Developers, Attorneys Tackle The Most-Asked Questions About The Opportunity Zones Program
Since the passage of the Opportunity Zone provision in January, commercial real estate developers, business owners and investors have been digging up information on how to incorporate the program into future investments and scouring the designated distressed neighborhoods for investment opportunities.
Established by the Tax Cut and Jobs Act, the Opportunity Zone program aims to give investors an incentive to put money into an Opportunity Fund that then invests in low-income neighborhoods, according to the census, as designated by the governor of each state.
In exchange, part of an investor's investment in the Opportunity Fund would be forgiven with the rest subject to a tax that varies depending on the length of the investment.
In theory, it seems like a program that could benefit investors and communities. Investors would receive partial forgiveness and be taxed less on their capital gains and neighborhoods designated as Opportunity Zones would receive a nice jolt of economic activity.
But there are several layers to this provision that are yet to be peeled back, and many of those enticed by the possibilities of Opportunity Zones still have a lot of questions.
Bisnow spoke to Manhattan Beach-based Kosmont Cos. CEO Larry Kosmont and Kosmont Cos. Chief Operating Officer Carolyn Petty, who have spent years working with municipalities, and Cox, Castle & Nicholson’s Erik Loomis, a partner and tax attorney. They tackled some of the most-asked questions about the Opportunity Fund program and how this provision could work.
Bisnow: In general, how could investors, developers and others take advantage of the Opportunity Zone program?
Kosmont said the program enables private investors to use capital gains received from another project and invest in certain designated Opportunity Zone areas.
"One of the intentions of the new tax law was to push towards freeing up capital that has been locked up and provide developers with an incentive to invest in these census tracts and disadvantaged communities," Petty said.
Bisnow: How does an Opportunity Fund work?
Loomis said the Opportunity Zone statute permits the taxpayer to roll over capital gains into a qualified Opportunity Fund, which could be an income tax partnership or a tax corporation. The rollover has to be done within 180 days of the sale or exchange of the original asset for an interest in the Opportunity Fund, he said.
"Ultimately, this fund you are investing in owns the qualified property, which is a significant point, because it is the interest in the fund that gets the benefit under the statute, not the underlying qualified Opportunity Zone property," he said. "In other words, the action in this area is with respect to the interest in the fund, either at the end of the deferral period or on the sale or exchange of the interest."
So while the statute posits a very simple rollover of gains into this interest, he said the devil is in the details as to the exit strategy with respect to the interest in the fund.
Bisnow: How similar is the Opportunity Zone program to a 1031 exchange? How is it different?
Kosmont said the fundamentals are very similar.
"You receive gains and you’re moving it into a protected circumstance if you invest it through a fund into an investment that is eligible. But that’s where [the similarity] begins and ends," Kosmont said.
Petty said one of the distinctions is that while a 1031 is specific to real estate, Opportunity Funds can accommodate capital gains from anything, expanding its capacity beyond real estate.
"Which is very exciting," she said. "It provides a way to unlock capital in the marketplace provided it is capital gains."
Bisnow: What exactly constitutes an investment in these areas? How is investment defined?
Both Loomis and Kosmont said the Opportunity Fund has to invest in a trade or business in the qualified Opportunity Zone. However, the term is not defined and there is still a lingering question as to what constitutes a business.
Loomis said, for example, an apartment building that is triple net leased would probably not qualify as a business under the provision.
But if the Opportunity Fund holds and operates an apartment building or a shopping center, it has a much better case and could probably qualify.
Loomis also mentions the statute prohibits “sin businesses” in the qualified zones. He provided examples such as a country club, golf course, racetrack or a liquor store.
Loomis said it is still unclear if the Opportunity Fund needs to already have the property at the time of the investment.
"It is not clear what happens if the fund expects to take cash from investors and use it to build or rehabilitate property to turn it into a property that gets the benefit under the rules," he said. "The statute could use some clarity in this regard, and although the statute provides for the Treasury to provide for a certification of funds, it is not clear when or if such guidance is forthcoming. There are a number of areas that could use guidance."
Bisnow: What are some of the tax benefits and the tiered structure of the program?
Loomis said the longer an investor holds onto interest in the Opportunity Fund, the less tax on the capital gains.
