The Tax Cuts and Jobs Act created a program that provides certain tax benefits related to designated census tracks, referred to as opportunity zones. These opportunity zones span the United States in low-income communities. These communities generally are ones with a 20 percent or greater poverty rate or median family income less than 80 percent of statewide median family income.
But just what do these zones mean for hotel investors—and just what is the opportunity?
“Anytime you have an opportunity zone, there is the possibility of generating tax savings and increased returns based on investments and projects in the opportunity zone, so this is important for hoteliers to be aware of,” said Joshua Ehrenfeld, partner of law firm Burr & Forman. He said that if a hotel developer or investor can find a project located in one of these opportunity zones, they can enjoy significant tax savings and potentially increase their returns on investment.
James Canup and David Lionberger, partners at law firm Hirschler, agreed. They said that investments in these zones through a qualified opportunity fund could provide a temporary deferral of capital gains and also the possibility of permanent exclusion of future appreciation on the investment in the QOF. They cited three major tax benefits in a QOF.
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First, Canup said a taxpayer can defer capital gains from the sale of any nonqualified-opportunity-zone asset sold to an unrelated party. However, those gains need to be reinvested within 180 days of the date of the sale in a QOF prior to Dec. 31, 2026. The deferral of capital gain from the sale of the nonqualified-opportunity-zone asset will be triggered earlier than Dec. 31, 2026, if the investment in the QOF is disposed of before Dec. 31, 2026.
Second, Lionberger said if the investment in a QOF is held by the taxpayer for at least five years, the basis of the investment is increased by 10 percent of the original deferred capital gain. If the investment in the QOF is held by the taxpayer for at least seven years, the basis on the investment is increased by an additional 5 percent (for a total of 15 percent) of the original deferred capital gain. This means that if the investment is held for at least seven years, the taxpayer will only recognize 85 percent of the capital gain that was initially deferred until Dec. 31, 2026.
Third, Canup said if the investment in the QOF is held by the taxpayer for at least 10 years, the basis on the investment in the QOF is increased to the fair market value of the investment at the time it is either sold or exchanged. This means that there is no capital gain recognized on the sale of the investment in the QOF.
CBRE provided an example of how tax benefits from QOZs work: An investor buys stock for $1 million and later sells it for $11 million. The investor then puts that $10 million gain into an OZ investment. Taxes on that $10 million capital gain can then be deferred until 2026. If it is invested for at least five years at the end of 2026, the capital gains tax liability would only be for $9 million, a 10-percent step up in basis. If it is invested for seven years at the end of 2026, the capital gains tax liability is only for $8.5 million, an additional 5-percent step up or 15 percent total. If the OZ investment is then sold for $20 million, achieving another $10 million gain, the new gain would be tax-free if sold after a hold period of at least 10 years.
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While the upsides look promising, sources said there are a few downsides. First, Lionberger said the rules surrounding investments in QOFs are complex. They also haven’t been fully fleshed out by the U.S. Treasury and Internal Revenue Service.
Ehrenfeld agreed that the rules offer a downside. “One qualification is holding rules, as you must be willing to follow up with a long-term holding,” he said. “These rules may not correspond to typical investment protocol including holding periods and expected returns. In a typical deal, you may be out in five years but in five years you might not be able to maximize on opportunity zones.”
Even so, hotel developers and investors are using the new tax law to their advantage. San Francisco-based JMA Ventures, a real estate investment and development firm, recently launched its second QOF to invest in ground-up development and renovation projects based in qualified opportunity zones in the western U.S. The fund is set to target multiple real estate types, including hospitality. When asked why the company decided to create a second QOF, CEO Todd Chapman said that the group is equipped to handle the complexity of the rules in order to benefit.
“The tax benefits of the opportunity zone program are only meaningful if the underlying asset is successful,” he said. “JMA’s experience vetting successful projects and leveraging various methods of data analytics to pinpoint and predict strong performing projects are important advantages of the fund.”
In recent years, JMA has managed the development of over $2 billion of real estate assets from concept and entitlement through completion and operation. The company developed the Sacramento Downtown Commons, which is located in an area that was later designated as a QOZ. The development includes the 250-room Kimpton Sawyer Hotel.
Look Before Leaping
Sources offered advice for hotel investors who are considering developing in a QOZ.
Ehrenfeld said that it’s first important to be precise and thorough about the financial model for the project.
“To take advantage of opportunity zones you have to be able to hit all the right characteristics, including the holding period, and if the model doesn’t reflect properly, the deal may be off,” he said.
Lionberger agreed, adding that the QOZ needs to make business sense apart from the tax benefits. “Investments in QOZs may pose challenges and certainly involve markets risks,” he said. “Investors should be confident that the investment makes sense from a business perspective.”
Ehrenfeld said that investors also need to compare the ROI for the QOZ to a typical ROI in a business model to understand where it might provide value or fall short. “Think of it as making an ‘apples to apples’ comparison,” he added.
He also said that research is key and investors need to be certain about the scope of a project. “You don’t want to enter a situation where the project creeps and suddenly does not qualify as an opportunity zone,” Ehrenfeld said.
Canup said taxpayers who want to take advantage of all three tax benefits should invest in a QOF this year in order to fully take advantage of the five- and seven-year holding requirements before the capital gain that is deferred on the sale of the non-QOZ asset must be recognized on Dec. 31, 2026.
Beyond that, all sources agreed that it’s best to seek advice of a qualified tax professional before investing in a QOF in order to forge ahead with full transparency—especially because the Treasury and IRS still need to provide more guidance.