Leveraged Breakdowns

Why Opportunity Zones Are All The Rage

Suppose you sit down for a REPE job interview and are asked this question: “If we completed a 1031 exchange into a mixed use project in an Opportunity Zone, exchanging a property with a tax basis of $32 million into a new project of $40 million, how much would my step-up in basis be in year 6?” How would you respond?

In your search for your first job in real estate private equity you may have come across the term “Opportunity Zones.” Perhaps this even came up as a REPE technical interview question that left you fumbling around for an answer. Leveraged Breakdowns is here to help you, as an outsider, learn the business from insiders. Pay attention, because this is a fascinating real estate investment case study on government incentivizing the private sector.

Opportunity Zones Defined

The federal government established Opportunity Zones in 2017 in order to spur capital investment in urban areas that are underserved. Opportunity Zones typically demonstrate higher unemployment, higher poverty, and lower income. Each state nominates census tracts (geographic areas defined by the Census Bureau with a myriad of uses outside of the census) as Opportunity Zones, which are then approved by the US Treasury.

So What’s the Appeal?

Investing in real estate in an Opportunity Zone has a significant tax advantage that piggybacks off of another tax incentive – 1031 exchanges (a beginner’s guide to 1031 exchanges can be found here). Specifically, there are two primary tax strategies that are permitted when investing in an Opportunity Zone:

  1. Basis step-up of previously earned capital gains: If capital gains are reinvested into an Opportunity Zone project and that asset is held for a period of time, you are permitted a step-up in your tax basis. If the asset is held for at least 5 years, you can step up the tax basis by ten percent. If the asset is held at least 7 years, you can step up the basis 15%.
  2. Permanent exclusion on new capital gains: For investments held at least 10 years there is no tax on the capital gains earned on that asset (as opposed to the gain that was earned elsewhere and invested in the Opportunity Zone).

A Specific Real Estate Investment Case Study

Suppose your firm sold an office building for $20,000,000, which had a tax basis of $15,000,000. The taxable gain would be $5,000,000. If that gain were invested in a new mixed-use project (commercial and residential) within an Opportunity Zone and held for 10 years, your firm would get to increase their tax basis in the original gain (which effectively reduces the gain from $5,000,000 down to $4,250,000) and not pay any tax on the capital gains for the Opportunity Zone Asset!

If the Opportunity Zone asset were held for seven years your firm would get the 15% step-up in basis, but would still owe tax on the capital gains from the Opportunity Zone asset.

Now it All Makes Sense

You can see why Opportunity Zones are very effective at bringing new capital investment into areas of cities that have traditionally struggled to attract new development. Real estate investors and REPE firms that have accumulated significant deferred tax liability from 1031 exchanges now have an avenue for reducing that deferred liability. Plus, if the assets are held for 10 years there are no new capital gains to add to the mix!

As you apply for real estate private equity jobs and sit through interviews, you now have an additional talking point you can use to demonstrate your insider’s knowledge of the business. Opportunity Zones are a very recent development in the business, and understanding them can help you wow your interviewer if he or she throws a very technical REPE interview question at you.

Be sure to check out our Forums and join the discussion on the answer to our interview question at the beginning of this post. You can also sign up for the Leveraged Breakdowns coursework, which is designed to help you crack to code for REPE interviews and help you land your dream job. Get started today!

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