Originally published November 8, 2018
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 QOZs?
Merkel: There are really two key risks related to QOZ investing from the viewpoint of the investment and business communities.
The first risk is an economic and general business risk. Not all QOZ’s are created equal and there are challenges to doing business in these areas. Ensuring that a deal makes sense on its merits before you layer on any tax incentives is prudent to making good investments. The tax benefits can make a good deal great but will never make a bad deal good.
The second risk is regulatory. While this program requires less regulatory reporting than other tax incentive programs, it is not less complex. There is a lot of misinformation in the market. It is clear that many people are relying on what they heard rather than truly reviewing and understanding all the guidance the IRS has released. This has led to significant investments that right from the start violated the regulations and are losing all the benefits of the program. In order to mitigate this risk, it is critical that you speak with a knowledgeable CPA and attorney before moving forward with any investment.
Q: Which industries besides real estate and construction are likely to benefit from QOZs?
Merkel: With the second set of proposed regulations, most industries can now qualify provided at least 70 percent of its tangible property is owned or leased and 50 percent of its gross income is earned in an opportunity zone. Thanks to the second set of proposed regulations, the 50 percent gross income test also provides safer harbors that can be relied upon which includes hours worked, amounts paid for services, or management or operational functions performed in an opportunity zone.
Many of the QOZs are located in emerging urban markets or near universities. These types of markets tend to attract startups in technology and life sciences, as well as service companies. It is important to note 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 QOZ preclude taking advantage of other real estate tax incentives?
Merkel: Many states have conformed to the federal QOZ regulations, meaning that all the federal tax benefits are the same at the state level. Some states including, Indiana, Louisiana, Rhode Island and South Carolina, to name a few, have or are working on passing regulations that would further support QOZ development by way of various local credit and incentive programs. There are a few non-conforming states, most notably California. However, most states, including California, are still debating the program and may ultimately decide to conform to the federal program.
In addition, there are many other incentive programs that can be layered on top of QOZ’s including New Market Tax Credits, Tax Increment Financing, State Credits, and Work Opportunity Credits to name a few.
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.