Comparing the Returns of an OZ Investment to a Non-OZ Investment

July 22, 2020
OZ Returns

In our most recent letter to investors we explain how to compare the benefits and returns of an OZ investment to a non-OZ investment. There are several important financial advantages in addition to the often discussed tax incentives of deferral, reduction and forgiveness of capital gains.

It's important to note that OZ benefits do not turn a bad investment into a good investment, and rather make a good investment much stronger. To start the comparison, let’s consider building an apartment building with and without OZ benefits:

Theoretical Project Example

Project Land Acquisition: $1,000,000

Project Building Cost: $27,500,000

Equity (Levered at 60%): $11,400,000

Cash on Cash at Stabilization: 8%

Cash Multiple (MOIC): 2.5

Theoretical Sample Investor

Recently Realized Capital Gains: $1,000,000

Cap Gains Tax Rate: 23.8%

Note, this primarily focuses on federal implications. State taxes have varying rates and varying levels of OZ conformity, some of which are discussed at the end of this post.

Benefit 1: Tax Deferral Results in Larger New Investment

Investing Capital Gains into a qualified opportunity zone fund allows you to defer taxes on those gains until 2026.  Assuming a capital gains tax rate of 23.8% and a gain of $1,000,000, that changes the size of your new investment by $238,000. This has significant implications for the life of the investment.

New Investment: $762,000 (Non-OZ) vs. $1,000,000 (OZ)

Percent Ownership in Project: 6.68% vs 8.77%

Benefit 2:  Deferred Tax Bill Can Be Reduced 10%

Barring an additional deferral, paying taxes in 2026 for the capital gains realized today is a requirement for which all OZ investors must account. We typically assume the same future tax rate of 23.8%, but it is important to know the 2026 bill will be paid at then current rates. To offset any concern, there is a 10% forgiveness for any OZ investment made before the end of 2021. This is technically a step up in basis from 0 to 10%, which will become important later. The net of it is that, with an OZ investment made before the end of 2021, you are paying taxes on 90% of your original gains. If we assume an unchanged tax rate, this reduces the tax bill from $238k to $214.2k.

Original Gains Taxed: $1,000,000 now vs $900,000 in 2026

Benefit 3:  Larger Initial Investment Increases Income

Because the new OZ investment is larger, there should be no surprise that the OZ investor receives more income over the life of the investment. Assume a simplistic 8% cash on cash is received as income following a 2 year build period.  In this case, the OZ investor receives more income in years 3-10. Income such as that produced by rental properties is treated as standard income and taxed as such. Investors will typically benefit from depreciation, which in the case of an OZ investment does not need to be recaptured (more below). Regardless, the increase in income is significant.

Investor Income: $487,680 vs $640,000

Benefit 4:  Depreciation Recapture Avoidance

Though this applies to any capitalized business, this is particularly common with real estate investments. Multi-family assets are depreciated over a 27.5 year period, resulting in $1M annual depreciation for our sample project. This depreciation helps offset income, but in a non-OZ investment, investors have to pay the piper when they sell the asset via something called depreciation recapture. When this happens, investors pay taxes on all the depreciation claimed over the hold period, currently at a federal rate of 25%. In the case of Opportunity Zones, depreciation recapture is forgiven. Under the covers, this is because properly held OZ investments have their basis raised to 100% upon sale after 10 years. Regardless, OZ investors avoid depreciation recapture which results in an under-appreciated benefit.

Annual Project Depreciation: $1,000,000

Annual Investor Depreciation: $69,273 vs. $90,909

Total Investor Depreciation: $534,737 vs. $701,754

Depreciation Recapture Tax: $534,737 vs. $0

Please note this example assumes standard, non-accelerated depreciation and adequate basis achieved via non-recourse debt. Different asset classes and state variability make depreciation one of the more complicated topics presented here.

Benefit 5:  Forgiveness of Tax on Gains Made Within the Zone

Capital gains made within a Qualified Opportunity Fund held for a full 10 years are completely forgiven. This is the most significant benefit of Opportunity Zone investments. Since the investor starts with a larger investment as a result of the cash deferral, the cash multiplier is even more important. Paired with the tax avoidance at the end of the investment, Opportunity Zones shine with their relative investment power. If we assume a 2.5 Multiple of Invested Capital (MOIC), the OZ investor will see greater gains and they will be tax free.

Initial Investment: $762,000 vs $1,000,000

Gains Upon Sale: $655,320 vs $860,000

Taxes on Gains: $155,966 vs $0

Net Gains: $499,354 vs $860,000

Additional Consideration 1:  OZ Money Stays At Work

Opportunity Zone investments, by design, must be held for 10 years to realize the full benefit. As a result, the investment stays at work over this long hold period. While it may be appealing to chase a high IRR investment with a short turn, not all investors will be able to find consistent deal flow at high returns to maintain an overall IRR for a long-period of time. If a non-OZ investor multiple investments over the same time period, there will be time in between each investment with no return, lowering their overall IRR.

Additional Consideration 2:  Market Timing

Short-term investments are inherently based on market timing. While some would argue that timing the market for 2-3 years is easier than timing for 10+, short term investments are rarely structured in such a way as to hold on for a couple more years to weather an investment cycle. By contrast, many OZ investments are being structured with lower leverage and the ability to weather short term market dynamics much better.

Additional Consideration 3:  Picking Multiple Big Winners

Anyone jumping on a short term investment will need to repeat that process multiple times in order to keep their money at work over a 10+ year period. Finding 3-4 consecutive, high-return investments can be challenging and risky relative to a conservatively structured Opportunity Zone Fund that had a seemingly lower IRR at the start.

Additional Consideration 4: Conforming States

Some states, including Colorado, chose to “conform” to the federal incentives associated with Opportunity Zones. If applying these benefits in a state that is fully conforming, investors received the same benefits at the state level. This can further enhance the benefits. For a complete list, see the Novogradec page on State Tax Code Conformity - Personal Income.