By now, anyone even remotely affiliated with the finance and investment industry has heard of the opportunity zone program. Created as part of the 2017 Tax Cuts and Jobs Acts, opportunity zones offer accredited investors significant tax breaks through participation in a qualified opportunity zone fund (“QOF”).
In October 2018 the IRS released the first round of regulations and proposed tax law. A public hearing on February 14, 2019 allowed stakeholder communities to provide the Treasury Department with feedback on the first round of program rules. This meeting, held at the IRS headquarters in D.C., was attended by more than 200 people, further driving home the incredible impact of opportunity zones.
It’s certainly an excellent opportunity for investors…and an exciting time to be working in finance! But this is still a young program and there are many details yet to be solidified. The first round of regulations focused largely on investors – tax benefits, potential capital gain, how and what to invest, etc. I anticipate the next round to address specific issues around fund management and compliance.
QOF Asset Reinvestment
One of the biggest issues I would like to see addressed is the current inability for fund asset turnover. As written now, assets in a QOF must be held for the full 10 years, potentially beyond peak profitability. This limits the ability to maximize returns for investors and ties capital into assets that may stop producing gains well before the end of the opportunity zone lifespan. This also limits the program’s intended impact on distressed communities.
Funds should be given the option to sell assets and reinvest the gains into other, opportunity zone qualified projects. Changing the current rules will allow companies like Caliber to build multiple new developments in a designated zone, exponentially increasing the potential for positive economic rejuvenation.
Under the current regulations, 70 percent of assets in a Qualified Opportunity Zone Business, which is a partnership or corporation that a QOF may invest in as a qualified asset, must be qualified opportunity zone assets. While this is more generous than the 90 percent of assets rule if the QOF owns the investment directly, it still poses a challenge in areas with high-valued land leases.
For example, if Caliber is developing a new apartment complex and the building itself will cost $6 million and another $4 million represents the value of the land lease, the project would not qualify, as the land lease is not qualified property because it is an intangible asset.
To get around this issue, Treasury could allow that projects be evaluated on tax basis, essentially excluding the project’s land lease value from the calculation as it would have no tax basis. As far as the asset tests are concerned, this $10 million project would then be a $6 million project, but it would be 100 percent in compliance with QOF regulations.
The current regulations make sense for real estate developments and stationary enterprises such as restaurants and retail, but exclude many service-type businesses. Requiring a company to generate 50 percent or more of its income in an opportunity zone severely limits the potential growth for these communities.
Think of tech companies or software as a service providers. While the headquarters may be firmly planted within an opportunity zone – providing job opportunities and the potential for improved infrastructure and increased area property values – its clients and subscribers can be located anywhere. This also presents a tracking issue. How will revenue dollars be reported in terms of zip codes and designated opportunity zones?
Maintaining the 50 percent gross income rule is contrary to the spirit of the law, limiting the amount and type of economic development spurred by opportunity zones.
Active Trade or Business
To meet opportunity zone qualifications, an asset must be an active trade or business. This can cause issues for many real estate investment companies that structure agreements with triple net leases.
Under a triple net lease, the tenant takes on all responsibility for a property including financial obligations such as paying real estate taxes, building insurance, and maintenance fees. From a tax standpoint this is not an active trade or business and, therefore, would not meet opportunity zone qualifications.
Again, this rule limits the type of development that can be brought into opportunity zone communities.
The Treasury Department is expected to release the next round of regulations this spring. It’s my hope, and expectation, that the updated rules will address many of these issues in a way that will maximize potential capital gain for investors and make the largest impact on underserved communities.