A coming spike in abandoned, foreclosed, and tax sale properties caused by the coronavirus pandemic could present a crucial commercial real estate investment opportunity in the coming months and years, especially in opportunity zones.
Opportunity zones (OZs) were created by the Tax Cuts and Jobs Act (TCJA) of 2017 to stimulate economic growth by providing a variety of tax benefits in the 8,700 census tracts designated so far as OZs and distributed across every U.S. state and territory, including metropolitan and rural areas.
Billions of dollars in capital have been pouring into the qualified opportunity funds (QOFs) created to invest in the zones, and federal guidance around taxing these investments is still evolving. Most recently, the IRS extended filing deadlines for the 2019 tax year and increased rehabilitation loan limits.
And, critically for commercial property investors, the IRS also put in place a carve-out for vacant property that could allow investors to avoid the requirements to substantially improve properties.
New rules for a land of OZ
Mike Krueger, a partner with Newmeyer Dillion in Walnut Creek, California, said this carve-out can potentially save investors time and millions.
"QOF investors may have new requirements, considerations, and investment opportunities in today's COVID-19 landscape and need to be alert to how the pandemic should impact their approach to opportunity zone investments," Krueger said.
Krueger specializes in counseling individual investors, developers, fund managers, and nationwide brokerage firms in all phases of OZ projects. Here he answers five questions that potential investors in commercial property inside such zones might want to ask.
Why do conditions now and going forward present a good opportunity for QOF investors?
First, there's the extended IRS deadline. You have 180 days to invest in a qualified opportunity zone business (QOZB) after you deposit the money in a qualified opportunity fund (QOF). The IRS extensions gave you more time to do that.
But the real benefit may well be the dramatic changes you see in the market because of the pandemic. Interest rates are very low and, like the recession that began in 2008, we're not going to see significant downturns for another year, but when we do, it's going to be quite dramatic again. Bankruptcies, vacancies, and panic will yield opportunity and real benefit to the right investments.
What is a qualified opportunity zone business (QOZB), and what's the significance of that designation?
It's a business that first of all is in one of the 8,700 designated opportunity zones. It's also a tract number. Then, there are a number of criteria from the IRS that investors have to meet that basically fall under a two-part test: "original use" and "substantially improved."
"Original use" means that a new startup or the existing company generates 50% or more of its revenue from that location. (That helps make opportunity zones especially attractive to startups, by the way.)
I work with a diverse group of high-net-worth investors -- including family offices, professional athletes, and wealth managers -- who are looking to diversify their portfolios and have deals put in front of them all the time. QOZBs are a potentially good option, depending on my clients' resources and interests.
What kinds of properties do you see presenting the best opportunities, and for what kinds of businesses?
Remember, QOFs are not into buying single-family homes. They're about big construction and commercial projects and businesses, including startups.
Look at the wave of bankruptcies we're seeing already -- JCPenney (OTCMKTS: JCPNQ), J. Crew, Office Depot (NASDAQ: ODP), Pier 1 (OTCMKTS: PIRRQ), just to name a few. Some are shutting all their doors, some aren't, but either way, there are a lot of opportunities developing quickly because of these disruptive changes.
Large-footprint retail has been declining for years, and now tech companies also are discovering they don't need millions of feet in office space since so much of their workforce has shown it can stay home indefinitely.
Plus, just look at many of these properties, such as the big malls that have shut down across the Midwest. They're often already on all major transportation lines, ADA compliant, and satisfy a lot of requirements that renovation would require.
Same with a lot of big office buildings with their natural light and other amenities. They're often perfectly sound buildings that just need to be repurposed. Companies manufacturing PPEs such as masks come to mind here. So does health care.
Maybe these buildings could instead contain outpatient oncology and dialysis facilities or other nursing activities. That kind of repurposing would bring high value to those properties in our new economy, and they also would lend themselves to the new reality of social distancing, just because of their size.
And now that the IRS has changed the rules about original use, carve-outs, and the investments in improvements, these are all factors that investors might carefully consider.
What is the original use carve-out all about, and why does it matter to investors?
The IRS issued guidance in December that, among many other provisions, no longer requires a property to have been vacant for three years, if it had been bought by a QOF after December 2018, to meet the "original use" test that otherwise requires investors to substantially improve that property.
If you do have to substantially improve the property, it can be a significant investment. If land and a building are worth a million dollars, for instance, and it doesn't qualify for one of those original use carve-outs, you have to put a million dollars into improvements.
Also, a building or land meets that rule if 80% of its usable space is empty. So, you can have a large property that's still 20% leased and it still qualifies for relief from the "substantially improve" rule.
And, buildings that are acquired directly from the government through bankruptcies or tax sales also don't have to be substantially improved, because of this new guidance.
Those are factors I think will be instrumental in the decision-making process as investors look at properties in opportunity zones, especially now with so many vacancies caused by the COVID-19 pandemic.
Can individual investors do opportunity zone investing on their own, or do they have to invest in a fund?
Sure, they can do it on their own. But you have to make sure you do the due diligence necessary on the IRS rules and on the properties themselves or hire professionals to do it. There also are rules about how much money you can individually raise for investing in them.
These can be pretty sophisticated situations. There are plenty of resources out there about opportunity zones, including software that lists properties and wealth management and legal professionals who are experienced and knowledgeable about this new area of investment.
It really depends on the resources you have and the level of direct involvement you want to have in managing the investment, but if you're serious about them, now is a good time to get started.