A Comprehensive Guide To The Opportunity Zones' Proposed Rules

On October 19, Treasury and the IRS released highly anticipated regulatory guidance related to the Opportunity Zone program. GlobeSt.com asked Real Estate Roundtable President and CEO Jeffrey DeBoer and Roundtable Senior Vice President and Counsel Ryan McCormick to explain the proposed rules and their implications for the real estate industry.

What is your main takeaway from the new Treasury regulations on Opportunity Zones?

DeBoer: The Treasury guidance is a clear indication the Administration is fully committed to an Opportunity Zone program that spurs broad-based job creation and creates new economic opportunity for businesses, entrepreneurs, and residents in low-income communities. The regulations help to implement the objectives of the lawmakers who designed the program, such as Senator Tim Scott (R-SC). With the regulatory regime now taking shape, we foresee Opportunity Fund investors actively partnering with local leaders and entrepreneurs on projects that both drive economic activity and respond to the needs of communities.

 What do the proposed regulations mean for real estate?

DeBoer: For real estate, the proposed regulations are unquestionably positive. They clarify key technical questions and open issues, and they should allow investments in funds and in underlying projects to go forward. While some important questions remain, we continue to believe that the Opportunity Zone program will be a powerful catalyst for transformational real estate investment in these designated low-income areas.

There has been some uncertainty regarding the type of gain that can be deferred and invested in an Opportunity Fund and who is eligible to make such an investment. Do the regulations put those questions to rest?

DeBoer: The proposed regulations take the view that only capital gain can be rolled into an Opportunity Fund and qualify for the new tax benefits. Ordinary gain, such as income subject to depreciation recapture, income from the sale of inventory, and income from the sale of intangible assets created by the taxpayer, would not be eligible, even if it arises from the sale of a business or parcel of real estate. That may be unduly restrictive, given the legislative language and underlying intent. Since only money from “gains” can be invested in qualifying Opportunity Funds, that definition should be broad, not narrow, to make the incentive as efficient as possible. On the positive side, capital gains will include short-term capital gain otherwise ineligible for a reduced rate. Presumably, the rule also encompasses REIT capital gain dividends. The gain cannot arise from a related party transaction. This is a sensible rule to ensure that only bona fide gain qualifies for the tax benefits.

McCormick: In addition, the regulations clarify who can defer gain by investing in an Opportunity Fund. Eligible investors include individuals, C corporations, REITs, partnerships, S corporations, trusts and estates. There had been concern that partnerships could not invest in Opportunity Funds because they are pass-through entities and not taxpayers. Partnerships can defer and invest gain in an Opportunity Fund. The regulations also confirm that a partner can invest his or her distributive share of a partnership’s capital gain if the partnership does not elect to do so.

The law requires investors to roll their capital gain into an Opportunity Fund within 180 days. Do the regulations clear up how the 180 day-period is measured?

DeBoer: Yes. Generally, the 180 days begins on the date the gain otherwise would be recognized for federal income tax purposes. For publicly traded stock, this is the trade date. For a REIT undistributed capital gain, the period begins on the last day of the REIT’s taxable year. For REIT capital gain dividends, the period begins when the dividend is paid. The regulations include a favorable rule that provides partners with greater flexibility, but generally the 180 day-period begins on the last day of the partnership’s taxable year.

Are there restrictions on the types of Opportunity Fund interests that an investor can hold?

DeBoer: Under the proposed rules, qualifying interests include equity interests issued by the fund. This could include preferred stock in a C corporation or a partnership interest with a special allocation. As anticipated, debt instruments do not qualify. The interest must be acquired solely in exchange for cash. However, the regulations clarify that a fund investor can use his or her equity interest as collateral for a loan.

Do the regulations resolve how quickly Opportunity Funds must invest their capital?

DeBoer: Absolutely. One area of concern had been a provision in the law which appeared to require that Opportunity Funds invest their capital within 6 months of raising it. In order to mobilize capital on the scale needed to stimulate meaningful growth, funds need more than 6 months to attract investors, evaluate investment opportunities, and deploy capital in a smart, productive way. The proposed rule creates a “working capital safe harbor.” Opportunity Funds have a minimum of 31 months to invest their working capital in qualified opportunity zone property. The longer runway aligns better with the practical realities of real estate investment.

