Opportunity zone rules aim to spur further business and real estate investment
The proposed regulations on opportunity zones issued by the Internal Revenue Service and the Treasury Department last week could unlock greater real estate investment in low-income communities and give business investors a chance to reap tremendous profits with their taxes deferred for years into the future. The impact on communities around the country could be far-reaching, driving up property values but also potentially making places to live less affordable.
The qualified opportunity zones are part of the Tax Cuts and Jobs Act of 2017, but they also build on tax breaks for what used to be referred to as “empowerment zones.” The proposed regulations issued last week permit the deferral of all or part of a gain invested in a Qualified Opportunity Fund, or QO Fund, that would otherwise be includible in income (see IRS issues guidance on opportunity zone investments and Trump’s opportunity zone rules deliver on investors’ wish list). The gain is deferred until the investment is sold or exchanged or Dec. 31, 2026, whichever date comes earlier. If the investment is held for at least 10 years, investors may be able to permanently exclude the gain from the sale or exchange of an investment in a QO Fund. The new guidance also makes it easier for opportunity zone funds to ensure compliance with the requirement that a fund has 90 percent of its assets invested in opportunity zones and expands the working capital safe harbors. The proposed regulations also provide clarity on treatment of gains on long-term investments, ownership and operation of the business, and what constitutes “qualified opportunity zone business property.”
“I really think that it addresses some more of those gating items that have maybe been holding up investors from really investing, or the market from taking off,” said Joseph Bredehoft, a partner in the St. Louis office of the law firm Husch Blackwell. “Some of those are the 50 percent gross income requirement. Some of the items around vacant land and land use, reinvestment, allowing lease property to qualify as qualified opportunity zone property, and then allowing a qualified opportunity fund more of a ramp-up period to invest its capital without violating the 90 percent requirement, which is especially helpful when a fund is being capitalized in the latter part of the year. It gives a little bit more of a runway for the fund to be able to deploy its capital in a qualified opportunity zone property.”
He believes the proposed regulations will make it more attractive for investors to get into these kinds of deals. “It provides more clarity in what investors can and cannot do, and what the investments need to look like in order to comply with the statute and the investors to receive tax benefits,” said Bredehoft. “Is everything settled 100 percent? No. But, I think some of those real gating items have been addressed, and now investors are going to have the information they need to make that decision, whether this is the type of investment that’s going to work for them or not.”
There may be some changes before the proposed regulations are finalized. “I definitely feel that this set of regulations was certainly responsive to concerns raised and comment letters issued,” said Bredehoft. “I know that the last hearing was certainly very well attended, and there were a lot of good points raised there. It’s hard for me to say whether there’s going to be many changes or not, but I definitely think that the IRS and the Department of the Treasury want to come up with a program that is flexible and that is attractive to investors. You can tell they really want to be able to make this a program an incentive that drives investment to low-income communities and really works.”
David G. Shapiro, a partner at the law firm Saul Ewing Arnstein & Lehr in Philadelphia, has been advising clients about the new opportunity zone provisions of the Tax Cuts and Jobs Act. He doesn’t expect to see many changes in the final regulations. “As adopted, the law is a grand experiment in tax incentives,” he said during a press conference Monday. “There aren’t certification or qualification requirements of the sort that we’ve seen with a lot of past incentive programs. There was a first round of regulations that came out a while back in 2018 that answered many questions and facilitated many real estate structures, but didn’t address some core items. The new proposed regulations released last Wednesday answer many questions and they’re generally taxpayer favorable. Treasury has indicated they don’t anticipate releasing another full set of regulations. I expect them to finalize the existing regulations with tweaks based on some commentary and then to issue more focused guidance such as notices or revenue rulings or revenue procedures dealing with specific issues that may affect a particular sub-issue or industry.”
Shapiro sees many benefits in the opportunity zone incentives. “The first thing is that somebody who invests in what’s called a qualified opportunity fund can defer rolled over capital gains,” he explained. “If I have, say, a million dollars of capital gains from selling Apple stock and I take that million dollars and invest it in an opportunity fund, if I then hold that investment through 2026, that million dollars of gain gets deferred until December 31 of 2026, which means I’d pick up that income and report it in my 2026 tax return, not this year. The second thing is that if an investor holds the investment for at least seven years, the deferred capital gains actually get reduced by 15 percent, so instead of paying tax on a million dollars of gain, I would only pay tax on $850,000. Third, an investor who holds for only five years, but not the full seven by the gain recognition would have a 10 percent reduction, but still that’s a significant reduction in capital gains.”
