The Opportunity Zone program was signed into law as part of the 2017 Tax Cuts and Jobs Act with the goal of spurring investment in underserved communities – and it has certainly attracted investors’ interest. When reinvested in an OZ, capital gains may be eligible for preferential tax treatment, with the possibility of eliminating tax on gains altogether on the sale of an OZ investment held for at least 10 years. To date, a reported 308 OZ funds have raised a cumulative $7.5 billion in equity, a testament to the program’s popularity.
Investors are still reviewing the 500-plus page Opportunity Zone (OZ) regulations published by the Treasury Department and IRS in late December. The final rule is the product of two sets of proposed regulations and feedback received from the public. The process started in October 2018 and is intended to answer a number of remaining questions about investing in OZs.
The relevant OZ statutory language outlines a very detailed process for making these investments. It includes numerous deadlines and criteria that must be met in order to take advantage of any tax benefits. But many have argued that the language was too vague to be interpreted consistently, and called on regulators to clarify key parts of the statute. In this respect, the final rule largely delivers, though additional issues will almost certainly crop up.
While certainly not exhaustive, here are some highlights of the key clarifications and changes made by the latest OZ regulations.
90 Percent Rule
The vehicle for investing in an OZ is a Qualified Opportunity Fund (QOF), which is in turn required to hold at least 90 percent of its assets in Qualified Opportunity Zone Business Property.
The new regulations provide guidance on how to measure assets for the purpose of this test. Most notably, they clarify that a QOF can exclude cash contributions from new investors received up to six months prior to conducting the test. This allows a QOF to still “pass” the test, even if it received a large investment that has not yet been deployed.
Working Capital Safe Harbor
Another aspect of the 90-percent rule is a safe harbor provision, which gives QOFs investing in tangible business property up to 31 months to deploy cash holdings before the rule is triggered. The idea is to give investors sufficient time to plan for the acquisition, rehabilitation, or construction of real property in an OZ, and not be penalized just because the capital wasn’t immediately deployed. The final rules stretch this period even further in certain circumstances, for example, in the case of delays stemming from a federally-declared disaster.
In order to be eligible under OZ rules, tangible property previously used in an OZ must be “substantially improved” through improvements that at least double the tax basis of each property. This prevents investors from simply buying an existing property and reaping the tax benefits without injecting additional capital into the community. One major change in the final regulations allows, under certain circumstances, the treatment of a group of buildings as a single property, with the cumulative basis and improvements pooled for purposes of the substantial improvement test.
For example, a QOF that buys a 4-building office park, where one of the four buildings is brand new, would not need to make improvements to each building in the amount of its individual basis, as long as all applicable criteria are met. Instead, the aggregate basis of the four properties would serve as the benchmark, and capital improvements could be directed only toward the properties that actually need them.
A big perk of investing in OZs is the ability to defer tax on eligible gains. Among the clarifications made by the final regulations on what, exactly, this term entails, there is an important change to how gains from the sale of depreciable property held for more than a year (known as Section 1231 assets) can be rolled into a QOF. Because of how Section 1231 gains and losses are netted, earlier regulatory proposals called for potential OZ investors to wait until the end of the tax year before investing these gains into a fund. The new rules instead allow for 1231 gains to be contributed to a QOF immediately, helping taxpayers who realize such gains early in the year.
The final regulations reaffirm the types of businesses (such as golf courses, spa and massage parlors, and gambling establishments) excluded from the OZ program, but also clarify that a de minimus amount (set at 5 percent of total gross income) of so-called “sin business” activity will not invalidate an otherwise eligible business. Interestingly, cannabis is not explicitly listed as a prohibited activity, but with marijuana still deemed illegal at the federal level according to the Weed News marijuana legalization map, investors appear to be holding off on directing funds towards these types of OZ businesses.
One of the common complaints in letters submitted to Treasury and the IRS during the rulemaking process centered on the exclusion of property rented on a “triple-net basis” from the definition of Qualified Opportunity Zone Business Property. In the eyes of the IRS, this arrangement – in which tenants are responsible for the bulk of occupancy costs – is an investment, rather than a trade or business, hence the exclusion.
The final rule better defines triple-net leases, and opens the door slightly when it comes to their use. A building with multiple tenants, only one of which is triple-net, is not necessarily disqualified. That said, unlike the rules surrounding “sin business” activity, there was no de minimus threshold specified, making this one of the vaguer sections of the final rule. Investors will likely avoid triple-net leases in OZ properties, or at least hold off on signing them until further guidance is issued.
This is a brief glimpse at portions of the new OZ regulations that seem relevant to NAIOP members, and is by no means exhaustive. Given the inherent complexity of the program, it’s all but certain that we will see additional regulatory guidance, private letter rulings, and even legislation to clarify or amend the existing law.
Opportunity Zones have tremendous potential to benefit both investors and underserved communities across the country, a key reason that NAIOP supported the provision as part of the 2017 Tax Cuts and Jobs Act. Individuals or businesses interested in taking advantage of the OZ program – particularly those anticipating generating a capital gain in the near future – should speak with their account or tax advisor about structuring their investment.