For many years, the government has implemented tax deferral provisions in the U.S. tax code in order to encourage taxpayer behavior. For the ordinary taxpayer, tax deferral opportunities include contributions made to employer-sponsored 401(k) and other qualified retirement plans; for real estate investors, tax deferral possibilities are available via IRC §1031 exchanges of certain types of appreciated property. However, rarely does the government offer tax elimination as an additional inducement. On Dec. 22, 2017, the Tax Cuts and Jobs Act of 2017 did just that, introducing IRC §1400Z (the opportunity zone provisions) which serves as an incentive for taxpayer investment in low-income neighborhoods by combining the benefits of both tax deferral and tax elimination.
In furtherance thereof, on Oct. 19, 2018, the U.S. Treasury released highly anticipated Proposed Regulations and Revenue Ruling 2018-29, which address certain issues associated with acquisitions of real property located in qualified opportunity zones. As a result, commercial mortgage lenders should see an increase in loan applications related to properties located in low-income areas as investors endeavor to take advantage of these tax benefits.
Under the opportunity zone provisions taxpayers investing capital gains in a “qualified opportunity fund” (QOF) within 180 days of realization receive three benefits; (1) tax deferral on the initial capital gain invested in the QOF, (2) potential basis step-up in the initial capital gain invested, and (3) tax elimination on the QOF investment appreciation.
Tax on the initial capital gain invested is deferred until the earlier of (1) the date that the QOF investment is sold and (2) December 31, 2026. At the conclusion of the deferral period, the initial capital gain invested will be taxed on the lesser of (a) the amount invested and (b) the then fair market value of the investment, in each case in excess of the taxpayer’s basis thereof. The taxpayer’s basis in the initial capital gain invested is zero, but if the taxpayer has held the QOF investment for at least five years at the time of the conclusion of the deferral period, the taxpayer’s basis will be increased by 10 percent of the initial capital gain invested. If the taxpayer has held the QOF investment for at least seven years at the time of the deferral period conclusion, the basis will be increased by an additional 5 percent of the initial capital gain. In addition, any appreciation in the QOF investment is eliminated provided the investment is held for at least 10 years.
To receive these benefits, the QOF must be a corporation or partnership organized for the purpose of investing in “qualified opportunity zone property” (qualified property). Qualified property is defined as tangible property used in a trade or business of the QOF if (1) the property was purchased by the QOF after Dec. 31, 2017, (2) the original use of the property in a “qualified opportunity zone” starts with the QOF, or the QOF substantially improves the property, and (3) substantially all of the use of the property was in a “qualified opportunity zone” during substantially all of the time the QOF holds the property. A “qualified opportunity zone” is a low-income community that is designated as a qualified opportunity zone by the state in which it is located and certified by the US Treasury. Future regulations will be required to clarify what “substantially all” of the use of the property and “substantially all” of the time holding the property means.
Qualified property will be treated as substantially improved by a QOF only if during any 30-month period beginning after the date of the property’s acquisition its basis is increased by an amount exceeding its initial cost basis. In the case of real property, the Proposed Regulations and Rev. Rul. 2018-29 clarify that even though land can never be put to first use by a taxpayer, the price paid for land is excluded for purposes of determining whether substantial improvement occurs. For example, if a QOF acquires a parcel of real estate, which includes land with a value of $60,000 and a building with a value of $40,000, to substantially improve this property would require that the QOF incur $40,000 of improvement to the building.
In addition, in order for the QOF to obtain the tax benefits, at least 90 percent of the assets of the QOF must be qualified property. The Proposed Regulations provide clarity on two important rules as to when cash can be treated as qualified property. Specifically, the Proposed Regulations provide that cash held as working capital will be counted as qualified property and that cash from the proceeds of selling qualified property will qualify so long as such cash is reinvested within a reasonable period of time in another qualified property. To determine whether a QOF holds 90 percent of its assets as qualified property, the assets are valued based on valuations used in audited financial statements, or if the company does not utilize audited financials, the value of the assets is equal to its initial cost basis. A QOF failing to meet the 90 percent asset percentage test will be required to pay a penalty for each month it fails the test.
