What investors need to know about opportunity zones

New guidance crystallizes the legislation that is likely to have a large impact on commercial real estate.

November 08, 2018

Property developers in the U.S. are eager to invest in opportunity zones, federally-designated areas where real estate can get a significant tax break. 

The opportunity zones, known as ‘OZs’, were created as part of the Tax Cuts and Jobs Act, which passed last December. Since then, sales of developable sites in OZs are up 80 percent in the first three quarters of 2018, compared to the same period last year, according to Real Capital Analytics

The pace isn’t likely to let up. Real estate funds specifically targeting OZs have also been raising billions of dollars.

“This could have a notable impact on commercial real estate,” says Lauro Ferroni, a research director at JLL. “It has the potential to increase real estate investment – and transform neighborhoods – for years to come.”

But up until recently, investors were still unclear on how to reap the capital gains tax deferral – and in some cases, forgiveness – offered by the plan. The Treasury Department’s much-anticipated temporary interim guidance, released on October 19, answered some of the most pressing questions, allowing fund managers to begin gathering money and investing.

Here are the key takeaways from the 74-page IRS document and what we know about the program so far.

Hotspots like L.A.’s Arts District are included

The position of the opportunity “zones” themselves is no longer up for debate. 

After soliciting recommendations from governors, the Treasury designated 8,700 census tracts as OZs: underdeveloped or distressed areas. 

However, because the 2010 Census was used to select the OZs, many neighborhoods that have already attracted a flurry of development over the past eight years were included. In fact, 75 percent of the OZs are within dense urban areas “many of which are ripe for this kind of growth,” says Arielle Einhorn, manager of investor research at JLL.

Those areas, including Downtown L.A.’s Arts District, are likely to be favored by developers, says Jeff Adkison, who leads one of JLL’s development and asset strategy groups in Los Angeles. 

“If you look at a map of where development has taken place in L.A. over the past eight years, and then you look at a map of the opportunity zones – they mostly overlap,” he says.

There are two ways to invest

Investments must be made through a Qualified Opportunity Fund (QOF) in order to qualify. 

The new guidance clarifies that the funds can either be used directly, to purchase or improve property, or indirectly, to acquire equity interests in partnerships or corporations, says Michael D. Haun, a partner at international law firm, Paul Hastings, in Los Angeles. 

In either scenario, QOFs can be created with the intention of purchasing a single or multiple assets. 

“It’s likely most funds will make indirect investments that are structured as real estate deals, many of which will be single-asset funds,” Haun says.

In some cases, less than 70 percent of a fund can be invested in an OZ and still qualify

The IRS guidance clarifies how much of a fund’s property needs to be in an opportunity zone. 

The original legislation dictates that a QOF is required to have 90 percent of its assets in qualified Opportunity Zone property, and that a business operated through an equity interest in a partnership or a corporation held by the QOF only qualifies if “substantially all” of its tangible property falls within an opportunity zone.  This test is performed two times per year: once at the end of the QOF’s six month taxable year and once at the end of the taxable year.

The new guidance now explains that “substantially all,” for OZ businesses, means 70 percent.

Combining the 90 percent asset requirement for opportunity funds with the 70 percent tangible property requirement for qualifying businesses could mean that an opportunity fund may only need to indirectly invest 63 percent of its assets in a zone.

“This could give developers more flexibility,” Ferroni says. “It could allow them to make other investments that help with the liquidity needed to ultimately pay the deferred gains.”

The tax break is bigger the longer a property is held

Investors holding a property for five years or less can defer taxes on gains from the sale of their original asset either until that investment is sold, or at the end of 2026. Assets held for five to seven years have their capital gains taxes reduced by 10 percent. Those held for seven to ten years reduce them by 15 percent, and properties held over 10 years have all capital gains taxes forgiven. 

This structure addresses previous criticisms that investors working in underserved markets often have a “get in and get out” mentality. 

“Using the Federal Historic Preservation Tax Incentives Program, for instance, developers might get a rebate on hard construction costs involved in revitalizing a historic building, then sell off that property two years later without a longer-term focus on the community,” says Ferroni. “With the implementation of these new OZ rules, meaningful interaction between investors and communities is by design.”

Continued investment into OZ projects is required

According to the IRS, investors are required to invest into a building at least as much capital as they acquired it for. Additional capital to improve or develop the asset must be invested during any 30-month period.

Still, more clarity is needed on the role of land value in this equation. The current guidance does not seem to include it as part of the calculation, which would lower the number investors must put into the project by a substantial amount.

The deadlines are tight

When an investor sells an appreciated asset, it has to reinvest the gains into a QOF within 180 days from the date of sale to qualify for the program’s tax benefits, if investing directly. 

A partnership, S-corporation, and possibly other pass-through entity’s 180-day period begins on the last day of the partnership’s taxable year in which the gain was realized, which allows for more flexibility, Haun says. 

All QOFs have until Dec. 31, 2019 to close on property within the OZ if they intend to take full advantage of capital gains deferments. That’s when the chance to receive the full benefit of the seven-year, 15 percent capital gains tax deferment expires.

More clarity is coming

The Treasury is expected to release more guidance soon on issues that were not addressed in this first release. 

This second round of guidance should further clarify the meaning of “substantially all” when it comes to real estate, beyond the 70 percent rule for QOZ businesses in the current guidance. 

It is also expected to clarify the “reasonable period” for a QOF to reinvest proceeds from the sale of qualifying assets without paying a penalty; administrative rules when a QOF fails to maintain the required 90 percent investment standard; and information reporting requirements, Haun says.

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