By Nicole Ament and Erik Jensen
One of the products of the Tax Cuts and Jobs Act, Qualified Opportunity Zones could have a significant impact on real estate development in 2019, including the hotel industry. While developing in an opportunity zone will not turn a bad hotel deal into a good deal, it can generate an increased pool of interested investors.
Hotel investors may not see the immediate potential of opportunity zones given that the census tracts designated as Qualified Opportunity Zones are technically low-income neighborhoods. However, a closer study of the Qualified Opportunity Zones map reveals that in many key markets the opportunity zones present strong possibilities for Qualified Opportunity Funds (QOF) to invest in hotel development, such as New York City, Hollywood, Washington D.C., and the entirety of Puerto Rico. Many opportunity zones are located immediately adjacent to neighborhoods that have already experienced gentrification and hotel demand is already present.
A real estate investor, hotel developer or other opportunity zone investor can realize tax benefits in two ways. First, a taxpayer may defer paying tax on capital gains to the extent that corresponding amounts are reinvested in a QOF within a specific time frame. Those capital gains are deferred until the earlier of the date the QOF is sold or Dec. 31, 2026. Additionally, if the QOF investment is held for longer than five years at the time, there is a 10 percent exclusion of the deferred gain. If held more than seven years, it becomes 15 percent.
It is important to note that the capital gains to be invested in a QOF subject to the deferral can be from any source, not just the capital gains resulting from the sale of real estate. This makes the QOF investment much more flexible than a 1031 exchange, and should generate an increased pool of interested investors.
While the deferral of current capital gains is attractive, it is the second significant tax benefit available to investors in a QOF that seems to be driving the most interest in QOF investment. If the investor holds the investment in the QOF for at least 10 years, the investor is eligible for an increase in basis of the QOF investment to its fair market value on the date the QOF investment is sold or exchanged, which results in a permanent exclusion of all post-investment appreciation.
An example of how tax benefits from Qualified Opportunity Zones work: An investor buys stock for $1 million and later sells it for $11 million, resulting in $10 million of capital gain. The investor then puts that $10 million of capital gain into an opportunity zone investment. Taxes on that $10 million capital gain can then be deferred until the end of 2026 (assuming the investor holds its opportunity zone investment until that time). If the opportunity zone investment is held for at least five years at the end of 2026, the capital gains tax liability would only be on $9 million, with 10 percent ($1 million) of the original gain being excluded. If the opportunity zone investment is held for seven years at the end of 2026, the capital gains tax liability would only be on $8.5 million, as an additional 5 percent ($500,000) of the original gain is excluded, for a total 15 percent ($1.5 million) exclusion. If the opportunity zone investment is then sold for $25 million after a hold period of at least 10 years, the entire $15 million of capital gain resulting from the sale would be tax free.
While much of the initial discussion surrounding opportunity zone investment has focused on real estate development, there is also potential to realize the tax benefits if the QOF invests in the operation of a hotel within an opportunity zone. If a QOF funds the operations of a new hotel that is located in a QOF, even if the underlying real estate is not owned by the QOF, then the QOF may be eligible for the same tax benefits described above. This means separate QOFs could own the underlying real estate and the hotel operations, with both QOFs ultimately potentially reaping the tax benefits from the investing in a new hotel development in an opportunity zone.
There are a number of timeline and tests that need to be met to ensure the investment can benefit from the opportunity zone tax benefits, such as a requirement that capital gains must be invested in a QOF within 180 days the gains are realized and 90 percent of the assets of the QOF must be qualified opportunity zone assets. However, the actual filing process with the IRS is a simple self-certification form.
While the potential hotel development in an opportunity zone needs to make business sense apart from the tax benefits, investors and owners that are willing to meet the various tests and holding rules could use the new tax benefits to their advantage and potentially attract a new pool of investors looking to capitalize on opportunity zones.