Opportunity zones facing some headwinds despite new rules
The Internal Revenue Service issued final regulations last week on opportunity zone funds, but while they answer some of the questions, many other issues remain that are likely to prompt questions from tax clients.
Opportunity zones were introduced as part of the Tax Cuts and Jobs Act, providing tax breaks for real estate investors and businesses who invest in economically distressed communities. They allow investors to defer their capital gains taxes for years, and perhaps even indefinitely. However, many of the projects that have launched so far have attracted criticism for being in areas that were already gentrifying and attracting investment. The new rules provide some clarity about the tax breaks and tax penalties and how much funding needs to be provided (see Opportunity zone requirements finalized).
However, some in Congress would like to see more detailed reporting by opportunity zone investors. Sen. Ron Wyden, D-Ore., recently introduced the Qualified Opportunity Zone Reporting and Reform Act, which would require public disclosure of the reporting and could potentially affect which census tracts and businesses are eligible for the tax break (see Democrats probe opportunity zone abuses with investigation, GAO report and legislation).
Joseph Wutz, a principal in The Bonadio Group’s tax department, has been speaking at seminars and conferences about opportunity zones and the potential challenges. He was cautious about the prospects for Wyden’s legislation being passed in Congress.
“It takes a lot for any legislation to go through the whole process and get signed into law,” he told Accounting Today before the regulations were finalized. “If anything comes out of this, I think it’s going to be the reporting requirements, which is something that was originally intended to be in the original legislation for the opportunity zone incentives. What this would do is it would bring some accountability and measurability to the opportunity zone incentives. Any time you set a goal, you want it to be something that you can measure. The goal with this incentive is to revitalize and inject capital into economically distressed areas. We need some metrics in order to be able to look at this five, 10, 15, however many years down the road and say whether this is successful, or are certain census tracts getting more attention than others. How can we steer funds into census tracts that need revitalization more than others? I know that the designation of some of those tracts has come under scrutiny of late.”
He noted that some of the reporting requirements in Wyden’s legislation were part of the original text in the initial opportunity zone provisions that ended up being dropped before the Tax Cuts and Jobs Act was passed in late 2017. “The intent is there shouldn’t be a huge burden on fund sponsors to produce this information, but at the same time it’s information that should be like how much opportunity zone capital is getting put into these eligible census tracts,” said Wutz. “How much of the property qualifies? The proposed legislation in Senator Wyden’s bill would extend the reporting down to qualified opportunity zone businesses, which is significant because the original text and the statute and the proposed regulations for the qualified opportunity zone only have the reporting at the qualified opportunity fund level.”
He sees advantages for both investors and businesses who get into opportunity zones early, but also urges caution. “With some careful planning, you can get a much greater tax benefit after the minimum 10-year holding period,” said Wutz. “Real estate is inherently a safer investment than an operating business. As long as your real estate is occupied and it’s cash flowing and you’re managing your expenses, you should come out in the black before depreciation expense. With an operating business, it’s a little tougher. Maybe you have employees, and you’ve got challenges relating to whatever particular industry, whether it be regulatory or industry specific, like if you’re a manufacturer. I think what we’re going to see once there’s more guidance issued is more things happening with operating businesses being set up in qualified opportunity zones. That’s what practitioners should be discussing with their clients, if they’re either located in an opportunity zone or they could be located in a qualified opportunity zone.”
He is already seeing interest from some of Bonadio’s clients. “It’s been primarily the real estate developers, those in the construction industry,” said Wutz. “I’m starting to see more of an uptick in interest from operating businesses. More of the interest that I’ve seen locally here has been with what I’ll call private OZ deals. That’s where you’ve got somebody who has either sold their business or a division of their business and they have a capital gain from that, so they’re able to invest in a qualified opportunity fund with that capital gain, but they want to maintain control over that particular investment., so maybe they start a business in an opportunity zone and deploy that gain into that zone. If they invest in someone else’s business, you’re making a long-term bet on the fund’s sponsor. And 10 years is a long time and you’re relying on that sponsor to be getting the right advice, to be managing the funds properly at all stages, from the inception of the funds to operating the project and then finally after a minimum of 10 years structuring and managing the exit because that’s where the biggest benefit is to be had, when you exit. So any kind of slip-up at the exit could have a smaller tax-free gain at the end.”
