The new tax law signed December, 2017 allows for investments in Enterprise Zones to be free of capital gains tax if held 10 years. Assuming someone is in the 23.8% federal bracket for capital gains this may seem appealing, but some of the tax savings might go to sellers of these properties. Assuming the properties appreciate immediately by half of the amount of the tax savings then the seller would indirectly get half of the value of the tax cut. If the buyer overpaid by half of 23.8% then he only saves half, which is 11.9%, then if divided by 10 years holding, that’s about 1% a year saved.
Every bit of savings helps to boost returns but what may be the key determinant of investment success is to buy quality properties or quality stocks and these requiring paying up for quality. Low quality stocks and low quality real estate have greater risks. Since preventing losses are an important part of investing one may find that paying up for quality relative to a poor quality property (as long as one is not paying bubble prices) actually ended up costing no more than the all-in cost of a low cost asset.
Quality investment real estate is a modern well constructed building in excellent condition located in an economically healthy, prosperous, growing area. It must be located in a place with a high locational value such as a crossroads or centrally located downtown area. The risk is that only poor quality real estate will be available in Enterprise Zones, which are low income census tract neighborhoods. It may be better to ignore this tax benefit and instead shop for the best quality real estate. Besides, real estate already has the best tax advantages such as depreciation, 1031 tax deferred exchanges, and the ability to fully deduct losses over the $3,000 annual capital loss limit.
The new Enterprise Zone law also allows deferrals of capital gains from other assets such as stocks if the proceeds are invested into an Enterprise Zone property, and a 10% reduction in the amount of the gain from the previous investment if the Enterprise Zone investment is held for ten years. A 10% cut in a 23.8% rate is 2.38% tax saved, which if divided by 10 years is a -0.24% annual savings. Is it really worth the trouble of buying a property in a poor area just to save some 0.24% tax?
The operating income on the property is still taxable. Since poor, low quality properties often have higher than normal cash flow profit (like a Value trap stock with a high dividend) and lower than normal capital gains then a disproportionate amount of the total return might go to the (taxwise unappealing) profits from operating income which is taxable as ordinary income. Rents are taxed as ordinary income, by contrast, dividends are taxed at the low capital gains rate. Of course, operating income from real estate benefits from the depreciation tax deduction, however that maybe subject to recapture tax, which could be changed to higher rates in future Congressional legislation.
Assuming that real estate has gone up too much thanks to the massive Fed QE bubble then this wouldn’t be the right time to buy it even if the tax icing on the cake is delicious what matters most are risk-adjusted before-tax Total Returns. Also the Fed’s goal to raise interest rates will be a dagger in the heart of real estate since rising discount rates act to deflate the value of investments.
Other risks are that the program is temporary and could be repealed by future Congresses or administrative rules could be changed making it difficult to meet all the hurdles needed to qualify. In 1988 a major tax law change ruined the tax benefits of rental real estate investments causing their value to plummet, leading to a rise in foreclosures which may have triggered the 1989-1990 recession that resulted in a massive $200Billion ($500Billion in today’s dollars) bank bailout. Bottom line is a tax savings of 1% a year on a poor area property is not a reason to buy in that area. Never let tax icing on the cake motivate you to invest.
Investors need independent financial advice about the hidden risks of Enterprise Zone investing.