The Basics of Opportunity Zones: 2017 Tax Reform Provides Development Incentives

You’ve probably heard something recently about Opportunity Zones (or o-zones), which were established by the Tax Cuts and Jobs Act of 2017 to employ tax incentives for long-term investments in rural and low-income, urban communities.  As the first national community investment program in over 15 years, it’s a natural fit for certain types of development projects, but since it’s written as part of the tax code, negotiating the specifics is critical.

There are currently 8,760 opportunity zones nationally, which comprise census tracts (or parts of them) nominated by various states, and certified by the Department of the Treasury.  The purpose of the legislation is to encourage private investment in these low-income tracts by allowing a temporary, 5- to 10-year deferral of tax on capital gains, a reduction in the amount of capital gains tax that must ultimately be paid, and potential tax-free appreciation in qualified opportunity zone funds.

All o-zone funds must hold at least 90 percent of their assets in a Qualified Opportunity Zone Property (QOZP), which is measured every six months in a given calendar or fiscal year.  Failure to meet this 90-percent rule can result in severe penalties.  While an o-zone fund can include both capital gains and other sources, only the capital gains are eligible for the o-zone tax benefits.

So let’s say you’re a developer proposing a new multi-family property in a certified o-zone, and looking for investors wanting to take advantage of this legislation.  To qualify as a QOZP, the property must be purchased after 2017, and the tax basis of the completed property must be at least double the original basis, plus one dollar.

For redevelopment projects in which the existing structure(s) are targeted to be razed or substantially rehabbed, this should be an easy milestone to hit.  However, there’s a strict timeline of 30 months to complete these improvements, which could prove more difficult for larger projects still early in the planning and approval process. There are also time pressures for investors, with capital gains required to be transferred to an o-zone fund within 180 days from the date they are realized.

But there is some help on the way:  HUD Secretary Ben Carson recently announced that his department will offer technical assistance, as well as providing preferential treatment for grant applicants with affordable housing projects in o-zones.  In addition, the Federal Housing Administration’s pilot program for financing low-income housing with tax credits was expanded to incorporate o-zone projects.

Even better, HUD is now working with other federal agencies and programs so that developers can combine o-zone tax benefits with other programs, such as the New Market Tax Credit.  Carson also confirmed HUD’s controversial initiative, announced last August, to encourage cities to change their zoning regulations in order to build more affordable housing.

For an investor, there are several options to save on capital gains.  If a taxpayer holds its ownership interest in the o-zone fund for at least five years, then 10 percent of the gain invested is excluded from the tax owed upon the sale of the taxpayer’s interest in the o-zone fund (or 2026, whichever is earlier). If the ownership interest is held for at least seven years, an additional five percent (for a total of 15 percent) of the invested gain is excluded, and if a taxpayer holds its ownership interest for at least 10 years, then all appreciation in the investment will also be tax-free when the taxpayer sells its interest.

To take full advantage of the statute’s current benefits – including a deferral of tax until 2026 and a 15 percent reduction in taxable gain -- investments must be made by the end of 2019. Still, taxpayers can make investments after 2019, and will also be able to benefit from the appreciation exclusion that many believe is the greatest advantage of the new law.

However, the rules that normally cap 50-percent ownership as the limit for determining if companies are related parties are further limited with o-zones.  In this case, cross-ownership is limited to 20 percent, and some builders will be unwilling to give up 80-percent equity to qualify for the tax advantages.  Still, for Low-Income Housing Tax Credit (LIHTC) project developers, their familiarity with giving investors majority ownership could help boost more affordable housing at a time of unyielding demand.

Finally, o-zone funds can also include investments in existing companies, not just properties.  But, as with all things related to our very complicated tax code, seeking advice from tax attorneys, CPAs and other experts is probably the first place to start.

Builders and Developers Adjust to a Softer Market

If there is one thing that building industry pros are good at, it is adjusting to the ebbs and flows of the cyclical nature of the housing market. Due to a combination of rising home prices, higher interest rates, and low inventory, the lengthy, post-recession housing rebound did soften considerably in the last part of 2018. 

However, it also remains to be seen if this softening is merely another pause in a longer story, or if the housing market is closer to the end of the current cycle. For now, most builders are not waiting for the answer, and are already using a combination of financial incentives, a more personal touch to guide homebuyers through the sales process, and tapping the wonders of Artificial Intelligence (AI) to clear existing inventory as soon as possible.

Long a standard tool in the builder’s marketing box, sales incentives can vary from covering more closing costs to free upgrades and even outright price cuts. According to recent national statistics, in the first month of 2019, 23 percent of builders lowered their prices – including incentives, but also outright price cuts – versus just four percent in the same month of 2018. While this nearly six-fold increase in net pricing cuts to buyers is certainly notable, it is still far less than the rate exceeding 40 percent back in 2010.

