Opportunity Zones and Tax Credits – A Powerful Combination
As investors begin deploying capital into Opportunity Zones, questions remain whether there will be enough projects to absorb the capital generating returns justifying the risk. However, the growing volume of investment opportunities we are seeing reflect reasonable risk/reward profiles. Specifically, structured real estate development projects maximizing available tax incentives, in addition to the Opportunity Zone benefits, can successfully reduce risk and improve returns given the extended holding period requirements. These investments provide market rate or better returns while also achieving the social benefit contemplated by the law that created the Opportunity Zones.
There are numerous tax incentive programs that, when coupled with the tax benefits provided by the Tax Cuts and Jobs Act of 2017 related to Opportunity Zone investments, can significantly improve the risk/reward of an Opportunity Zone project. These tax incentives come in the form of Low-Income Housing Credits (LIHTC), Historical Tax Credits (HTC), New Market Tax Credits (NMTC), Tax Incentive Financing (TIF) and Property Tax Abatements (PTA). Regardless of the credits applied, the impact is an Opportunity Zone investment that provides social benefit in low-income neighborhoods while producing significant after-tax returns to investors.
Our initial focus looks at LIHTCs which can significantly improve returns over time while providing workforce housing, senior living and community service facilities in areas most in need of economic stimulus. LIHTCs are the federal government’s primary program for encouraging the investment of private equity in the development of affordable rental housing for low-income households. Since its creation in 1986, the LIHTC program has created or preserved over 3 million units of rental housing affordable to those making 60 percent of the area median income (AMI) or less. LIHTCs are the only major funding source for producing and preserving affordable rental housing.
How do LIHTCs work? Low-income housing tax credits (LIHTC) incentivize developers to construct or rehabilitate facilities benefiting low-income households. Developers sell these credits to investors, generally financial institutions, to provide equity financing and underwrite the project. LIHTCs are allocated competitively under federal guidelines and distributed by each state using specific criteria set for issuance of these credits. LIHTC deals require partners that include governmental agencies, tax credit investors, additional equity investors and developers who execute the project and manage the property. In addition, LIHTC projects may also qualify for other federal financing programs that provide block grants or low interest loans.
How do LIHTCs benefit an Opportunity Zone project? First, the tax investor exchanges cash for the rights to use the tax credits as offsets to their income thereby reducing the amount required from Opportunity Zone investors and the amount of debt financing to completely fund the project. Deals are structured so that ownership shifts from the tax credit investors to the equity investors as the tax credits are exhausted. In order for the tax investors to utilize the tax credits, they need to own 99.9% of the project while the tax credits are generated but their return is solely driven by the credit generation so that once the credits are exhausted, they exit the partnership without any expectation of their equity being returned. Additionally, the deals are structured where the preferred return flows to the Opportunity Zone investors. That preferred return can be used to increase the pace of debt repayment generating a potentially larger capital gain upon sale of the property.
There are additional complexities associated with LIHTC transactions, but the result is that the economics are well suited for Opportunity Zone investing. First, the holding period necessary to exhaust the tax credits is consistent with the holding period for any gain on the investment to be excluded from a taxpayer’s income upon liquidation. Second, the demand for low-income housing is strong meaning that occupancy rates for LIHTC funded projects are high. Third, other government programs, such as Medicare, supplement the rents paid by tenants improving yield on each unit. Finally, the tax credit equity is ultimately extinguished improving the project’s debt-equity ratio after the tax credits expire.
In addition to LIHTCs, many projects also qualify for Historical Tax Credits (HTC). The HTC program encourages private sector investment in the rehabilitation and re-use of historic buildings. The federal tax credit allows program participants to claim 20 percent of eligible improvement expenses against their federal tax liability. Since the Tax Reform Act of 1976, the HTC program has facilitated the rehabilitation of over 42,000 certified historic buildings and has attracted more than $84 billion in new private capital to the historic cores of cities and towns across the nation. These funds have enhanced property values; created jobs; generated local, state, and federal tax revenues; and revitalized communities in need of economic development.
Many projects that qualify for LIHTC benefits also qualify for HTC benefits. HTC tax credits have less restrictions than LIHTC credits and are extinguished more quickly. For HTC, the period where the credits are generated is generally 5 years. Again, the impact on an Opportunity Zone investment involves the reduction of project debt improving long-term after-tax returns for Opportunity Zone investors.
At JMP, we are working with developers experienced in the LIHTC and HTC markets. While additional credits such as TIFs, NMTCs and PTAs may be available, the LIHTC and HTC programs make certain Opportunity Zone investments more attractive over the longer required holding period. Together, these projects achieve the desired objectives of Opportunity Zones through socially beneficial development in low-income areas that produces long-term tax benefits with market-rate or better returns.
About JMP OppZone Services LLC – JMP OppZone Services (“JMP”) assists investors interested in taking advantage of the tax deferral opportunities associated with Opportunity Zone investments. JMP also assists project sponsors in creating commingled vehicles to pool assets to fund investments in Opportunity Zone locations. JMP provides investors with a platform that provides maximum flexibility to leverage the benefits of the law and corresponding regulations. We can assist with getting the clock started on the deferral and holding periods. Through our network of professionals, JMP assists with structuring and support services to form the QOF creating a structure through an underlying investment in a Qualified Opportunity Zone Business (“QOZB”) that provides the investor with time to evaluate, select and invest in appropriate Opportunity Zone investments.
This document is intended to provide information to help investors understand aspects of the relevant regulations issued by the Treasury related to Opportunity Zone investing. Nothing contained in is this document should be considered legal or tax advice and investors should consult their legal and tax advisors before making any decision to defer capital gains or make an investment in Qualified Opportunity Zone Property or a Qualified Opportunity Zone Business.
 Low-Income Housing Tax Credits.” U.S. Department of Housing and Urban Development, 6 June 2018. Web. www.huduser.gov/portal/datasets/lihtc.html