Commercial Real Estate: The New Qualified Opportunity Zone Program
Attorney Linda S. Koffman offers her latest newsletter, Commercial Real Estate Insights, with her views on the new Qualified Opportunity Zone Program:
While there has been general economic recovery in the United States since the financial crisis began the last quarter of 2007, certain parts of the country have continued to struggle with slow job and business growth. To help stimulate growth, the new Qualified Opportunity Zone Program (the “Act”) was added to the tax code by the Tax Cuts and Jobs Act of 2017. The Act provides a new federal tax incentive for investment in low-income areas designated as “Opportunity Zones.” This new tax investment vehicle received bi-partisan support and is gaining attention both as a way for investors to defer (and potentially avoid) capital gains and as a substantial federal attempt to help revitalize economically distressed areas that have been left behind in the general economic recovery.
A Qualified Opportunity Zone
The Act outlined the criteria and process for the Governor in each state and U.S. territory and the Mayor of the District of Columbia) to identify up to 25% of the census tracts under their jurisdiction (along with a limited number of adjacent census tracts) from among those census tracts that qualify for designation by meeting the poverty and income criteria. Of those nominated census tracts, the Secretary of the U.S. Treasury (via designation of authority to the Internal Revenue Service [“IRS”]) certified approximately 8,700 “Qualified Opportunity Zones” (“QOZ”). The entire list of QOZ is published here. As shown in this list, there are QOZ in each of the 50 states, in the District of Columbia and in 5 U.S. territories.
Tax Benefits of the Opportunity Zone Program
Tax benefits are available to taxpayers that invest in an operating business or in real property in a QOZ using an investment vehicle called a “Qualified Opportunity Fund” (“QOF”). A QOF must meet specified criteria set forth in the Act and must be formed as a corporation or partnership for income tax purposes. This means that a limited liability company can qualify for tax purposes as well. An investor can form its own QOF for direct investment in a QOZ or a third party can form a QOF to pool multiple investors for investment in one or more QOZs.
The investor can roll the capital gains from the sale of anything (a business, shares of stock, real property, works of art, etc.) into a QOF and obtain the tax benefits if the taxpayer meets the criteria set forth in the Act. Investment through a QOF provides both a deferral of capital gains on the sale of any asset and a step-up in basis if the investment (i) is a sale of an appreciated asset to an unrelated person, (ii) the taxpayer elects to defer the gain in the tax return for the year of the sale, (iii) the taxpayer does not make another election to defer the tax with respect to the same sale or exchange (e.g., a 1031 exchange), and (iv) the taxpayer invests the deferred gain in one or more QOFs within 180 days from the sale of that appreciated asset.
Investors will receive a deferral of taxation on all taxable capital invested in a QOF until the earlier of the date the investment is sold or exchanged or December 31, 2026. If a taxpayer invests in a QOF and holds its investment for at least 5 years, it will be eligible to receive a 10% reduction of the gain realized. If the taxpayer invests in a QOF and holds its investment in a QOF for at least 7 years, it will be eligible to receive a 15% reduction the gain realized. Investors who invest by December 31, 2019 and hold their investment for 10 years or more, are eligible for an increase in basis equal to the fair market value of the investment on the date it is sold or exchanged. This means that the basis will be equal to the sale price and therefore, no capital gain will be recognized, and no tax will be due.
The proposed regulations explain that investors may hold assets in a QOZ until January 1, 2048. The proposed regulations also permit an investor to make the basis step-up election even after December 31, 2028, when each of the QOZ designations will have expired. Any investment in an opportunity zone must be exited prior to January 1, 2048, subject to additional legislation.
Types of Investments Made Through a QOF and How the Program Works
Once a QOF is formed, it can invest in any type of real property (for example, single family residences, mixed-use, industrial) and any type of business with limited exceptions. Properties used for certain types of businesses are excluded from the tax advantage. These include any private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store where the principal business involves the sale of alcoholic beverages for consumption off premises.
According to the Act, the QOF must invest at least 90% of its assets in “property” located in a designated QOZ. “Property” is specifically defined in the Act as stock, partnership interests or real property. The “property” must be purchased after December, 2018 for cash. QOF will be able to choose the first month in which they are treated as a QOF. A minimum of 90% of the assets of a QOF must be in QOZ “property”, as measured as of the end of the sixth and twelfth month of the QOF’s taxable year, with interest-like penalties imposed to the extent that the foregoing test is not satisfied. A QOF must value its assets for purposes of the 90% asset test using values reported on the QOF’s audited or filed financial statements (or using the cost of the assets if it does not have them). Though QOZ designations expire at the end of 2028, taxpayers may continue to hold QOF interests invested in those zones and still may step up the basis of their QOZ investments to fair market value if they hold those investments for a 10 year period.
The new law appeared to require QOFs to invest their capital within 6 months of raising it. However, most QOFs need more than 6 months to attract investors, evaluate investment opportunities, and deploy capital in a smart, productive way. The IRS issued a regulation proposing a “working capital safe harbor,” which allows a QOF a minimum of 31 months to invest their working capital in QOF “property.” This longer time period aligns better with the practical realities of real estate investment.