After five years, the interest in the entity would give a basis boost of 10%, he said. For example, if an investor rolls over $1M in untaxed capital gains into an Opportunity Fund in 2018 (for the sake of this example the property has not appreciated), after five years if the interest is sold for $1M, the taxpayer receives a basis boost of $100K and so the taxpayer has only $900K of gain.
"At this point the taxpayer has achieved both a five-year deferral on its original gain, and has also reduced the gain by 10%," he said.
In seven years, it gets an additional 5% boost, or 15% total. Using the $1M interest example above, there would only be tax on $850K of gain.
But in 2026 that deferral ends, Loomis said.
"At that point, you look to the interest and any basis in the five- or seven-year rule and you determine your gain in the interest," he said. "If the initial $1M investment was held for eight years, then you are taxed on that $850K of gain. However, that depends on an investment in the fund in 2018."
He said an investment made after 2018 cannot take advantage of the seven-year provision, and similarly investments after 2021 lose the ability to get the basis boost under the five-year provision.
The most attractive provision regards what happens if an investor can hold the investment for 10 years or more, he said.
"If the taxpayer holds for 10 years and then sells or exchanges the interest, the way the statute is designed, its basis becomes equal to the fair market value immediately prior to that transfer," he said. "If you sell your interest for $1.5M, you don’t have any gain at all, although, in our example above, the taxpayer did pay tax on a portion of the original $1M rollover. That is the bonus in this. You have the deferral piece until 2026 and the forgiveness of any gain above your original $1M investment. You keep all of the $1.5M less what tax was paid on the original investment."
But, he said that this is only a federal tax benefit unless states begin to incorporate the provision; the entire investment could be taxable at the state level.
Bisnow: What are some of your other concerns with this program?
Loomis said his biggest concern is what happens to those who sell in 2029. Under the statute as it is written, the qualified Opportunity Zone property definition will expire after 2028.
"So the property owned by the Opportunity Fund can no longer be qualified Opportunity Zone property," he said. "If there is no such thing as Opportunity Zone property anymore, then the taxpayer may find itself not holding an interest that gets any benefit.
"In other words, for taxpayers that can acquire a fund interest in 2018 and dispose of the interest in 2028, treatment is fairly clear," he said. "Outside of that subset of possible interest holders, things are less clear at best."
He does not think that is the provision's intention and believes there will be forthcoming regulation or an Internal Revenue Code amendment to provide investors comfort on this point, "but the million-dollar question is when that might happen."
He also expressed concern on what happens at the 10-year mark when the investor has to sell the interest in the Opportunity Fund.
"What kind of buyers will you get for this interest in 10 years? That interest may have accrued 10 years’ worth of business-related liabilities," he said. "That could pose transactional obstacles, although there may be creative ways to structure an exit."
Bisnow: What could a company or investor do to start preparing for an Opportunity Zone investment?
Kosmont said there still needs to be more clarity of eligibility in the program and responsible fund managers to step up in the marketplace.
"Who is that? That is someone or an entity that proposes to work in the specific areas that are prepared by certain investors and they are putting their intellectual and financial muscle to go into that fund," Kosmont said.
Kosmont said cities with these designated Opportunity Zone areas need to help investors streamline the process.
"Opportunity drives investments, which come from the marketplace or the city," he said. "They could create a special district, upgrade zoning and/or expedite the approval process in that zone. In other words, the funds would then have an opportunity to promote something that is extraordinarily attractive because it got augmented by local policy."
Bisnow: Since these Opportunity Zones are in poor neighborhoods (according to census data), given today's politically charged climate, how does an investor or company lessen fears of gentrification?
Kosmont said there is no single answer when it comes to this issue.
"The fear of gentrification is always the antithesis of the expectations of new investments," Kosmont said. "There is a tension that always seems to exist and I think the only way to get through that tension is to outreach to that community effectively and speak to them; find project amenities that improve the quality of life along with the return on investments; and then you are viewed as a long-term player ready to invest money and bring jobs to that area as opposed to a single one-hit wonder that wants to win and leave.
"That is what tends to ameliorate that suspicion of gentrification. It does not solve it, but those are things that soften that blow," he said.