Morgan Stanley- Finding Opportunity in Opportunity Zones

FINDING OPPORTUNITY IN OPPORTUNITY ZONES

The Tax Cuts and Jobs Act introduced a new federal tax incentive designed to promote capital formation and investment in designated economically distressed communities called Opportunity Zones. Over 8,700 census tracts have been designated across the country, including in Puerto Rico and other US territories. The incentive has the possibility to become the nation’s largest economic develop-ment program, with estimates of $100 billion in initial investment.

• We see the greatest opportunity for benefits in urban zones and tracts with high population density, such as the New York, Los Angeles, Chicago, and Houston metropolitan areas.
Redeploying unrealized capital gains into Opportunity Funds may lead to significant tax benefits for investors. The incentive provides deferral and a reduction of taxes upon realizing capital gains and excludes taxes on new gains generated by Opportunity Funds, if held for 10 years. For 10-year investments with annual returns between 5% and 15%, investors could realize after-tax profit increases between 27% to 52% versus traditional investments.

• Investment Implications Summary:

Real Estate & Asset Managers: We believe real estate will be the primary asset class for Opportunity Fund investment. For prop-erty types, we see the greatest benefit to affordable and work-force housing, where there are significant rental affordability challenges facing the market. Indeed, while it will likely have a small impact on the 7.2mn national shortfall of affordable rental housing, it’s impact could be much greater across individual cities and states (see Exhibit 9 and Appendix B: Rental Affordability Gap by State ). Investment formation is likely geared to private partnership Opportunity Funds versus REITs, given the structure’s already low-tax profile. Platform real estate managers, such as Blackstone (BX), also have the scale and expertise to monetize this opportunity through developments and as fund sponsors.

• Retailers & Restaurants: ~76% of Opportunity Zones lie within metro areas and ~10% of the US population live within a desig-nated zone. Leveraging our proprietary AlphaWise retail data-base, we were able to screen for retail companies that are well positioned. We like Dollar Stores and Discounters’ exposure, par-ticularly DG. In restaurants, we believe WING, DPZ, DNKN are well suited given their domestic growth profiles (note these compa-nies are franchisors that would benefit from incremental royalty/franchisee fees). In broadline retail, HD, WMT, LOW, COST, TSCO, and LL have strong exposure and may benefit from increased eco-nomic activity.

• Municipal Credit: Opportunity Zone incentives create a credit uplift opportunity as zones are disproportionately located in low-er-rated geographies: the median single-A county has 14% of its population living within a designated zone versus 5% for the median Aaa county. Investment in these communities could boost the tax base and improve credit health. But a credit uplift is not guaranteed; Opportunity Zone incentives alone likely can’t change the complex dynamics governing whether or not an under-performing area transforms into a more vibrant economic zone.

• Impact Investing: Opportunity Funds can provide an interesting alternative for impact investing with the potential to generate attractive economic returns and societal benefits. It is important for Opportunity Funds to have a clearly defined strategy and to target improvements in key demographic KPIs, providing a means to effectively measure the impact created.

Summary of Key Tax Benefits:

Deferral of Capital Gains: Individuals or corporations with any cap-ital gain, from the sale of stock to the sale of real estate, can defer taxation on an unlimited amount of realized gains until 2027 if the gain is reinvested in an Opportunity Fund.

• Reduction of Capital Gains: 10% of the realized capital gain tax is forgiven for fund investments held for 5 years, and 15% is forgiven for funds held for at least 7 years, via a tax basis step-up.

• Permanent Exclusion of Taxable Income on Fund Gains: Most appealing, investors pay no capital gain taxes on new gains gener-ated by Opportunity Funds if held for 10 years.

Forthcoming Regulations Are a Key Catalyst: While the contours of the law are known, supporting regulations and agency interpreta-tion are critical for investor participation. US Treasury is expected to release the first round of Opportunity Zone regulations later this month, which we expect will catalyze investment deployment into 2019.

Exhibit 1:

Opportunity Fund Benefit Timeline

Opportunity Zone Fund Investment Example: Assume a taxpayer has $100 of capital gains in an existing investment and a 23.8% tax rate. The taxpayer sells the investment and reinvests the capital gains in an Opportunity Fund. This allows the taxpayer to defer paying capital gains taxes until December 31, 2026, or upon sale of the Opportunity Fund investment, whichever comes first.

If held for five years, the $100 capital gain basis is stepped up by 10%, leaving only $90 of the deferred gain taxable. After seven years, the basis is stepped up an additional 5%, resulting in an $85 tax basis. On December 31, 2026, the taxpayer will owe $20 ($85*23.8%) in tax. Once the tax is paid on the deferred gain, there will be no additional taxation on the initial $100 investment.

If the fund investment is held for 10 years, the investor will receive a tax basis step-up equal to the fair value of the fund, thus eliminating any tax liability on the appreciation of the $100 fund investment.

Summary: Opportunity Zones are economically distressed census tracts designated by state governors and the Treasury Department. The program permits the reinvestment of capital gains into Opportunity Funds, which then make the investments into qualified Opportunity Zones. Taxpayers are incentivized to invest in Opportunity Funds through the ability to defer taxation on the reinvested capital gains, as well as the potential to eliminate capital gains on Opportunity Fund appreciation.

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Morgan Stanley – Finding Opportunity in Opportunity Zones

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