Alternatively, the QOF may elect to indirectly invest in qualified property by holding either “qualified opportunity zone stock” or “qualified opportunity zone partnership interest”. “Qualified opportunity zone stock” and “qualified opportunity zone partnership interest” is stock or an interest in a U.S. corporation or partnership, respectively. The stock or interest must be acquired by the QOF after December 31, 2017, at original issue and solely in exchange for cash. At the time the stock or interest is issued, the entity must be a “qualified opportunity zone business” (qualified business). The entity must remain a qualified business for substantially all of the time the QOF holds the stock or interest.
A qualified business is a trade or business in which substantially all of the tangible property owned or leased by the taxpayer is “qualified opportunity zone business property” (opportunity zone business property). The Proposed Regulations provide a safe harbor clarifying that if 70 percent or more of the tangible property of an entity is an opportunity zone business property,” the entity will own an adequate amount of tangible property to meet this requirement. In addition, at least 50 percent of the total qualified business’s gross income must be derived from the active conduct of such business, a “substantial portion” of the intangible property of the QOF must be used in such qualified business, and the average of the aggregate unadjusted basis of the opportunity zone business property” attributable to “nonqualified financial property” must be less than 5 percent.
In sum, a QOF can invest its funds in a qualified property through a qualified business that is a corporation or partnership, or it can invest directly into a qualified property. One advantage of investing directly in a qualified property is the ability to engage in any business, whereas qualified businesses are restricted from engaging in a specific list of activities (i.e., any 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 the premises).
Other advantages of a QOF investing directly in a qualified property include the QOF’s ability to hold up to 10 percent of the QOF’s assets in cash (versus a 5 percent—plus working capital—threshold for qualified businesses) and the absence of a minimum percentage of gross income that the QOF must derive from the qualified property (versus the requirement that a minimum of 50 percent of a qualified business’ gross income be derived from a qualified property).
On the other hand, the advantages of a QOF investing in a qualified business include the absence of a minimum percentage of QOF assets that must be invested in tangible property (versus the minimum 90 percent requirement). Thus, a qualified business can be comprised entirely of intellectual property. For example, a tech startup company located in a qualified opportunity zone could issue qualified opportunity zone stock even if the majority of its assets is comprised of intellectual property. Moreover, to the extent the qualified business owns tangible property only 70 percent of such property need be opportunity zone business properties. This flexibility on asset composition puts the qualified business investment at an advantage in many cases.
How It Works: By the Numbers
As an example, assume an investor invests $1 million of capital gain in a QOF in 2019 (a QOF investment). The deferred gain will be taxed at the earlier of (1) the date on which the taxpayer sells the QOF Investment, or (2) Dec. 31, 2026. The amount taxed will be $1 million, reduced by the investor’s basis in the QOF investment. If on the date that the QOF investment is sold the QOF investment is worth less than $1 million, then the QOF investment is taxed at its fair market value on the date on which it is sold, reduced by the investor’s basis in the QOF investment.
The investor’s basis in the QOF investment is initially zero, but if the investor holds the QOF investment for at least five years (e.g., until 2024), the investor’s basis in the QOF investment becomes $100,000 (10 percent of $1 million); if the investor holds the QOF investment for at least seven years (e.g., until 2026), the investor’s basis in the QOF investment becomes $150,000 (15 percent of $1 million). After the $1 million is taxed, the taxpayer’s new basis in the QOF investment becomes $1 million.
Therefore, if the investor holds the QOF investment for nine years (e.g., until 2028), the amount taxed will be any appreciation in the investment over the $1 million of new basis. However, if the investor holds the QOF investment for at least 10 years (e.g., until 2029), the investor’s basis in the QOF investment is increased to the fair market value of the QSF Investment on the date on which it is sold, resulting in none of the investment appreciation being taxed (i.e. any increase in the investment over $1 million is never taxed).
The opportunity zone provisions provide rare tax benefits for many investors that are likely to spur increased investment in low-income areas. As a result, commercial mortgages lenders may find themselves being asked to make more mortgage loans on real property located in such areas, and, therefore, should be familiar with the opportunity zone provisions and related regulations.
Jeffrey B. Steiner and Dino Fazlibegu are partners at McDermott Will & Emery. David Danesh, an associate at the firm, assisted in the preparation of this article.