The break on capital gains taxes is especially attractive. ”The really big piece that I think a lot of investors are focused on is not just this deferral, but the elimination of capital gains on appreciation,” said Shapiro. “Let’s say I have a million dollars invested in an opportunity fund and the value of that fund appreciates if I hold it for more than a decade. It appreciates to say $6 million, so I have $5 million of gain. But when I sell my fund investment, I would not be taxed on that $5 million of gain. I’d only have paid tax on the million dollars that I rolled over into the fund, and that’s in 2026.”
He believes that not only real estate investors will be able to benefit from the tax break, but also other types of businesses. “Everyone has looked at it as a real estate focused play until now and a real estate benefit,” said Shapiro. “But in the long term, if you think about what your goal is, for sustained economic development, you need not just real estate, but a lot of operating businesses, and this is an incentive to locate an operating business in an opportunity zone.”
Venture capital funds may be able to benefit as well. “To attract investments, one of the things you look at is how do you do it,” said Shapiro. “Do you do it on a micro scale or on a large scale? Real estate projects are often at a size where you can have a single fund that invests in a single real estate project. That tends not to work so well from an operating business perspective. Venture investors like to invest in many, many dozens of companies. The way the law was written, it was not clear that if a fund holds an investment in an operating company that otherwise satisfies the opportunity zones business rules and then sells that investment, it was not clear that the investors in the fund would be able to get the exclusion from gain or whether the entirety of the investment had to be sold at once. The biggest change in these proposed rules is to say that if a fund sells something in which it has invested, and it’s a qualified opportunity zone business, more than the 10-year hold out, then the investor can elect to exclude the gain from that particular sale in the same way that the investor could exclude gains from sale of the fund. This really opens the door to venture fund type investment, which opens the door to funding operating businesses.”
The latest set of proposed regulations makes it easier for operating businesses and startup companies to get involved in opportunity zones. “One of the key requirements for an opportunity zone business to qualify as a good investment eligible for all the benefits here is that half of its gross income must be derived from business activities in an opportunity zone,” said Shapiro. “No one was really sure what that meant, especially in the context of a pre-revenue startup. Also, if you’ve got sales around the world, it’s not clear whether the sales would be taxed where the customer is or taxed where your employees are and how you would allocate. The regulations address this by providing three really important safe harbors that make it workable. The first two are based on employees or independent contractors working for the company. Either half of the hours they work collectively are worked in an opportunity zone, or half of the compensation paid to them is for services performed in an opportunity zone, so that’s a relatively easy one because you know where your headcount is and you can set up your facility in an opportunity zone. There are still other tests you have to satisfy in terms of your tangible property based in the zone, but this was a really big one and no one was quite sure how it would work.”
The proposed regulations also clarify the requirements for tangible property. “There’s a third test that’s a little more complicated,” said Shapiro. “The tangible property of the business located in an opportunity zone and the management or operational functions performed in the opportunity zone are each necessary for the generation of at least half of the gross income of the trade or business. That’s still better than where things were before these regulations, but I suspect in practice that one’s going to be harder to apply, and that’s one you fall back on if you can’t satisfy either hours or compensation. My strong suspicion is that startup businesses are going to be very focused on where the workforce is located and it might put some limits on telecommuting in those contexts. There’s also still the ability to rely on general facts and circumstances if there’s an audit, where you can prove that really half your income is generated from within a zone by whatever means you would want to test, but people like having safe harbors and certainty.”
The proposed regulations also help businesses from a leasing perspective. “One of the general requirements for a business to qualify is that 70 percent of its tangible property be acquired originally by purchase and be located in an opportunity zone,” said Shapiro. “What the regulations did is they said that leased property is OK, and a lot of businesses favor leasing over purchase for all kinds of reasons. So that’s another big, important change that now we know that we can qualify leased property so a startup business that may not be able to afford significant capital expenditures and is leasing the stuff it needs. That can work.”
The proposed regulations also clarify the rules for working capital at operating businesses. “What the new regulations do is they say that if you’re an operating business, cash held for use in the business in the zone, to cover payroll and other business expenses like that, also counts as working capital,” said Shapiro. “All of these things put together answer a lot of the open questions that we had about how the rules could work for operating businesses and provide enough clarity that I think this is really going to be very important, and it will be very attractive for investors too. If you think about real estate vs. operating businesses, operating businesses have a much bigger upside, so the potential incentive draw of a tax-free return is greater to invest in non-real estate potentially than to real estate investors. Also, for real estate, there are other tools to defer gains and limit tax liabilities such as like-kind exchanges. This is really the only tool that people investing in operating businesses have to exclude gains from tax, and the tool is now primed to work. As I see it, these rules could lead to a very significant wave of investment. When I’m advising startup clients, I’m talking to them now about how are you going to structure your business to be able to attract this potential capital.”
