Opportunity Zones and Commercial Real Estate

A. DeBoer: The point of the program is to encourage capital formation and patient, long-term investment in these areas by reducing or eliminating capital gains taxes for taxpayers investing in newly established Opportunity Funds. An Opportunity Fund itself is created in the private sector, and it may be organized as a partnership or corporation. Thus, a qualified fund may be owned by a single individual, by a small number of partners, or by a large pool of investors operating with a professional fund manager. Opportunity Funds can invest in income-producing real estate located in an Opportunity Zone, such as an apartment complex, shopping center, or office building. Depending on how the Treasury Department drafts the implementing rules, Opportunity Zones could be a powerful new tool for mobilizing capital for real estate projects that create jobs, improve communities, and spur economic growth. In the real estate industry, there is a tremendous amount of interest in Opportunity Zones right now. But there are also many unanswered questions. The Real Estate Roundtable is meeting regularly with lawmakers and Administration officials to provide industry feedback and support the implementation process.

Q. How do the Opportunity Zones' capital investment tax incentives work?

A. DeBoer: In short, capital gain from prior investments — proceeds from the sale of real estate, stocks, securities, etc. — can be rolled into an Opportunity Fund and the tax that would otherwise be owed on the gain from the prior investment is deferred and not taxed until the end of 2026. Capital gains tax on this deferred gain is reduced by 10% if the investment is held for five years or 15% if the investment is held for seven years (through a tax basis “step-up”). Third, capital gain generated from the investments made by the Opportunity Fund are exempt from capital gains tax altogether if the investment in the Opportunity Fund is held for at least 10 years. Thus, Opportunity Zones incentivize capital investment in two critical ways: 1) the deferred and reduced tax owed on capital gain that is rolled into an Opportunity Fund; and 2) the elimination of capital gains tax on the subsequent gain from long-term Opportunity Fund investments. However, there is an important and often overlooked limitation. The exclusion of capital gain for investments in Opportunity Funds held for 10 years is only available to equity investments that are financed with rolled-over gain. Thus, if a taxpayer invests $10 in an Opportunity Fund, but only $7 represents gain from a prior investment, then only 70% of the taxpayer's equity investment is eligible for the capital gains exclusion (assuming the investment is held for 10 years). At least currently, the capital gains exclusion does not extend to new capital that cannot be traced to gain from a prior investment. In the future, if Congress looks to build and expand on the existing Opportunity Zone law, we will urge policymakers to consider extending the Opportunity Zone benefits to new capital.

Q. This is not the first time the federal government has experimented with tax incentives to spur private investment in low-income communities. How do Opportunity Zones differ from prior efforts?

A. McCormick: Community-based tax incentives such as Enterprise Zones, Enterprise Communities, Renewal Communities, and the New Markets Tax Credit (NMTC) have been part of the federal tax system for 25 years. At best, these programs have met with mixed results. Various factors have contributed to their underutilization. Excessive complexity has deterred potential beneficiaries. Generally, the tax benefits are too small to justify the compliance costs and cumbersome, bureaucratic hurdles. The programs have imposed restrictions on the size of investments. Moreover, an emphasis on employment subsidies has discouraged investment by capital-intensive businesses. Perhaps most importantly, the programs have not incentivized taxpayers to exit existing investments and redirect their capital to the targeted areas, nor have they facilitated the pooling of capital from multiple sources. Opportunity Zones aim to avoid the mistakes of these earlier schemes and achieve a level of scale that, hopefully, will result in a virtuous cycle of investment leading to additional investment. Unlike prior programs, Opportunity Zones reward taxpayers for exiting from existing investments and redirecting their capital to low-income communities. Unlike the NMTC, investors do not have to compete with one another for a limited number of tax credits in a costly, centralized process. Opportunity Zones also promote the pooling of capital through Opportunity Funds. It is this pooling feature that could be transformative in terms of mobilizing capital from disparate sources to support jobs and growth. Moreover, the fund structure that underlies the program may result in a business model where local entrepreneurs with knowledge and expertise partner with outside investors, creating a new cadre of business leaders and lasting benefits for the community.

Q. Where are the Opportunity Zones located?

A. McCormick: Congress delegated the Opportunity Zone selection process to the governors of the 50 States, five U.S. possessions, and the District of Columbia. All of Puerto Rico is an Opportunity Zone. States could designate up to 25% of the low-income census tracts as Opportunity Zones (or minimum of 25 zones). States also had some flexibility to designate contiguous census tracts that did not meet the full, low-income criteria. The low-income criteria is similar to the test used for the New Markets Tax Credit. The process went very quickly. States had about four months to make their designations, which will remain in effect for the next 10 years. The 8,700+ designated census tracts are home to nearly 35 million Americans. In aggregate, they have an average poverty rate of 32%.

