What Should Businesses Know About Qualified Opportunity Zones?

The Tax Cuts and Jobs Act (TCJA) passed last December to overhaul the federal tax code has had a significant impact on the real estate industry. The new law provided tax breaks, but lacked guidance from the IRS, which is hindering some tax planning.

Yet amidst these changes, a significant program has been established designed to spur economic activity — and incentivize investors — in areas most in need.

The TCJA includes a new Economic Opportunity Zones (EOZ) program, which expands businesses’ ability to utilize a portion of the estimated $2.3 trillion of unrealized capital gains. If utilized effectively, this EOZ program could return far-reaching benefits to capital flows and incentivize increased activity for the real estate industry.

While everyone is still waiting for further regulations, stakeholders across the real estate industry and beyond are moving to seize the opportunities presented by this program.

The EOZ program is conceptually dissimilar to previous economic incentive programs such as the Empire Zones Program, Low Income Housing, and New Markets tax credits. This new program has fewer limitations, making it a viable option for a greater amount of investors.

As part of the EOZ program, the IRS has designated more than 8,000 low-income communities (including more than 300 in New York City) as Qualified Opportunity Zones (QOZ). Funds are investment vehicles that can be set up as a partnership for investing in eligible property that is located in the QOZ.

Investors can defer taxes on capital gains — which would otherwise face a maximum federal tax rate of anywhere between 20 and 37 percent plus 3.8 percent surtax — by investing long-term in these funds, which invest back into low-income communities by developing or re-developing properties within the community.

The proposed regulations recently released clarify that individuals, corporations, regulated investment companies, REITs, partnerships and other pass through entities can make an election to defer capital gains. The regulations also clarified that a partner in a partnership can elect to defer a capital gain if the partnership did not make an election to defer.

Owners and developers that have already or will acquire property in QOZs after December 31, 2017 can establish Qualified Opportunity Funds (QOF) to raise financing from incentivized investors for their projects. To become a QOF, an eligible taxpayer self certifies. No approval or action by the IRS is required. To self-certify, a taxpayer that meets certain requirements merely completes a form that is soon to be released and attaches that form to their federal income tax return for the taxable year.

The benefits of an investment in a QOF are as follows: If, for example, an investor holds the gain — rolled over into the QOF — for at least five years, the basis of such investment will be increased by 10 percent of the amount of the gain deferred. If the taxpayer then holds that investment for at least seven years, the basis is increased by an additional 5 percent of the gain deferred, therefore the investor will pay tax on only 85 percent of the original gain. The tax on the gain would be due in 2026, unless accelerated due to a sale of the QOF investment. If that investment is then held for a period of at least 10 years, the basis of the investment in the fund can be stepped-up to the fair market value on the date of disposal, thus making all the appreciation on the new investment tax-free.

Unlike 1031 exchanges, which require the entire proceeds from the sale of the original property to be reinvested into a new property within 180 days to defer the tax on a gain and requires that within 45 days exchange properties must be identified, the EOZ program requires only the amount of the gain to roll into a fund, within 180 days of a sale. Since only putting in the gain proceeds is necessary, the investor does not have to put in all the proceeds. An investor can take out their original investment.

The new law also places far less restrictions on the type of gain eligible for deferment. It only requires that the capital gain stem from a sale or exchange to an unrelated person. Real estate, personal property, intangibles assets, stocks, and virtually any other capital asset should qualify. In contrast, under the new tax law, eligibility for 1031 exchange treatment is now restricted to gains from the sale of real property only.

Finally, while not participating in the program as investors or establishing funds, brokerage and construction professionals that operate in these zones will likely see increased activity. With investors incentivized to invest in funds to defer gains, developers will likely seek to acquire land and assets, set up funds and build and renovate in these areas in greater frequency than before the law was passed.

While the EOZ program presents significant opportunities for real estate businesses and other business in QOZs, it should be reiterated that the primary focus of this legislation is to spur overall economic activity, and in turn improve quality of life for individuals in these zones. Crafters of this legislation have put forward a creative path to realize this admirable goal, and as the program matures, we expect to see more outside stakeholders bring investment to these communities.

Click here for the recording of our January 10th webinar on the new Opportunity Zone Funds.