable opportunities may be scarce since areas must be stable enough to attract investor demand, but also be in enough need that they qualify for the program.
From an investor’s perspective, risks include limited IRS regulation and guidance, asset performance, the investment timeline, and the eventual payment of capital gains taxes. Whether Opportunity Zones can revitalize communities and enhance the economic opportunity of their residents is not yet known. Regardless, Opportunity Zones will influence multifamily market activity in low-income markets across the country in the coming years.
Recent Updates on Opportunity Zones
There has been recent federal activity with regard to the Opportunity Zone program. Within a short period of time the IRS released its second round of proposed OZ guidance, and the White House Opportunity and Revitalization Council issued an implementation plan. In addition, HUD released an overview of activities in OZs and a request for input, and important bipartisan legislation is reported to be advancing. For more details on these activities, see: