Investors like REITs (Real Estate Investment Trusts) mostly for their dividends. After all, REITs must distribute 90% of their income through dividends. But if you've read about opportunity zones and are interested in investing in them, can you do it through REITs?
Opportunity Zones Refresher
The opportunity zone (OZ) program came onto the scene with the establishment of the Tax Cuts and Jobs Act of 2017. The US government set aside a large number of land tracts in economically distressed areas. The program's goal was to encourage long-term investment in these tracts, thus improving economic conditions in these areas.
The vehicle for many investors to get involved with OZs was Qualified Opportunity Funds (QOFs), which invest in businesses or real estate located in OZs. In return, investors would receive tax benefits.
These tax benefits include:
- Deferral of taxes on capital gains until 2026
- Reduction in the amount of capital gains taxes owed
- Complete exclusion of capital gains taxes on any appreciation in the investment if it is held for 10 years.
To qualify for these tax benefits, the QOF must invest 90% of its assets in an OZ. Those of you familiar with REITs may already see an issue.
Can REITs invest in Opportunity Zones?
REITs are required to distribute at least 90% of their income as dividends to shareholders. By coincidence, that is the same percentage of assets required to be invested in OZs. Since REITs typically do not retain earnings for investment purposes, meeting the 90% asset investment requirement can be difficult.
However, the IRS has provided an alternative method for REITs to get involved with OZs. This is done through partnerships or subsidiaries. This arrangement allows REITs to distribute at least 90% of their income while indirectly investing in OZs.
Another consideration, which is not specific to REITs, is the type of property that OZs must invest in. For an OZF to invest in a property, it must be a new investment or substantially improved. This means that the cost of the improvements made to the property must exceed the property's original basis within 30 months of acquisition. That's a fairly limiting factor, as meeting those requirements can be a tall order.
Additionally, REITs have the mandate to invest in specific properties. Many OZs do not fall within those mandates.
Another condition is that the OZ program requires that at least 50% of the gross income of businesses located in OZ properties come from within the zone. This means that REITs may need to ensure that the businesses occupying their properties meet this requirement.
Advantages and disadvantages of REITs investing in Opportunity Zones
In the end, some of the issues facing REITs when investing in OZs are similar to issues facing any investor. Although REITs may have some additional challenges.
REITs can still enjoy capital gains tax deferrals until 2026, allowing them to reinvest their earnings short term. Additionally, the complete exclusion of capital gains taxes on any appreciation in the investment if it is held for 10 years can help REITs generate long-term returns.
OZs provide a method for diversification. Specifically diversifying into economically distressed areas. While these areas may be at higher risk than some more established properties, there is also the potential for higher returns. Moreover, investing in OZs can help REITs meet their social responsibility goals by supporting economic development in underserved communities.
Some disadvantages are that the program is still relatively new. As with anything new, there is a lack of data on the long-term performance of investments in OZs. REITs may also face additional regulatory and compliance requirements when investing in OZs.
In summary, REITs can invest in OZs but may face challenges that other investors do not have to consider.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Investors in QOFs will need to hold their investments for certain time periods to receive the full QOZ Program tax benefits. A failure to do so may result in the potential tax benefits to the investor being reduced or eliminated.
If a fund fails to meet any of the qualification requirements to be considered a QOF, the anticipated QOZ Program tax benefits may be reduced or eliminated. Furthermore, a fund may fail to qualify as a QOF for non-tax reasons beyond its control, such as financing issues, zoning issues, disputes with co-investors, etc.
Distributions to investors in a QOF may result in a taxable gain to such investors.
The tax treatment of distributions to holders of interests in a QOF are uncertain, including whether distributions impact the aforementioned QOZ Program tax benefits.
A QOF must make investments in Qualified Opportunity Zones, which carries the inherent risk associated with investing in economically depressed areas.
A REIT is a security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages.
REITs receive special tax considerations and typically offer investors high yields, as well as a highly liquid method of investing in real estate.
There are risks associated with these types of investments and include but are not limited to the following:
- Typically, no secondary market exists for the security listed above.
- Potential difficulty discerning between routine interest payments and principal repayment.
- Redemption price of a REIT may be worth more or less than the original price paid.
- Value of the shares in the trust will fluctuate with the portfolio of underlying real estate.
- There is no guarantee you will receive any income.
- Involves risks such as refinancing in the real estate industry, interest rates, availability of mortgage funds, operating expenses, cost of insurance, lease terminations, potential economic and regulatory changes.
This is neither an offer to sell nor a solicitation or an offer to buy the securities described herein. The offering is made only by the Prospectus.
