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?
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:
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.
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.
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.