As an alternative to investing directly in real property, the QOF may also invest in an entity that operates a business as long as that business meets the requirements of a “qualified opportunity zone business” as set forth in the Act. Among other requirements, a “qualified opportunity zone business” must have at least 70% of the tangible property owned or leased by its trade or business in a QOZ (which ultimately means the entity can have an unlimited amount of intangible property in its business no matter where it is located). An interest in a “qualified opportunity zone business” entity that is held by a QOF is treated as “property” for purposes of the 90% asset test that applies to QOF.
The Act delineates that tangible property acquired after December 31, 2017 must first be used within the QOZ after acquisition by the QOF, or must be “substantially improved” by the QOF after acquisition. A property is “substantially improved” if, during any 30-month period after the date of acquisition of such property, the QOF invests sufficient capital to double the original adjusted basis of the property. IRS regulations and an accompanying revenue ruling clarify that the QOF is not required to substantially improve the land on which the structure is located (nor substantially improve the structure itself) to satisfy the “substantial improvement” test. This clarification is a major boost to the rehabilitation of real estate properties in many urban QOZ where the value of the land may greatly exceed the value of the improvements.
Using Leverage in the QOF
The proposed IRS regulations confirm that the deemed contributions of cash that arise when the QOF itself incurs debt does not create a separate, taxable interest in the QOF. This favorable result occurs even though the deemed contributions of cash do not represent a contribution of deferred gain. The rule should allow QOFs to mobilize even greater amounts of capital for productive and beneficial investment.
The proposed regulations also clarify that an investment in the QOF must be equity (not debt), including preferred stock or a partnership interest with special allocation. The tax payment may use borrowed funds to make an equity investment in a QOF and the status as an eligible interest in a QOF is not impaired by the taxpayer’s use of the interest as collateral for a loan, whether it is a purchase-month loan or otherwise. If the QOF is a partnership, investors may elect to defer part or all of a capital gain, and that deferred gain will not be included in the distributive shares of the partners.
New White House Council Supports the Opportunity Zone Program
The Act was not the end to the wave of momentum for revitalization of distressed economic communities. On December 12, 2018, President Donald Trump signed an executive order establishing the White House Opportunity and Revitalization Council (the “Council”), a program that encourages both public and private investment in QOZs and other economically distressed areas. The HUD Secretary will chair the Council, which will be comprised of representatives from the White House and at least 16 federal agencies or executive departments. It will assess opportunities and recommend policies for federal agencies to prioritize economically distressed communities and minimize regulatory burden on investment in these communities. The Council will submit its initial findings to the President in mid-March 2019. One hundred twenty days later, it will present the President with recommended legislative, regulatory and policy changes to promote investment in urban and economically distressed communities. Within a year, the Council will present recommended legislative, regulatory and policy changes to assist state, local and tribal governments with accessing federal resources to use in economically distressed communities.
Using the Opportunity Zone Program To Aid Federally Declared Disaster Areas
In the House of Representatives, at the end of 2018, Representative Mark Meadows introduced the Disaster Recovery and Opportunity Act, which would allow governors to designate up to 5% of federally declared disaster areas as QOZs in order to aid recovery efforts.
In the Senate, a bi-partisan group of Senators from the States of California, Florida and North Carolina introduced a bill to designate Hurricane Florence, Hurricane Michael and California wildfire disaster areas as QOZs.
What This Means for the 2019 Investor
Although the Act was passed, it left a number of ambiguities many of which were later clarified by the IRS when it issued regulations on October 19, 2018. These proposed regulations are in draft form and are subject to public comment and possible amendment. On January 7, the IRS announced the cancellation of a public hearing on the proposed regulations due to the ongoing government shutdown. Although the regulations are in proposed form, the Department of Treasury indicated that taxpayers can rely on most elements of the regulations for now, provided they rely on those provisions in their entirety.
Although further regulations are anticipated, a number of funds have been formed, which hope to take maximum advantage of the tax incentives. Novogradac & Company LLC maintains a listing of the funds that have chosen to be listed publicly. The listings show the broad array of fund size, investment type (operating business or real estate product type) and geographic focus. The company explicitly states that the funds listed are based solely on information provided by the company to Novogradac & Company, and therefore may be inaccurate or out of date.
Although there has been tremendous investor interest, an investor is well advised to look at the fundamentals of the investment and the operator’s track record to determine if the investment stands on its own. In the case of real property development, knowledge of the entitlement process and relationships with local government officials can be critical. In the case of a business, operating a successful business in an economically disadvantaged community can be very different from operating a business elsewhere.
For investors who currently own real property or qualified “property” (as defined in the Act) in a QOZ, those investors may already be reaping the benefits from the Act in the form of higher valuations.
The number of QOF formed to date reflects the pressure this year to move quickly because the gain that is rolled into a QOF is only deferred until the end of 2026–meaning the equity investment must be made by the end of 2019 in order to get the full 15% tax basis step-up that comes from investing in an QOP for 7 years. Given this time frame, 2019 is extremely critical for investors looking to maximize their tax benefits under this Opportunity Zone program.