Buyers may also be choosing smaller units. According to preliminary data for November 2018 from the U.S. Census Bureau, the median price of a new home sold was $302,400, down seven percent from the previous month, and falling nearly 12 percent year-over-year. At the same time, seasonally adjusted sales were up nearly 17 percent from October, but fell nearly eight percent since November 2017. Meanwhile, the average months of supply for new homes edged down to 6.0 months versus 7.0 the month before, but up sharply from 4.9 year-over-year.

A separate report from the Mortgage Bankers Association (MBA) for January 2019 showed a strong, 29-percent sales rebound for seasonally adjusted sales of new, single-family homes after two disappointing months to the fastest pace since 2013. Although January applications for new home mortgages were flat year-over-year, they rebounded by a sharp 43 percent from December.

Certainly one major factor helping buyer demand has been a steady decline in lending rates, which, according to Freddie Mac, were currently trending around 4.4 percent in mid-February for a conventional, 30-year fixed-rate mortgage. While this average rate is still up sharply from just below four percent a year ago, the nearly 60-basis point drop from November 2018 can mean over $12,000 in extra purchasing power for that $300,000 home.

Today’s technology is also assisting builders to offer a more personal touch throughout the sales process. Considering that a single- family home start can take as long as 90 days from the date of deposit, anxious homebuyers may be looking for reasons to cancel if they are not seeing physical proof of their new home coming to fruition. That is where a “more communication is always better” mindset can help keep sales on track, using a variety of regular video-enabled emails on a regular basis. By educating the buyer from the builder’s point of view, sales managers can also better manage expectations through closing day.

While AI can certainly help with this ongoing communication, it is becoming even more important when personalizing online advertising and messages for new leads with services including Google, Facebook, Instagram, and others. For example, Google’s new ‘responsive search ads’ apply inputs from clients and then use machine learning to arrive at the most ‘perfect’ ad for an individual. According to the experience of online marketing consultant Do You Convert, this evolving technology can help lower costs-per- click by 18 percent, and improve click-through rates by of to 46 percent.

On the existing home side, brokerage giant Keller Williams recently launched its own proprietary AI system called Command. Intended to replace other, off-the-shelf CRM competitors, the company analyzed the pros and cons of other systems, and assembled a team of 27,000 people – many of them agents – to create a solution that could be customized to each user. Later this year, the brokerage plans to launch its own consumer-oriented app to compete with Zillow.

In both cases, the idea is to win the race for a one-stop shop where potential buyers can search for homes, mortgages, and other related services without leaving the company’s branded garden. Those builders who manage to harness today’s evolving technology without losing the personal touch of a talented sales person will likely outperform their competitors.

Technology Continues to Change Real Estate Sales

Lead, Follow, or Get out of the Way -- Author Unknown

Is it time to finally bid goodbye to the traditional method of selling homes along with its standard, six-percent commission?

After many years of impacting the fields of retail, travel, stock trading and others, technology is now increasingly poised to change how both new and existing homes are bought and sold. While there will probably always be a market for traditional agents, only those with area expertise and excellent customer service will survive in this new marketplace.

When Jack Ryan, a former Goldman Sachs partner and technology investor, went to sell his Southern California home to an interested party in 2015, he contacted his local real estate agent who would help him complete the paperwork – for six percent of the sales price. Frustrated with this response and hiring an attorney instead for a small fee, he soon co-founded Real Estate Exchange (REX), which uses artificial intelligence (AI), machine learning and big data to match buyers and sellers for just a two-percent commission.

Unlike competitors such as Redfin and PurpleBricks, which discount the listing fee but still require sellers to offer a buy-side commission, REX bypasses the MLS entirely, thus cutting out three percent of the equation. For those buyers who insist that their agent receive a cut, it can still be negotiated with the seller, or the buyer can roll the cost onto their own mortgage. Should anyone experience buyer’s remorse, REX even offers a 30-day, money-back guarantee.

For those sellers looking for a faster route, “iBuyers” such as Redfin Now, Zillow Offers, OpenDoor, OfferPad, and Perch provide what is often a below-market cash offer in exchange for an almost-immediate sale. While Zillow expressly encourages sellers to bring in their own professional agent, the others close the deal mostly in-house. For this convenience, they charge overall fees ranging from six to 13 percent, depending on the strength of the market and the condition of the property.

Coldwell Banker, in partnership with Home Partners of America, is leveraging the rent-to-own giant’s subsidiary, cataLIST, for cash offers to sellers in select markets. If the seller turns down the offer as too low, then the home is still marketed as a traditional listing.

For larger new home builders, NewHomeSourceProfessional, a unit of Builders Digital Experience (BDX), specifically partners with buyer’s agents to help its builder members move inventory to a digital audience. Billed as an “MLS for new homes” and free to agents, the system not only regularly scrapes builders’ websites for pricing and inventory changes, but can also pull specific information about floor plans, school districts and other community information.

Going one step further and leveraging the power of AI, last year BDX also unveiled HomLuv, which allows buyers to review and rank more than one million images from 100,000 different new homes. As buyers pin their favorites, the system learns their preferences and begins matching them with participating builders for their locations of interest.

