On Oct. 19, the U.S. Treasury Department issued proposed regulations for the federal Opportunity Zone tax incentive program created under the 2017 Tax Cuts and Job Act.
These regulations were highly anticipated by the real estate development and fund creation communities, which have been eagerly awaiting clarity from Treasury since the creation of the Opportunity Zone program last year.
The program could become the most impactful federal incentive for equity capital investment in low-income and distressed communities ever. It offers significant capital gains tax benefits for taxpayers who invest in projects and businesses in low-income areas, allowing investors to delay, reduce and potentially eliminate capital gains taxes on appreciated assets or business located in and on Qualified Opportunity Zone investments.
Qualified Opportunity Zones are census tracts located in all 50 states and Puerto Rico in low-income communities. A detailed interactive map by state identifying the applicable Opportunity Zones is available at https://eig.org/opportunityzones.
As Forbes magazine indicated, there is likely $6 trillion of capital gains in the United States that represent potential available investment capital that could use this program to drive investment into applicable Qualified Opportunity Zone businesses or real estate.
The program is not limited to any specific product type, nor does it mandate any job creation requirements as part of the investment in a Qualified Opportunity Zone. Thus, the program is applicable to any type of investor with capital gains from the sale of personal property or real property and to developers/owners of all property types including multifamily rental, retail, hotels, industrial, commercial, office, industries, self-storage, assisted living, affordable housing, etc.
Under the Opportunity Zone program, individuals and other entities can delay paying federal income tax on capital gains until as late as Dec. 31, 2026 – provided those gains are invested in Qualified Opportunity Funds investing 90 percent of their assets in businesses or tangible property located in a Qualified Opportunity Zone. In addition, the gains on investments in Qualified Opportunity Funds can be federal income tax-free if the investment is held for at least 10 years. These tax benefits could reduce the cost of capital for these projects, making them more viable, especially when paired with other development incentives like the New Markets Tax Credit or Low-Income Housing Tax Credit.
Specifically, appreciation of value of investments in qualified businesses or real estate within the Opportunity Zones that are held for at least 10 years are not subject to federal capital gains tax if the investment is sold prior to Dec. 31, 2047. Thus, in short, the longer one has an investment within a Qualified Opportunity Fund within an Opportunity Zone, the more one can reduce its capital gain – either by 10 percent (if five years) or 15 percent (if seven years or longer).
And if one stays in the zone for 10 years or more and the property or qualified business appreciated in value, the appreciation is not subject to capital gains tax at the federal level. The regulations as proposed give the investor/owner until Dec. 31, 2047, to sell the business or property in order to take advantage of the no capital gains to be paid on the sale of appreciated assets rules. Moreover, some states are also allowing state capital gains to also be deferred and reduced as well – in our case in Florida, which already has no individual income tax, we are lucky as corporations have also been granted the Opportunity Zone benefits (unlike states such as New Jersey, Pennsylvania and California which have not elected to follow the federal rules as of yet).
Additionally, owners of low tax basis properties can sell their properties and defer the capital gains to the extent the gains are invested in a Qualified Opportunity Zone, which will likely attract investor capital that is looking to defer capital gains, thereby making the Qualified Opportunity Zones potentially more valuable than non-Qualified Opportunity Zone properties.
While the benefits of the program can be advantageous, investors and developers seeking to capitalize on the Opportunity Zone program need to move quickly in order to take full advantage of the tax benefit as demand increases and the time period diminishes.
In other words, since the program only lasts until 2026, the seven-year ability to reduce capital gains by 15 percent will disappear if investments are not made by 2019 and the five-year ability to reduce capital gains by 10 percent will disappear if not made by 2021. Therefore, in the interest of maximizing the value of the program, investors and developers need to move quickly to commence development and acquisitions in order to maximize the time periods available to invest their capital gains inside the windows provided by the program.
Additionally, in order to defer short- and long-term capital gains realized on the sale of property, the capital gain portion of the sale or disposition has to be reinvested within 180 days in a Qualified Opportunity Fund.
It’s also important to note that gains are required to be recognized on the earlier of a disposal of the Qualified Opportunity Fund investment or by Dec. 31, 2026, and are reduced over time.
The basis of the Qualified Opportunity Zone investment increases by 10 percent of the deferred gain if the investment is held for five years from the date of reinvestment and by 15 percent if held for seven years from the date of reinvestment. In other words, the gain on which capital gains is paid is reduced to 85 percent of the original gain.
While the recently announced regulations provided clarity on the specific time period for self-certification as an Qualified Opportunity Zone fund, what constitutes a Qualified Opportunity Zone business and what structures now qualify as Qualified Opportunity Zone Funds (i.e., limited partnerships, C corporations, limited liability companies, REITs, RICs, etc.), investors need to be aware that certain rules regarding related parties and original use property still need to be clarified by Treasury in additional regulations.
In South Florida
In South Florida, the program will drive investment from all types of developers and investors seeking to place their capital gains into funds and seeking to place applicable businesses into Qualified Zones in order to potentially defer and reduce applicable capital gains. Developers will seek to purchase land in order to build with their own capital and/or equity from Opportunity Zone investment vehicles in order to utilize cheaper sources of capital and drive development returns.
Atypical real estate investors who are looking to defer and reduce capital gains may not be looking for typical real estate like returns due to the fact that they will be able to defer and reduce their capital gains via the Opportunity Zone program which will likely create a healthy dynamic for capital flows. Sectors such as multifamily, warehouse, self-storage, grocery anchor retail and assisted living will see substantial interest from investors and developers.
In Miami-Dade County, areas such as Coral Gables, South Miami, Hialeah and Wynwood will likely be hot spots for focused/targeted Opportunity Zone investment. In Broward County, parts of Pompano Beach, Plantation, Fort Lauderdale and Hollywood will likely see interest for focused/targeted Opportunity Zone investment.
Not a day goes by without news regarding Opportunity Zones and the ability to utilize them for development and capital gains deferral.
Now is the time to optimize any capital gains deferrals and reductions you have vis-à-vis the sale of personal property or real property. Interested investors are already focusing on deploying capital in Florida and elsewhere in substantially improving various asset classes and in creating funds to deploy in investing in various asset classes.
Jay Steinman is a real estate and finance attorney and partner in Duane Morris’ Miami office. He represents domestic and international real estate development and investment companies as well as financial institutions, family offices, real estate dedicated funds, and owners and operators of all real estate asset classes. He can be reached at JSteinman@duanemorris.com.
William Rohrer is an international tax attorney, a certified public accountant and a partner in Duane Morris’ Miami office. He advises foreign and domestic clients on strategic tax planning, including business transactional planning with an emphasis on inbound tax-advantaged structures for doing business, including investing in real estate, within the United States and outbound foreign tax credit optimization structures. He can be reached at WRohrer@duanemorris.com.
Brad A. Molotsky is a real estate attorney and partner in Duane Morris’ New Jersey and Philadelphia offices. He advises clients on commercial leasing, including cannabis leasing, acquisitions, Opportunity Zone fund creation and fund deployment, financing, public-private partnerships and real estate joint ventures. He can be reached at BAMolotsky@duanemorris.com.