Primer on Opportunity Zones and Qualified Opportunity Funds: Eligibility Requirements and Tax ConsiderationsAugust 2, 2018
By offering investors the opportunity to defer the recognition of capital gains and realize a stepped-up basis in investments made in a Qualified Opportunity Fund (“QOF”), Opportunity Zones, created by Congress as part of the Tax Cuts and Jobs Act of 2017 (“TCJA”), provide a means for real estate developers and businesses to attract capital that typically has not been interested in economically-distressed areas. The Treasury Department’s recent finalization of designated Opportunity Zones in certain low-income communities and contiguous census tracts is a significant step forward in the program’s implementation. The program now presents compelling opportunities for investors to reinvest gains in low-income areas and opportunities for real estate developers and businesses in those areas to attract new capital.
Opportunity Zone Designations in New York
To spur investment in areas that historically have suffered from a lack of capital, the TCJA passed in December 2017 provided for the designation of Opportunity Zones in low-income communities as well as certain contiguous census tracts. In New York State, for example, the Empire State Development Corporation (“ESDC”) led the analysis that resulted in the nomination of 514 census tracts for designation in the state, including 306 census tracts in the five boroughs of New York City. ESDC has provided maps, and a list of the designated census tracts on its website. Additionally, the complete list of census tracts has been published by the Internal Revenue Service (“IRS”). In New York City, Opportunity Zones are located in areas such as the Rockaways in Queens, the North Shore of Staten Island, large portions of the South Bronx, Sunset Park and Red Hook in Brooklyn and Inwood in Manhattan.
Qualifying Opportunity Zone Investments
Investors need to invest in a QOF to access the program’s tax benefits. Thus, a real estate developer or business seeking to access Opportunity Zone capital either needs to establish a qualifying entity or engage an established QOF seeking out projects in which to invest. A QOF is a corporation or partnership in which at least 90 percent of the assets are in qualified Opportunity Zone property. To establish a QOF, an eligible entity needs to self-certify by completing a form that the IRS has indicated it will release later in the summer of 2018, and attaching the form to its tax return. Given this, a real estate developer seeking Opportunity Zone capital can form an entity and self-certify.
As noted above, the key test for a QOF is that at least 90 percent of its assets consist of qualified Opportunity Zone property. To ensure that it meets this asset test, the TCJA requires a QOF to invest in Qualified Opportunity Zone property, which consists of any of the following: (i) qualified Opportunity Zone stock; (ii) qualified Opportunity Zone partnership interests; and (iii) qualified Opportunity Zone business property.
Accordingly, a QOF formed by a real estate developer could hold either real estate or an interest in the real estate owning entity subject to the following limitations. For an interest in a partnership or a corporation to qualify, the interest must be acquired after 2017 from the entity, which at the time of acquisition must be a qualified Opportunity Zone business or organized to be a qualified Opportunity Zone business; and it must qualify as a qualified Opportunity Zone business during the QOF’s holding period. A qualified Opportunity Zone business is a trade or business in which: (i) substantially all of the tangible property owned or leased is located in a qualified Opportunity Zone, (ii) at least 50% of the business’s total gross income is derived from the active conduct of a qualified business within a qualified Opportunity Zone, (iii) less than 5% of the average of the aggregate unadjusted bases of the business’s property must be attributable to nonqualified financial property; and (iv) a substantial portion of the business’s intangible property must be used in the active conduct of a qualified business in a qualified Opportunity Zone.
Qualified Opportunity Zone business property is tangible property acquired by the QOF after December 31, 2017 and either the original use of such property needs to start with the QOF investment or the QOF must substantially improve the property. The TCJA defines substantial improvement as additions to the property’s basis, during any 30-month period after acquisition, at least equal to the adjusted basis at the beginning of such period. Additionally, the use of such property needs to be in a qualified Opportunity Zone for substantially all of the QOF’s holding period.
Whether a QOF is holding stock or partnership interests or property, in each case, the TCJA requires that there be an underlying business that meets the definition of a qualified Opportunity Zone business. For a business to qualify, the tangible property owned or leased by the business needs to be qualified Opportunity Zone business property (i.e., acquired after December 31, 2017 and meet the original use or substantial improvement test. In addition, the business needs to satisfy the following requirements: (i) at least 50 percent of the total gross income of the business is derived from the active conduct of such business; (ii) a substantial portion of the intangible property of such entity is used in the active conduct of any such business; and (iii) less than five percent of the average of the aggregate unadjusted bases of the property of the business is attributable to nonqualified financial property.
In addition to the above criteria for the underlying business, the TCJA specifies certain businesses as being excluded from the program. The underlying business cannot be a “private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises.” Notably, residential development is not included as a prohibited business so a qualifying project is not limited to commercial developments. It should be noted though that we expect the Treasury Department to provide more guidance with respect to matters such as qualifying businesses and properties.
Potential Tax Benefits for Opportunity Zone Investors
Investors who invest capital gains in QOFs can both defer tax on those gains and potentially exclude gains from the QOF investment. Since the program seeks to spur long-term investment in historically distressed communities, the level of an investor’s tax benefit depends on the length of the investor’s holding period for the investment.
An investor can exclude from gross income the gain on any third-party sale or exchange of property provided that such gain is reinvested in a QOF within 180 days of the sale or exchange. The investor can make this election on its tax return for the tax year in which the gain would otherwise have been recognized. Under the TCJA, the deferral period ends on the earlier of (i) the sale or exchange of the QOF investment and (ii) December 31, 2026.
An investor’s basis for its investment in a QOF increases as the holding period increases. When an investor holds its Opportunity Zone investment for five years, the basis for such investment is increased by 10 percent of the amount of gain deferred. When an investor holds its Opportunity Zone investment for seven years, the basis for such investment is increased by an additional five percent of the amount of gain deferred for an aggregate basis increase of 15 percent. Additionally, if the Opportunity Zone investment is held for at least 10 years, then the basis of the investment is stepped up to the fair market value of the investment. In this case, an investor would not pay any tax on the appreciated value of its Opportunity Zone investment. An investor would only pay tax on the 85 percent of the original gain in connection with its 2026 tax return due to the expiration of the deferral period on December 31, 2026. Since the tax benefits to an investor increase as the investor’s holding period increases, Opportunity Zones offer real estate developers and businesses the opportunity to access capital that is more likely willing to remain in the project or business for a longer period of time.
To date, in addition to finalizing the list of designated census tracts, the Treasury Department issued a set of FAQs on Opportunity Zones. The Treasury Department has indicated that it plans to publish further guidance with respect to the program’s implementation later in the summer of 2018. We will provide further updates on Opportunity Zones as information is released by the Treasury Department.