Ronald Fieldstone, a partner at the law firm Saul Ewing Arnstein & Lehr in Miami, is particularly focused on the advantages for real estate investors. “The best thing the new regulations did was to answer the key question of whether you could own multiple assets in an OZ fund, because based upon the prior regulations, the only way to exit your investment as an investor and get your tax-free step up in basis after 10 years was to sell your interest in the OZ fund,” he said during the same press conference. “Therefore, everyone in the industry that was structuring transactions needed to take into account having multiple assets in the same fund because if you have multiple assets, then you have to find one buyer to buy your interest in the fund to buy all your assets, which is not a very efficient situation. The regulations clarified that. They say no, you can sell your assets directly and the investors will get the step up, providing the asset is held for 10 or more years. So all of a sudden this changes the whole structure of the industry because now you can have a single OZ fund that raises money continuously until Dec. 31, 2026, which is the deadline for investing capital gains money, and every time you buy an asset, you have a 10-year hold. Once you reach the 10 years, you can sell that asset and the investors in the fund will get the step up in basis tax free, providing other requirements are met, and be able to exit that share of the investment. That was a tremendous benefit to the industry because the industry was assuming each fund had to own directly an asset only and couldn’t do multiple assets.”
Real estate investors can benefit from the way many deals are structured. “Virtually all real estate transactions are designed as two-tier structures,” said Fieldstone. “The fund is on top, which is a partnership structure or a corporate structure, and the taxpayer. Most of the funds are going to be flow-through entities like partnerships, LLCs, generally, and you have a lower-tier entity that will not be a wholly owned subsidiary. It’s very technical, but you need to have a taxpayer, so the lower tier could be owned 99 percent by the fund and 1 percent by somebody else or another entity, and that gives you a lower-tier partnership taxpayer. What that does is enable the easing of rules on the OZ assets. If you have a direct OZ investment in a property, then all of the money must be qualified OZ property. If you invest in a subsidiary entity, which is a separate taxpayer, then you have relaxing of those rules, so at the fund level, 90 percent of the money needs to be qualified OZ money, 10 percent can be used for other purposes like syndication costs, operating costs or whatever, and then when you go to the lower-tier entity, there’s a 70 percent rule that 70 percent of the property at the lower-tier entity needs to be qualified OZ property, which means that you can actually have assets that are owned outside of the OZ territory that would qualify, providing their values and costs do not exceed 30 percent. The two-tier structure allows quite a bit of flexibility in the process.”
He also pointed to some clarifications on pre-existing ownership in the proposed regulations. “When we deal with our clients as professionals, a lot of them are very excited because they find out that their asset that they own is an OZ asset,” said Fieldstone, “They say, ‘Great, I own an asset in an OZ zone.’ Well, it’s not so great if you owned it prior to 2018 because under the rules and the statute and the regulations, the asset must be acquired after 2017. You are excluded if you pre-owned the asset. But you have three options. One option is that you can lease the property to a new OZ entity. The leasing of the property is not a sale if it’s an arm’s length lease. The regulations did clarify that as long as the rents are arm’s length and if there’s an option to purchase it arm’s length so there’s no ‘disguised sale,’ then that’s a good viable situation even if you owned the asset prior to ’18. You can lease it to an affiliate party. You can own the new party. You can be the majority owner. You can develop it because the new entity is deemed a new party as opposed to the pre-existing party.”
There are other possible options as well, including the so-called 80/20 rule. “Option number 2 is what’s called the 80/20 rule,” said Fieldstone. “The 80/20 rule means I can sell my property to an OZ fund as an asset, providing I and my affiliates do not own more than 20 percent of the profits and the capital account of that fund. So if I promote it, I can’t own more than 20 percent total. An example would be, I sell the property, I make capital gains and actually take those capital gains proceeds and invest them in the fund as long as I don’t own more than 20 percent. That’s called the 80/20 affiliation rule. The government did not want you selling property to yourself, so they developed the 80/20 standard. It’s pretty extreme because some standards in tax law are 50/50, but in this case it’s 80/20 so you can only own 20 percent. The third way to get around this restriction is contributing the asset to the OZ fund. That’s OK because you don’t have an 80/20 rule and you get it into a new fund. The advantage is for OZ purposes the amount of your tax basis in the property you’re contributing is deemed to be your investment in the new OZ fund. So that means you may have owned land for 10 or 20 years. It’s got a very low tax basis. And you contributed into the fund. That gives you the ability to ignore the 80/20 because you’re no longer subject to the 80/20 rule. You didn’t make a sale. You contributed the asset in, and then you as a developer are the party who owned the land or the prior property and can make a capital gains investment in the fund. Now the disadvantage is the value of the asset contributed is not subject to capital gains depreciation and tax-free treatment, so the government doesn’t give you that benefit. It says no, you can contribute it in, and everybody else that contributes capital gains proceeds gets the benefit because you get a carryover basis in the amount of the asset you’ve contributed. So we’ve got three ways of getting a pre-owned property into an OZ fund. A lot of people aren’t aware of this, and this is extremely flexible in dealing in OZ transactions.”