Q. How soon until we start to see real estate-focused Opportunity Funds in the marketplace?

A. DeBoer: Investors and real estate fund managers are actively in the process of evaluating options, setting up funds, and conducting due diligence. We expect the first funds may be closely held partnerships. In those cases, decisions can be made relatively quickly and decisively, and the investors may be willing to bear some of the regulatory risk associated with a new program that has not yet been fully implemented. As time passes and the regulatory regimes takes shape, the pool of Opportunity Fund investors may grow.

A. McCormick: There is some pressure to move quickly, because gain that is rolled into an Opportunity Fund is only deferred until the end of 2026. As a result, the equity investment must be made by the end of 2019 in order to get the full 15% tax basis “step-up” that comes from investing in an Opportunity Fund for seven years. In addition, in order for an Opportunity Fund investment to qualify for the tax incentives, the underlying property must be acquired by the fund after Dec. 31, 2017. That said, the law delegated many of the key implementation issues to the Treasury Department to resolve. These include: 1) how an Opportunity Fund is certified; 2) how quickly must an Opportunity Fund deploy new capital; and 3) when has an existing real estate asset qualified as an eligible investment?

Q. Let's explore those issues in greater detail. What are the issues with respect to Opportunity Fund certification?

A. McCormick: A qualified Opportunity Fund is an investment vehicle, structured as a corporation or a partnership, organized for the purpose of investing in Opportunity Zone property. The IRS has indicated that taxpayers can self-certify as Opportunity Funds by completing an as-yet-unreleased form. No formal approval or action by the IRS is required. Some commentators have suggested that regulators should create a vetting process in which Opportunity Funds are “screened” by the federal government for specific social purposes or objectives before investments are made and placed. We believe Treasury review would create an unnecessary bottleneck that would delay economic investment in low-income communities. In a streamlined federal process built around self-certification of Opportunity Funds and market-driven investment decisions, private capital should be better able to flow to its best use while local authorities will continue to have ultimate authority over new projects and developments.

Q. What rules govern the timing of Opportunity Fund investments?

A. McCormick: An Opportunity Fund may be subject to penalty unless 90% of its assets consist of Opportunity Zone property. The 90% asset test is measured biannually. The test has been interpreted by some commentators as a strict requirement that an Opportunity Fund must deploy new capital within six months. We believe this would be an overly restrictive interpretation of the statute, and we have asked Treasury to clarify the law to reflect typical real estate fundraising and investment timelines. The construction or rehabilitation of real estate may take much longer than six months to complete. During the construction or rehabilitation process, cash and cash equivalents may be a large portion of the assets held by the fund. We believe Opportunity Funds should have a longer runway to invest their capital and comply with the 90% test; this would be consistent with the manner in which real estate investment actually occurs and the extended timelines that Congress has provided for other purposes.

Q. When does real estate qualify for Opportunity Zone tax benefits?

A. McCormick: Under the Opportunity Zone law, the original use of qualifying real estate must commence with the Opportunity Fund, or the property must be substantially improved by the Opportunity Fund. This requirement may not be overly burdensome for new construction and development. However, in low-income, urban communities, the substantial improvement test may be a significant hurdle for real estate projects, notwithstanding the capital-intensive nature of rehabilitating, renovating, or repositioning real estate. The property improvements must exceed the tax basis of the property at the time of acquisition. This is a higher standard than the test used for private activity bonds and the Low-Income Housing Tax Credit. In order to maximize capital formation and job growth, we are asking Treasury to use its regulatory authority to implement the substantial improvement test as flexibly as possible. Additionally, we are recommending that policymakers consider legislative enhancements to the Opportunity Zone program that would extend eligibility to significant property renovation and value-add projects, which are otherwise unlikely to meet the statutory substantial improvement test. A modified test could greatly expand the impact of the program in low-income, urban communities where existing, dilapidated and underutilized buildings — rather than open land — comprise the majority of real estate in need of investment and revitalization.

Q. What are the next steps in the process?

A. DeBoer: We anticipate Treasury will soon issue guidance that we expect will address some of the most immediate issues, such as how investors roll over gain from existing investments into Opportunity Funds. However, it may leave some other questions unanswered, such as how Treasury will interpret the substantial improvement test for existing real estate assets. Going forward, it will be critical for interested elements of our industry to remain actively involved in the rule-making process. The Roundtable has benefited immensely from the insight and wisdom of members of our Tax Policy Advisory Committee, which helped developed our recent comment letter. We plan to continue to meet with Treasury staff, key lawmakers, and others to provide insight into how the industry can truly help the Opportunity Zone program fulfill its ambitious objective of stimulating economic development and job creation. [Editor's Note: An Opportunity Zone FAQ page is available from the IRS at .]

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Erika Morphy has been writing about commercial real estate at GlobeSt.com for more than 10 years, covering the capital markets, the Mid-Atlantic region and national topics. She's a nerd so favorite examples of the former include accounting standards, Basel III and what Congress is brewing. This article also appeared on Globest.com (Online), an ALM sibling publication of this newsletter.