At this point, just about everyone involved in real estate investments has heard about the Opportunity Zone Program. Tucked away in the Tax Cuts and Jobs Act of 2017, this program encourages investors to invest capital gains from the sale of assets into Qualified Opportunity Funds (QOF). Those funds, in turn, funnel money into government-designated Opportunity Zones. Though still in its infancy, the program is being hailed as a win-win. The investor can defer capital gains taxes, while much-needed resources can help improve properties and businesses within government-designated census tracts.
There are strict rules to qualify for these tax incentives and properties or businesses involved in net lease agreements are unlikely to qualify.
While net lease properties offer many benefits to investors, the very nature of these assets make them difficult, at present, to qualify for the tax deferral through the Opportunity Zone program.
The Real Estate Perspective
The IRS and U.S. Department of the Treasury released Opportunity Zone guidance in October 2018, with more to come. A recent update to the guidelines stipulate to qualify for the deferral:
- Capital gains must be invested in a qualified opportunity (QOF) within 180 days.
- The fund must hold at least 90 percent of its assets in qualified opportunity zone property.
- The investment in the QOF must be an equity interest, not a debt interest.
All three of these requirements can be met by investors looking to buy net lease properties. Unfortunately, the “substantial improvement” requirement within 30 months of the purchase date will disqualify most net lease assets. While some net lease investors may be responsible for the roof and structure of their properties, they are likely not required to improve either of these.
QOFs, for the most part, need to target development and rehab projects through a direct, or active, investment. That fund will be actively involved with property improvements or ground-up development. In other words, an active investment.
Net lease properties are passive investments. Let's say your fund acquires interest in a net lease McDonald's or Dollar General in an Opportunity Zone. Under the terms of a triple net lease, the investor is not directly responsible for upkeep or maintenance of that real estate, which is the lessee's responsibility. If the fund isn't directly involved with property improvements or upgrades, it doesn't meet O-Zone guidance.
The Business Perspective
A QOF can invest in an Opportunity Zone business as long as at least 50% of gross income is derived from that business' active conduct. The key words here are “active conduct.” Active conduct, as defined by the program, means meaningful participation in management or operations of a trade or business. The net lease agreement with the above-mentioned McDonald's or Dollar General scenario doesn't involve active conduct, no influence or say in that business' operations or personnel decisions.
The good news of a passive net lease investment is, you'll continue to receive an income flow from the investment whether that business makes a killing or is currently struggling. On the other hand, the investment won't qualify for the Opportunity Zone tax deferment on your capital gains.
Dot the “I”s
At this time, we're waiting for additional guidance concerning the Opportunity Zone program; such information could clarify the role of net lease properties within Opportunity Zones. It is safe to assume that, for the time being, a QOF that invests in net lease properties would not qualify for tax-deferral benefits under the program. However, as we've often indicated, there are many advantages to net lease investments. You need to determine the best options for your portfolio.
Jonathan Hipp is president and CEO of Calkain Cos. The views expressed here are the author's own and not that of ALM's Real Estate Media Group.
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Jonathan Hipp
Jonathan Hipp began his career in real estate over 25 years ago. In his early years as a broker, he ventured into the net lease industry and quickly began leading the US net lease market, closing over $3 billion in transactions. In 2005, Jon founded Calkain Companies, a company focused solely on net lease investment services. As President and CEO, he has been instrumental in building the firm into one of the leading Net Lease real estate companies, transacting over $12 billion of net lease deal volume over the past 13 years. He has expanded Calkain’s services to include brokerage, advisory, asset management, capital markets, and industry research. He has become a well-known resource, panelist, and speaker at various Net Lease and Industry conferences and is a regular contributor to GlobeSt.com on real estate trends. In June 2015, Jon’s passion for the real estate business was again recognized as he was nominated for the Top Real Estate Player in the DC area by SmartCEO magazine.
