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Opportunity zones open a new frontier for lenders


The Trump administration and Congress have placed a big bet on opportunity zones. The federal government stands to give away billions of dollars in tax breaks for commercial real estate investors who buy properties in roughly 8,700 designated tracts across the U.S. Whether this program will raise the fortunes of decaying neighborhoods as intended remains to be seen.

For the time being, however, opportunity zones are already drawing investors to economically depressed areas. This also should provide new opportunities for commercial mortgage brokers and lenders.

opportzoneOpportunity zones were born out of the Tax Cuts and Jobs Act of 2017, the Trump administration’s signature tax overhaul. Basically, the program provides a carrot for equity investors to buy into startup businesses or purchase real estate in designated neighborhoods — places they wouldn’t necessarily go.

The program is structured so investors can defer federal tax payments on capital gains, a benefit that potentially could reap tens of millions in tax savings for some individual investors.

The tax break is purely for equity investments, but the expected dealmaking surge in opportunity zones is expected to spur considerable demand for commercial real estate loans. In order to gain the tax break, for example, an investor who buys a property in an opportunity zone will have to make significant dollar investments to upgrade or repurpose the properties. Most of the renovation or construction costs are expected to be financed by commercial mortgages. 

“Naturally, being developers, they’re going to look to maximize their returns by using leverage,” said Matt Cole, executive managing director of Hackensack, New Jersey-based Silver Arch Capital Partners.

Cole said deals are already happening. Silver Arch Capital recently financed a deal in Paterson, New Jersey, where a property owner is repurposing two large former mill buildings into multiuse properties. The plans include a pop-up market and a hotel. The owners of existing buildings in opportunity zones can retain an interest in the property and bring in another investor with ideas.

“You have owners of the properties that aren’t necessarily developers,” Cole said. “They’re not real estate buyers and sellers. These are people that have owned and operated properties. It gives them an opportunity to bring in partners.”

Cole also said that the program should generally give the commercial real estate market a shot in the arm, at a time late in the cycle when investors have gotten nervous about the market.

“We’ve reached a point in the cycle where there’s not a tremendous amount of new development going on, at least in most sectors,” Cole said.  “At this particular point in the cycle, it’s perfect timing.”

Generous incentives

Much of the dealmaking in opportunity zones is expected to happen over the next couple of years, when investors can gain the maximum tax benefits. There are three incentives for investing in a commercial property and holding it for an extended period.

First, if the investor sells another commercial property or gains a big windfall from the stock market, they can invest the profit in an opportunity zone and defer their federal tax on that gain until up to 2026.

Second, the investor can get a tax reduction for the original capital gain by maintaining their interest in the opportunity zone.  If, for example, the investor buys a commercial property and holds it for seven years, they also get a 15 percent reduction on the original capital-gains tax.

The most potentially lucrative benefit, however, is that if the investor holds their interest in the property for more than 10 years, they won’t have to pay any federal tax on the capital gains when they ultimately sell the property. Although the designated opportunity zones are scheduled to end in 2028, investors can defer any capital gains on a property sold within an opportunity zone until 2048.

Congress projected in 2018 that the tax breaks would cost roughly $1.6 billion over 10 years. That figure, however, assumed that all benefits from the program would end in 2026. Internal Revenue Service regulations have made it possible to claim benefits until 2048, so the cost is likely to be significantly higher than initially estimated, according to the Tax Policy Center, a partnership between the Urban Institute and Brookings Institution.

Not enough strings attached?

The program was the byproduct of rare cooperation in Washington, D.C., and was originally introduced as a bipartisan bill known as the Investing in Opportunity Act. There is nothing new about giving tax incentives to spark development. Most states and many cities have programs that attempt to entice investors to economically challenged areas. These programs always draw their share of critics, however, and some programs have produced spectacular failures. 

The state of New York, for example, shelved its Empire Zone program — which was intended to create jobs in struggling upstate communities — in 2010 after state officials came under fire for handing out hundreds of millions in state-tax credits to individual companies that were already located in these communities. The companies included numerous local law firms that knew the program’s loopholes, as well as the owner of two aging power plants that received more than $190 million in tax breaks even though the state was suing the company for environmental pollution, according to a 2017 article by the Post-Standard of Syracuse, New York.

Brady Meixell, a research analyst at the Metropolitan Housing and Communities Policy Center at the Urban Institute, said that the potential tax savings are generous enough to draw big investments in certain opportunity zones, but the program could fizzle in areas that need the most investment. The dollars could flow primarily into neighborhoods that may draw investors anyway.

Meixell noted that opportunity zones in up-and-coming areas and ones closest to affluent neighborhoods will likely attract the most interest.

“You get the tax breaks for investing in central Berkeley [California], which has an opportunity zone, as you would into an opportunity zone in Youngstown, Ohio,” Meixell said. “Just because something is designated does not necessarily mean it’s going to be getting a substantial amount of capital. You could certainly get clumping around better-off zones and those zones that are on the brink of gentrification, which is a big concern going forward.”

Meixell also said that the federal guidelines don’t place many strings on investors. A developer could theoretically buy affordable apartment units, tear them down and put up luxury condominiums. In a report, the Tax Policy Center also noted that an investor could qualify for a significant tax break by purchasing a parking lot and renovating the parking attendant’s shed.

“How do we ensure the investments are fitting into the community need and maximizing benefits is the big question that’s still on the table,” Meixell said.


 

Questions? Contact at (425) 984-6017 or victorw@scotsmanguide.com.

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