Opportunity zones: Who profits, when and how?
A Q&A with Troy Merkel, RSM US LLP
INSIGHT ARTICLE |
The rollout of new specially designated tax-saving districts slated for development across the United States was unveiled as part of the federal government’s post-recessionary $1.5 trillion tax reform package - the Tax Cuts and Jobs Act - announced in late 2017.
These so-called “opportunity zones” were set up to attract investments and stimulate economic growth in urban, suburban and rural areas where development has been stagnant. The U.S. Treasury issued proposed regulations in October to provide guidance on how the zones would operate, the types of investors permitted to participate and the types of projects that may qualify.
In anticipation of the new rules, real estate investment firms, private equity firms, Silicon Valley and others have eagerly begun to raise capital for qualified opportunity zone investment funds designed to take advantage of investments in projects targeted for these tax-saving areas. Depending on the holding period, eligible capital gains from investments in a qualified OZ fund can avoid tax on up to 15 percent of the original gain and defer tax on the remaining original gain until the earlier of the sale of the fund or the end of 2026. Moreover, gains on appreciation of property inside the fund can escape taxation entirely if the investment in the fund is held for at least 10 years. Steve Mnuchin, U.S. Treasury secretary, said in early October that he expected OZs to pull in more than $100 billion in fresh capital.
Depending on the holding period, eligible capital gains from investments in a qualified OZ fund can avoid tax on up to 15 percent of the original gain and defer tax on the remaining original gain until the earlier of the sale of the fund or the end of 2026.
The Treasury’s draft regulations are subject to a two-month public comment period; news media reported they would likely be completed by spring of 2019.
RSM’s Troy Merkel, a real estate partner located in the firm’s Boston office, provides a run-down on how OZs work and the investors and sectors that stand to benefit from their implementation.
Q: What qualifies as an OZ and who has the authority to designate an area?
Merkel: OZs are low-income census tracts, which are areas with a poverty rate of 20 percent or more and a median family income of 80 percent or less of the areas’ median income. In addition, up to 5 percent of census tracts that are contiguous to an OZ may qualify, provided the median family income does not exceed 125 percent of the median family income in the nearby OZ. The governor of each state was allowed to designate up to 25 percent of these census tracks as OZs. The governors have made their selections and all the OZs have been declared.
Q: What type of investors qualify?
Merkel: The range of investors is quite broad. It may include individuals, C corporations, real estate investment trusts, partnerships and other pass-through entities, including common trust funds. It is important to note that in order to benefit from a qualified opportunity zone investment, these investors need to have recognized recent capital gains.
Q: How does the tax-savings work? Have you assessed what hold time is the best?
Merkel: The overall concept is one of deferral and partial forgiveness of capital gains tax. In addition, there are potential benefits upon the exit of the qualified opportunity zone investment. Let’s take an investor who recently sold some stock with a basis of $50,000 for $150,000, resulting in a capital gain of $100,000, which would normally be taxed that year. That investor has 180 days to decide to invest a portion or all of the $100,000 gain in an OZ investment, either directly or through an investment vehicle like a fund. At that point, any taxes on the gain are deferred until the OZ investment is sold or until 2026. Let’s assume our investor elects to invest all of the $100,000 gain. Now if the investor were to hold onto the OZ investment for five years, the gain would be reduced by 10 percent ($90,000). If the investor holds the OZ investment for seven years, the gain is reduced an additional 5 percent ($85,000). If the investor holds the investment for 10 years, the basis of the OZ investment would be automatically adjusted to the sales prices, resulting in no taxes paid on the sale of the OZ investment. As such, the best hold time for the investment to fully realize the tax benefits is 10 years. For a real estate investor, five-, seven- and 10-year hold periods are the norm and an easy sell to investors.
Q: What type of risk is associated with these OZ districts and are there strategies to mitigate it?
Merkel: The need for a 90 percent tangible asset and the 50 percent income to come from the OZ will be easy for real estate investors to meet. The initial risk is being able to make a qualified investment and required improvements, which means a dollar-for-dollar improvement in the tangible property, in time. Fortunately, the IRS recently released guidance that will make it easier for real estate companies to meet this requirement. The IRS has stated that land is not included when calculating the basis of the tangible asset needed to be improved, thereby reducing the total cost of improvements. Furthermore, there is a safe harbor that allows for the initial investment and substantial improvement to occur over a 31-month period.
Once you have made the investment and substantial improvements required to qualify for the OZ investment benefits, the next biggest risk is helping investors with tax planning. If investments are held past 2026, there will be a tax due on the original gain (as adjusted for any reductions). There is a high likelihood that this tax payment may not be aligned when the investors receive cash from the investments. It is important that anyone investing in OZs understands that this tax is coming and has a clear plan in place to handle this tax payment, likely through a financing or operating distribution.
Q: Which industries besides real estate and construction are likely to benefit from OZs?
Merkel: Any industry that can operate with 90 percent of its tangible assets and 50 percent of its income from an OZ. Many of the OZs are located in emerging urban markets. These types of markets tend to attract startups in the technology and life sciences space, as well as service companies. It is important to note as well that your tangible assets do not need to be a building. The tangible assets could be leasehold improvements to spaces that companies often lease for five, seven or 10 years.
Q: Does investment in a designated OZ preclude taking advantage of other real estate tax incentives such as historic rehabilitation credits?
Merkel: No. There is nothing precluding an investor of taking advantage of historic, new market or low-income housing tax credits. In many cases, investors were already looking to take advantage of these traditional redevelopment-driven tax incentives, and the OZ benefits make these types of investments even more attractive. In addition to these federal tax incentives, OZ investors can look to take advantage of state and local tax credits or funding, which are often designated for the same census tracts as the OZs.
Q: How do you think investment in OZ funds compares to other asset classes such as private equity?
Merkel: A typical private equity fund has a lifespan of approximately 10 years, which will likely match the typical lifespan of an OZ fund. In addition, both funds have the benefit of liquidating and reinvesting within the fund. We are still waiting on clarity regarding how long an OZ fund has to reinvest proceeds from a sale, but the ability to recycle capital exists with both types of funds. It also should be mentioned that nothing precludes the investor from only taking the five-year deferral and 10 percent reduction of the initial gain benefit.
Ultimately, any tax benefit won’t make a bad investment good, but it can make a good investment great. If a fund, PE or other, has the opportunity to invest in a OZ, it can provide a significant increase in the returns, whether the investment is held for five or 10 years.
More on qualified opportunity zones
The proposed regulations address many concerns around qualified opportunity zones but questions remain to be addressed in further guidance.
The IRS released proposed regulations and a Revenue Ruling providing guidance on the newly created Qualified Opportunity Zones.
The Tax Cuts and Jobs Act of 2017 established opportunity zones to encourage long-term investments in low-income communities nationwide.