For smaller and custom home builders, Edgewise Realty is another option which offers a closer, direct-to-buyer partnership similar to REX, which also allows clients to reserve units with just a $1,000 deposit, upload financial documents, and make choices about features and upgrades. Currently working with about 30 different builders across the country and charging a flat one-percent listing fee, Edgewise buyers can also get regular updates with photos and videos.

But what if a potential buyer first has a home to sell?

To address that situation, BDX has teamed up with Keller Williams International in multiple U.S. markets for its New Home Ambassador and National Builder Trade-in programs.  Although the ambassador program allows agents to create a separate and personally branded website to search new home listings, the trade-in program charges a discounted, three- to four-percent commission while still offering the expertise of professional stagers and agents, and even lease buy-out programs for renters.

Meanwhile, upstart Knock has another strategy appealing to builders, which is to purchase a seller’s chosen new home for cash -- often at a discount -- and then sell the old home the traditional way. Only when the old home escrow closes do the buyers receive title to the new one.

Similarly, Ribbon finds buyers first, and then offers sellers a competitive, all-cash bid for a commission of 1.95 percent. With Ribbon, buyers can even rent out their new homes at market rates until they’re able to obtain a suitable mortgage, whereas if a Knock listing is taking too long to sell, it can also be temporarily converted to an income property.

Indeed, the times, they are a-changin’.

A Look Ahead to 2019: A more balanced housing market, but geopolitical turmoil brews

For most of this year, we saw the steady global expansion underway since mid-2016 continuing, with growth during the 2018-19 period projected to remain at its 2017 levels.

That’s the good news.

However, even with the International Monetary Fund’s (IMF) estimate of 3.7 percent growth in 2019, more downside risks to this growth rate have emerged in the past six to eight months, as political turmoil continues to spread to more places around the world.

Here in the U.S, the Federal Reserve is still projecting GDP growth to slow to 2.5 percent in 2019 after 2018’s tax cuts helped boost annual GDP growth to 3.1 percent. Unemployment remains low at 3.7 percent, and, as of October, there were one million more jobs than there were people actively seeking work, which has put upward pressure on wages as the competition for skilled workers heats up.

More recently, however, wild swings in the stock market due to escalating trade tensions with China and slowdowns in other developed countries have dramatically impacted the global appetite for risk, with the State Street Investor Confidence Index declining at the fastest pace in a decade over the last few months.

Still, one positive side effect of this volatility for the housing market has been a recent escape to the safety of long-term bonds, helping to reverse the steady increase in mortgage rates. This, in turn, could help make housing purchases more affordable and give buyers a badly needed break. Indeed, after several years of steady growth for housing sales and prices, 2019 is likely to return to a more balanced market between buyers and sellers, at least temporarily.

Projections by multiple sources including the NAR, Realtor.com and Zillow are envisioning a market with home prices still rising, albeit at a slower rate of growth. As buyers wait to catch their breath, Realtor.com is also suggesting that overall sales levels could slip by about two percent, while the NAR is predicting a small gain of one percent.

However, beyond the short run, these slipping or mostly flat sales levels could also exacerbate the country’s overall housing shortage even more. According to a recent study by Freddie Mac, the annual rate of U.S. construction is about 370,000 units below long-term housing demand, leading to a current pent-up shortfall of over 2.5 million homes. In many popular markets, until construction of new homes is able to increase and stabilize at higher levels, excess demand will continue to put some pressure on home prices and rents.

At the same time, the inventory shortage is not equally divided among housing sectors. In 2018, the NAHB modified their Leading Markets Index (LMI) to measure building permits against historical norms while adjusting for population growth. According to their new methodology, as of the third quarter of 2018, single-family permit activity, adjusted for population growth, was operating at 59 percent of potential capacity. Meanwhile, multi-family permit activity was at 98 percent of capacity. 

Since multi-family construction generally offers more affordable housing options, the City of Minneapolis is taking this idea one step further by rezoning single-family neighborhoods to higher densities. In early December, their City Council approved the Minneapolis 2040 plan, which will allow up to three-family homes in the city’s residential neighborhoods, remove minimum parking requirements for all new construction, and permit high-density buildings along transit corridors.

The idea is to break open restrictive zoning laws in order to provide new opportunities for residents to move for schools or a job, allow aging residents to downsize without leaving their neighborhoods, slow the displacement of lower-income residents in gentrifying areas, and address the lack of affordable housing citywide.

Whether or not this idea will spread to other cities, the timing is opportune. More millennial buyers are moving into their home buying years, and are expected to represent 45 percent of mortgages in 2019, with most looking to buy that first home. Gen X buyers are expected to account for another 37 percent of new mortgages, most likely trading up to the mid- to high-priced tiers, while Baby Boomers looking to relocate or downsize will capture 17 percent.

Finally, another wild card to consider is the impact of the 2018 tax cut on the housing market, with overall sales levels declining soon after it passed. Although most renters will enjoy a higher standard deduction and thus lower taxes, for owners the result is less clear, as some will find lower benefits from fewer personal exemptions and itemized deductions, especially in high-tax states. If nothing else, 2019 will certainly prove to be interesting.

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