The 10-year holding period can be more of a long-term investment that many clients might prefer. “Ten years is longer than a lot of real estate projects are held, so that can start to get a little uncomfortable for real estate investors after, say, year 5,” said Wutz. “Especially if you’ve done a cost segregation study, a lot of your depreciation is starting to burn off. If you did a cost segregation study, you’ve front-loaded a lot of that depreciation, and allocating some of your costs to five-year property as opposed to property that would otherwise have to be depreciated over 27 and a half years or 39 years, depending on what type of property it is.”
Investors may want to wait before doing cost segregation. “Maybe that’s not something you would do right away, because with a qualified opportunity zone investment your initial basis is zero,” said Wutz. “If you’re a partnership, you can have a basis in qualified nonrecourse liabilities. But otherwise, there are a few things that go into whether or not you will be able to actually take losses for the first few years, where you still have your capital gain that’s deferred, and you don’t get your basis steps up until year 5 and year 7, if you make your investment by December 31 of this year, which is rapidly approaching.”
Bill Smith, managing director of CBIZ MHM’s National Tax Office, has also been hearing from clients asking about opportunity zones as the December 31 date approaches for getting the maximum tax benefit. “Part of the benefits of qualified opportunity zones are going away if you don’t invest by December 31,” he said. “We get a lot of questions about them, but not much work. I think where we might end up getting work is getting involved in tracking the asset test. There’s an asset test once you have your QOZ business operating. You have to have a certain percentage of assets that are used directly within the qualified opportunity zone, and those rules are also highly complex. We have clients who say, ‘Can you give me your spreadsheet or your tool that you use to track assets in a QOZ?’ But we don’t have one of those. They’re all brand new. It’s highly complex.”
Smith advises clients to make sure the investment is in a sound business, and not just to focus on the tax benefits. “The first thing you look at is it a good business deal, because it’s great to get tax savings, but if you lose 100 percent of your money, the tax savings didn’t really do much for you,” he said. “You need to make sure you’re investing with somebody you trust, that they know how to do the business deal and that it would be a good investment even if it weren’t a QOZ. Don’t think you’re going to recoup your money from the QOZ tax benefits. If you’ve got a good investment that’s a QOZ, it’s beautiful because you have these great tax benefits. Otherwise, if you lose all your money, you’re not going to be happy.”
Wutz is similarly cautious with his clients: “There’s got to be careful planning at every step just to make sure you’re not stepping on any landmines for other tax reasons, including the rules with qualified opportunity zone investments,” he said.
He sees some benefits, particularly for businesses that set up shop in opportunity zones. “We’re seeing them for the most part going to areas that are in need of the capital investment,” said Wutz. “We’ve seen in the headlines there are zones that may not seem like they check off the boxes of what you would expect a qualified opportunity zone to be. I think about areas that haven’t had a lot of activity for a while. An example that I tend to use is certain countries around the world that have hosted the Olympics in years past where they set up all this infrastructure and they have the Olympics, and then nothing really happens there for years after the fact. That’s another reason why I think it’s so important that operating businesses are really the ticket for sustained growth in these areas. We’re seeing a lot of residential apartments and residential space being built. That’s great, but if you can set up a business in an opportunity zone that’s going to create jobs, that will promote the self-sustaining economy within that area. It’s great to have somewhere for people to live, but people also need to have jobs.”
However, he still has some words of caution for opportunity zone investors and businesses. “Get your ducks in a row before the fact, before you even set up the fund and issue any kind of documents, especially if you’re taking on any outside investors,” said Wutz. “That’s where you need to check off all the boxes to be compliant with SEC regulations and things like that.”