Is an Opportunity Zone the Right Investment for You?

The hottest pitch in real estate is the opportunity zone, one of 8,700 geographic areas in the United States in need of economic investment.

Opportunity zones encompass three enticements that make real estate attractive to professional investors: the promise of change in underserved areas, the chance of an outsize investment return and the opportunity for a huge tax break.

But confusion arose over how to invest in the opportunity zones, which were designated in the 2017 tax overhaul. Guidance from the Treasury Department, released last month, helped clarify how investments in these zones would work. It also acted as a green light for managers raising money for funds to invest in these.

There’s just one big catch. To maximize the tax benefits, investors are restricted to a holding period — five, seven or 10 years, depending on the tax break — which limits their ability to sell the real estate.

Wealth advisers said this restriction should raise more caution, but it hasn’t. Investors are not asking essential questions. They need to consider that the property market in an opportunity zone could be depressed when it is time to sell. If the investments sour, there may be a rush to dump them in Year 10. They also need to consider their investment strategy: whether to maximize returns or increase social benefit.

Unlike buying shares of Apple or Google, which you can sell whenever you’d like or hold on to forever, investing in an opportunity zone has a set of time hurdles set by the special tax treatment.

Because the guidelines are so strict, Frazer Rice, senior wealth strategist at Calamos Wealth Management, recommends working with experienced managers.

“They need local relationships because these places don’t have a good track record,” he said. “You need something beyond real estate experience.”

What has piqued the interest of fund managers is not necessarily the affect their investments could have in a neighborhood or the return on the real estate. Instead, it is the way the tax incentive has been structured.

Investors who roll over money with embedded gains from other investments into an opportunity zone before the end of this year can defer taxes on those gains for years. If the money remains invested for five years, investors get a 10 percent break on the gains; after seven years, the tax break rises to 15 percent.

On top of that, the gains in the opportunity zone investment itself are tax free after 10 years. So if a $1 million investment is worth $2.5 million after a decade, the investor has a $1.5 million tax-free gain.

And none of that takes into account the depreciation and other tax benefits that come with owning real estate.

The Treasury Department also clarified what qualified as work done in an opportunity zone. When the legislation came out, investors wondered whether any business activity could occur outside that zone. Requiring all work to be done in a depressed area would have helped the community but would have also made achieving high returns more difficult for investors.

The new guidance provided by Treasury officials used more relaxed tests that looked at hours, wages or tangible property.

Other reasons would also be considered, said Marla Miller, managing director in the national tax office at BDO. That meant that businesses in an opportunity zone did not necessarily have to be intended for the people who live and work in the neighborhood.

“Before, we thought it would be a lot of coffee shops and nail salons because we thought you had to perform everything in the opportunity zone,” she said.

The legislation had already faced criticism because the areas eligible for the tax incentives are not all the same.

Take two neighboring zones in Connecticut, for example. South Norwalk has a booming real estate market, as younger professionals move there and frequent the thriving restaurant and night-life scene. But neighborhoods in Bridgeport, just a few exits up Interstate 95, remain economically challenged.

“South Norwalk is a great opportunity zone,” Mr. Rice said, “but if you’re stuck in the middle of Bridgeport, you could have all the tax benefits you want, but it may not turn out to be a great investment situation.”

Ms. Miller said it was wiser to think about the investment as if it were any other project. “If the project does not stand on its own and the fundamentals aren’t there, it’s not a good deal,” she said.

Michael Tillman, chief executive of PTM Partners, an opportunity zone fund, agreed. “The deals should be the same deals you’d be doing if they weren’t in an opportunity zone,” he said.

That’s good advice, whether you are deciding on the location of the property or your investment strategy.

Investors should do some research on neighborhoods before investing in an opportunity zone, said Stefan Schimenes, chief executive of InvestReal, which matches investors and projects in opportunity zones.

“Do you want to invest in a neighborhood that has already appreciated or one with a greater chance for appreciation?” Mr. Schimenes said.

Through the company’s database, an investor can see areas that were economically depressed in 2010 and that now have a median household income of $100,000 or more, which would represent a secure investment. Or it can find areas that are in need of a real economic boost, which would be riskier but provide a greater social impact.

Two of the company’s measures, for example, aim to rate an area’s investment potential. The first examines current conditions, while the second determines how that score will improve or deteriorate over the next 10 years.

“You can’t just build a city in the desert and hope in 10 years it’s going to create momentum and you can exit,” Mr. Schimenes said.

“We’re seeing a lot of developers trying to push terms that are a little too aggressive with the investor,” he added. “Yet a lot of investors might be desperate, and they’ll just invest.”

This is where strategy matters. Investors need to consider which approach they are going to adopt. It could be one that provides a secure return on a property near a thriving metropolitan area, or it could be one that looks to improve the quality of life in an economically challenged area, at the risk of a lower return.

Picking an investment fund will help establish your strategy. PTM Partners, which was started by three real estate developers who had met at the real estate developer LeFrak, is focused on developing properties on the edge of opportunity zones in major metropolitan areas.

The fund’s first two projects are a 360-unit development in Miami and a 454-unit apartment building that was a former F.B.I. office building in Washington. A third site, in St. Petersburg, Fla., is under contract.

Mr. Tillman, the chief executive, said his firm’s strategy was to take opportunity zones and overlay demographic data like wages, home size and other economic measures. The goal is to select markets “where long-term growth factors are present or in some areas they have already commenced,” he said.

SoLa Impact has a different strategy: investing with a social conscience. It is raising its third fund to invest in housing in Compton, Watts and other low-income neighborhoods in Los Angeles.

“Our investors were very attracted to the social impact of what we were doing,” said Martin Muoto, founder and managing partner. “In Fund 3, two-thirds of the investors care about social impact and one-third are primarily motivated by tax avoid.”

And that’s fine by him. “These are folks who wouldn’t normally invest in Compton or Watts, but they’re invested and they’re allowing me to do my work,” Mr. Muoto said.

Both funds hope to sell their investments close to the 10th year. Mr. Tillman believes he has identified areas that will still be strong then, while Mr. Muoto is banking on the continued need for basic housing and the attention the 2028 Summer Olympics will bring to Los Angeles.

Real estate is an inherently local market, so they both could be right. But investors should consider the downside, and whether the tax break is worth it.

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