Investing in Qualified Opportunity Zones could allow investors to defer and reduce taxes on initial capital gains, as well as eliminate taxes on new capital gains if certain requirements are met.
When the proposed Qualified Opportunity Zone regulations were first released on Oct. 28, 2018, the real estate community buzzed with cautious optimism for the new tax benefit program. The potential benefits of the program were obvious. Less obvious, however, was how the final regulations would look once numerous unanswered questions about the program were addressed. Would the program present a once-in-a-lifetime opportunity, or would it result in a squandered chance for the government to make an impact in the communities that were subject to benefit from the program?
A round of updates in May 2019 helped clarify some of the issues, but many substantial concerns were not adequately addressed until the Internal Revenue Service (IRS) released final regulations on Dec. 19, 2019, which answered many questions from the real estate community.
The final regulations have been generally considered favorable for investors, and these are some examples of why that is the case:
REFINANCINGS ARE POSSIBLE
Real estate deals generally return money to investors in three main ways. First, if there is excess cash flow from operations, that money may be distributed to investors. Second, if the investment was purchased with leverage and its value rises, then the sponsor could refinance the loan secured by the property with a larger loan thereby “cashing out” equity that can be returned to investors. Finally, a sale of the property that has risen in value results in profits, which are returned to investors.
Since investors’ capital must be kept in an Opportunity Zone investment for 10 years to qualify for the full benefits of the program, it was unclear from the initial regulations if money distributed as the result of a refinance during the holding period could be returned to investors and what the tax treatment would be.
Based on the final regulations, cash from a refinance of the existing mortgage loan can be distributed to investors, and generally, the cash distribution is tax free to the investor. There is a caveat though. Money from a refinance can’t be returned to investors within the first two years from when the property is acquired.
CHOICES FOR THE 180 DAYS RULE
The original Opportunity Zone proposed regulations stipulated that investors have 180 days after realizing capital gains to invest those gains in an Opportunity Zone Fund, and this still holds true within the final regulations.
However, the final regulations also clarified rules specifically for investors in partnerships or S corporations. For these investors, if their entity realized capital gains, but such entity chose not to deploy such gains in a Qualified Opportunity Fund and instead chose to report such gains to its partners (as K-1 gains), the investors have two additional choices. They can elect to start their 180-day period from the last day of the tax year (usually Dec. 31) or they could start the period from March 15 of the following year, which is the day the partnership’s tax returns are due without extension, rather than the date of realization. Investors must pick one of the three options for each investment and cannot mix and match between the three options.
For example, if Investor A sells their shares in Stock X and earns $100,000, $50,000 of which is capital gains, they have 180 days from the date of the sale to deploy the $50,000 in an Opportunity Zone Fund.
However, imagine if Company B sells part of its business in May 4, 2020, which results in a capital gain for its partners. Then Company B reports such gains to investors on their K-1s. Each partner can make the decision to start their 180-day period from that May 4 realization date, from Dec. 31, 2020, the last day of the year, or from March 15, 2021.
OPPORTUNITY ZONES PLUS OTHER TAX BENEFITS
As Opportunity Zones already offer a major tax benefit, it was unknown during the earlier rounds of the Opportunity Zone regulations whether it would be possible benefit from that program while also still obtaining additional local and state tax advantages.
With the final regulations, it is now understood that it is possible to combine Opportunity Zone benefits with local or state tax incentives as long as the Qualified Opportunity Zone Business meet the specified requirements.
SUBSTANTIAL IMPROVEMENT ON AN AGGREGATE BASIS
For an Opportunity Zone investment to qualify, the investment must be substantially improved, which means at least doubling the basis (or the original investment amount) in the property, excluding the cost of land.
With the final regulations, it is now clear that these substantial improvements may be measured on an aggregate basis, instead of a property by property basis. Therefore, if a Qualified Opportunity Zone Business (QOZB) invested in a portfolio with five buildings, and the QOZB doubled the basis of the portfolio with renovations, it is counted as substantially improved. The QOZB could improve just two of the five buildings in the portfolio, but as long as the cost to upgrade those two buildings doubles the basis of the investment, then the aggregate portfolio still qualifies for the tax benefits. This gives the QOZB the freedom to choose how to improve the portfolio and maximize its potential.
The Opportunity Zone program is still a new program and there are still some situations where the answers are unknown. Additionally, every investor and every transaction are unique and requires analysis by a qualified tax professional. However, the final regulations released by the IRS answered many lingering questions and the general consensus is that the rules are very investor friendly. As the program was created to incentivize investors to put their hard-earned capital into investments in areas that are historically distressed, there can of course be inherent risks to the transaction. However, the federal government has demonstrated a willingness to mitigate some of those risks with attractive rules, which bodes well for Opportunity Zone investments.
This article is the second in ArborCrowd’s Opportunity Zone series. Read the first article: Opportunity Zones: Where, What, Why and How?