There’s another wrinkle in the proposed regulations clarifying prior use restrictions. “I’ll give you an example,” said Fieldstone. “There’s a dilapidated apartment project. Pretend you’re buying at arm’s length, so there’s no 80/20 rule. You’re just buying it from a third-party seller, but there’s a pre-existing use. The apartment project has been occupied during the prior five years. If it’s vacant for over five years, there is no prior use. They exclude it from prior use. or if it’s not depreciated, which would be very unlikely. Let’s assume it’s in the middle of construction and it’s never been depreciated, that’s excluded from prior use. If you have a prior use property, when you buy the property, which all qualifies as an OZ asset, you need to meet what’s called the substantial improvement test. The substantial improvement test says that you must invest in improvements to that property or expansion of that property. Let’s assume you add more apartment units or you have a piece of land adjacent to it that was owned and you build more apartment units; you must invest an amount of money equal to the building value that was transferred. So if you buy a dilapidated apartment project, let’s assume you get an appraiser who says, ‘OK, the land is worth $5 million, and the building is worth $5 million.’ The regulations make it clear the land value is excluded in calculating substantial improvement, which means I only have to spend $5 million to improve the property to qualify as a good OZ asset. So the benefit here is that the government is really encouraging renovation of existing properties with expansion of those existing properties, and they exclude the land value because they look at land as not being relevant in capital expenditures because land is land. If you had a piece of land, there would never be a prior use test because the land is not occupied. This is only existing buildings. It’s very applicable to multi-families and to hotels. If you’re dealing with hotel projects and the hotel is run down and needs to be fixed up, there would be a substantial expenditure.”
He believes the opportunity zone program will have substantial ramifications on social policy and the impact on communities is not yet clear. Many states are getting on board, but the federal government plans to keep a close eye on how the program will be affecting low-income communities who could be priced out of all the development that’s supposed to be done for their benefit.
“When the statute was adopted and then the regs came out, there was significant criticism in the industry about the opportunity zone concept because there was no accountability for whether you were really benefiting a community and the residents of that community,” said Fieldstone. “For instance, if you’re in a gentrified area like Brooklyn, for example, or Long Island City, where Amazon was going [to set up a second headquarters], they got tremendous criticism. How could Amazon be in an OZ zone where they could invest and get tax-free appreciation. So basically I think the government started realizing because of many of the articles and commentaries that it kind of rushed it through and didn’t account for what was happening to the residents and the people in the community. So based on that, when the new regs came out last week, at the same time the Department of the Treasury issued what’s called a request for information on data collection and tracking for qualified opportunity zones.”
The Treasury said it was seeking public input to collect and track information related to investments in opportunity zones to measure the effectiveness of the policy in achieving the program’s stated goals of benefiting communities while at the same time making the investment attractive.
“These are the types of things we think are very relevant and they should be tracked,” said Fieldstone. “The government is now forcing a tracking system that’s going to do that, which is good, and these are the things that we think are very relevant in OZ investments. One, job creation. Is a development in an OZ going to create jobs? Is it going to create affordable housing? Is it displacing residents? Are they getting increased services for a lower-income population, including transportation, health care, food, education? Are they going to engage local residents to see what they say about what’s going to happen to their community? Are the OZ projects going to take advantage of community grant programs, which exist all over the country? Local and state programs to encourage development in these zones that used to be called empowerment zones. The goal here of the government proclamation is to assist in monitoring this. What’s happened is states have caught on. You have 16 states and the territory of Puerto Rico that have either proposed or adopted OZ laws that are going to try to provide local incentives if you develop in OZ zones, providing that you do something that they deem relevant. This includes Florida, Ohio, Maryland, Oklahoma, Louisiana, West Virginia, Rhode Island, Arkansas, Vermont, California, Washington, Texas, Kentucky, Nebraska, Mississippi, South Carolina and Puerto Rico as well. Maryland just passed a very comprehensive law. The governor was all over this, and they’re granting over $50 million in incentives for OZ projects because of how valuable that is to the community.”