Do funds automatically qualify for the working capital safe harbor, or do specific requirements apply?

McCormick: In short, an Opportunity Fund must have a plan for spending its capital, and it must be acting in good faith to do so. More specifically, the fund must put in writing that the funds are designated for the acquisition, construction, or substantial improvement of property in a qualified zone. The fund must have a written schedule for the expenditure of working capital within 31 months of receipt. Lastly, the working capital must be used in a manner consistent with these requirements.

Can an Opportunity Fund use leverage to increase its investment and maximize its impact in an Opportunity Zone?

DeBoer: The proposed rules reduce a significant source of tax risk for Opportunity Funds organized as partnerships that use leverage. The regulations confirm that the deemed contributions of cash that arise when the Opportunity Fund itself incurs debt do not create a separate, taxable interest in the fund. This favorable result occurs even though the deemed contributions of cash do not represent a contribution of deferred gain. The rule should allow Opportunity Funds to mobilize even greater amounts of capital for productive and beneficial investment.

Do the regulations shed light on what constitutes the original use or substantial improvement of an Opportunity Zone property?

DeBoer: The “original use” and “substantial improvement” tests are critical elements of the Opportunity Zone program, and they are clarified in important ways in the proposed rules. Keep in mind, Congress wanted to stimulate new capital investment, not simply the transfer of income-producing assets from one owner to another. Therefore, property must either be put to its original use by the fund, or the fund must substantially improve the property. The Opportunity Zone law defines substantial improvement as the doubling of the adjusted tax basis of the property. The regulations provide that the original use and substantial improvement requirements only relate to the structure and not the underlying land.

For example, assume a fund acquires an abandoned factory in an Opportunity Zone for $1 million with the intention of converting the factory to multifamily housing and allocates $600,000 of the cost to the value of the land and $400,000 to the value of the structure. Previously, it was unclear whether the fund was obligated to spend $1 million improving the property (cost of the land and structure) or $400,000 (cost of the structure). The regulations and an accompanying revenue ruling from the IRS clarify that the substantial improvement test requires the fund to spend $400,000 on property improvements. The fund is not required to separately substantially improve the land on which the structure is located. This clarification will be a major boost to the rehabilitation of languishing real estate properties in urban Opportunity Zones where the value of the land may greatly exceed the value of the buildings located on the land.

McCormick: Moreover, although it is not explicitly stated in the Treasury guidance, it appears that the government intends to treat the land as qualified opportunity zone business property—effectively “bootstrapping” the land to the structure and counting the value of the land as qualifying property for purposes of the law’s 90 percent asset test. Under the asset test, 90 percent of the assets of an Opportunity Fund must consist of qualifying property.

Under the Opportunity Zone statute, “substantially all” of the tangible property owned or leased by a trade or business must be qualified opportunity zone business property. Do the regulations give meaning to “substantially all”?

DeBoer: In another favorable rule, a trade or business satisfies the substantially all requirement if at least 70 percent of the property is qualified opportunity zone business property. The 70 percent standard will give Opportunity Funds greater flexibility in the design and structure of their Opportunity Zone projects.

These are proposed regulations, does that mean they may change significantly?

McCormick: They are in proposed form, but Treasury indicated that taxpayers can rely on most elements of the regulations now, provided they rely on those provisions in their entirety. Because of the generally favorable nature of the rules, we anticipate they will survive the review process largely intact. Of course, anyone contemplating an Opportunity Fund investment should review them in their entirety, provide input during the comment period, and closely follow the implementation process.

Going forward, what will be the Roundtable and the real estate industry’s focus?

DeBoer: Many questions remain. Some of the most important questions relate to Opportunity Fund transactions and the tax consequences when a fund buys, sells, and/or reinvests in Opportunity Zone property. How is carried interest taxed in an Opportunity Fund? How is the active trade or business requirement measured? What happens when extenuating, unforeseeable circumstances cause delays? Will Treasury provide additional safe harbors for funds that are making a good faith effort to complete a project. Treasury and the White House have indicated that additional guidance is forthcoming before the end of the year. The Roundtable will be working with policymakers to ensure the next tranche of guidance and the final rules maximize productive, job-creating investment in Opportunity Zones.