Opportunity Zone Financing: Showering Investment Dollars into the Community
By Judith Blackwell1
A new investment vehicle known as Opportunity Zone financing is about to rain investment dollars down on your community – but are you prepared to capture those dollars? Metaphorically speaking – are you ready with your bucket and do you have any idea where to place it? If you are a developer or a business person focused on seeking investment dollars to finance a business or a real estate development project in an economically challenged community, then you may want to explore structuring your project to take advantage of this new funding vehicle. Finally, if you are an investor who has recently realized capital gains or is anticipating realizing them, then this program is tailor made to provide you with options for tax relief.
In 2017 the Opportunity Zone program was created by Congress as part of the Tax Cuts and Jobs Act (the “Act”). Essentially this program allows investors to defer or reduce capital gains liability, and in certain cases to even eliminate capital gains liability, by reinvesting their realized gains into certain economically disadvantaged areas which have been designated as Qualified Opportunity Zones by the state and federal government. The goal of this program is to encourage private investment in distressed communities through use of these federal income tax incentives.
Which Distressed Communities?
Pursuant to the Act, governors of US states and territories were given until April 2018 to nominate qualifying census tracts in their jurisdictions for designation as Qualified Opportunity Zones. Eligibility for nomination as an Opportunity Zone required that such a census tract must meet the following low-income requirements:
- A poverty rate of at least 20%; or
- (i) For census tracts not located within a metropolitan area, a median family income at or below 80 percent of statewide median family income, or
(ii) For census tracts located within a metropolitan area, a median family income at or below 80 percent of the greater of the statewide median family income or the metropolitan area median family income.2
Up to 25% of low-income neighborhoods that meet the income qualifications of the program described above in each state, district, or territory could be designated as Opportunity Zones. Furthermore, an additional 5% of each jurisdiction could qualify for nomination as an Opportunity Zone if the census tract was contiguous with a low-income Opportunity Zone; and that census tract had a median family income of that does not exceed 125% of the median family income of the adjacent Qualified Opportunity Zone.
In June of 2018 The US Department of Treasury officially certified more than 8,700 tracts as Qualified Opportunity Zones.3 For example, 628 designated opportunity zones exist at this time in the State of Texas, and 514 designated opportunity zones are in the State of New York. US territories are also eligible, and notably all of Puerto Rico has been designated as an Opportunity Zone.
How is Private Investment Attracted to these Communities?
Private investors are incentivized to invest in these communities through investment into a Qualified Opportunity Zone Fund (a “QOF”). If an investor realizes gains from prior investments which would otherwise be taxed as capital gains, defers these gains for the year of sale, and reinvests these gains within 180 days into a Qualified Opportunity Fund (“QOF”), then that investor is entitled to the following benefits:
- After holding the investment in the QOF for 5 years, he/she can exclude 10% of the gain that was originally deferred
- Alternatively after holding the investment in the QOF for 7 years, he/she can exclude 15% of the gain that was originally deferred; and
- The investor can realize a permanent exclusion of all gain on the actual investment in the QOF, other than reinvested gain, after holding the investment in the QOF for at least 10 years.
Even gains from the sale of a 1231 asset4 (e.g. buildings and equipment held for over one year) would be eligible for this treatment. There is no limit to the size of the investment in the QOF. Also, the investor is not required to reinvest all of the proceeds of the sale or the exchange that created the capital gains, but instead is only required to reinvest the gain amount back into a QOF which makes this vehicle much more attractive than a 1031 exchange, because the investor can cash out while still protecting his/her gains. There is no requirement that the investment funds come from real estate or that they go back into real estate.
Furthermore, any taxpayer realizing gains which would otherwise be treated as capital gains can take advantage of this vehicle; so individuals, C corps (including REITS), partnerships, S corps, trusts and estates are all potential investors in a QOF.
Interested investors cannot achieve these benefits by investing directly in the opportunity zone itself, but must either find a QOF to invest in or start their own.
What counts as Qualified Opportunity Fund (“QOF”)?
A QOF may be a corporation or a partnership, or an LLC electing to be taxed as a partnership, and it must have self-certified as a QOF by filing with the IRS. The QOF either invests in the Qualified Opportunity Zone directly by holding Qualified Opportunity Zone Business Property or indirectly by holding QOZ stock or QOZ partnership interests.
The QOF must hold at least 90% of its assets in Qualified Opportunity Zone Property which could include 1) qualified opportunity zone stock, 2) qualified opportunity zone partnership interest; and 3) qualified opportunity zone business property. Compliance with this requirement is measured on the last day of the first six month period of the taxable year of the QOF and on the last day of the taxable year of the QOF.
PENALTIES TO A QOF FOR FAILURE TO COMPLY WITH THE 90% RULE ARE SIGNIFICANT. The penalty is imposed monthly on the difference at the IRS underpayment rate5 of 5%. For example, a $20 Million fund would need to invest 90% or $18 Million in Qualified Opportunity Zone Property. If, when measured on the last day of the first six month period of the taxable year of the QOF and on the last day of the taxable year of the QOF, it is determined that only $16 million was in compliance, then the monthly penalty would be 5% of $2 Million, or $100,000 per month!
The ramifications of this penalty system are that the QOF must be scrupulous about quickly investing in Qualified Opportunity Zone Property so that the 6 month and year end 90% requirements are met. Timely distributions of cash are also recommended as well as any other mechanisms that will avoid the fund holding large amounts of cash for too long.
Describe Direct QOF Investment
Direct QOF investment is achieved by acquiring Qualified Opportunity Zone Property.
Qualified Opportunity Zone Business Property is any tangible property used in a trade or business of the QOF if acquired by purchase after December 31, 2017. The original use of such property must begin with the QOF or the QOF must substantially improve the property, and throughout the QOF’s holding period of the property substantially all of the use of the property must be in the QOZ. In this context, the QOF can invest in the construction of new buildings and can also invest in the substantial improvement of existing unused buildings; but if the QOF improves an existing building, it must invest more in the improvement of the building than it paid to buy the building. Additionally any such development of a building must be completed within 30 months of its purchase by the QOF. The rules surrounding this program are designed to cause the QOF to bring new property into use in the Opportunity Zone, so a fund that simply acquires property already in use in the zone will not qualify without adding substantial improvement. Substantial improvement requires improvements equal to the Opportunity Zone Fund’s initial investment into the existing property over a 30-month period.
For instance, if an Opportunity Zone Fund acquires existing real property in an Opportunity Zone for $1 million, the fund has 30 months to invest an additional $1 million for improvements to that property in order to qualify for this program. Certain enterprises such as golf courses, country clubs, massage parlors, hot tub facilities, suntan facilities, race tracks or other facilities used for gambling, and liquor stores are excluded from qualifying as QOF improvements.
Describe Indirect QOF Investment
Indirect QOF investment is achieved by holding QOZ stock or by holding QOZ partnership interests.
Qualified Opportunity Zone Stock is any stock in a domestic corporation acquired solely in exchange for cash by the QOF at its original issuance after December 31 2017. At the time of the stock issuance the corporation must either have already been a Qualified Opportunity Zone Business. In the case of a newly organized business, such a corporation must have been organized for the purpose of being a Qualified Opportunity Zone Business. As with direct investments, during substantially all of the QOF’s holding period of such stock, the corporation must remain qualified as a Qualified Opportunity Zone Business.
A Qualified Opportunity Zone Partnership Interest is any capital or profit interest in a domestic partnership if it is acquired by a QOF from the partnership after December 31, 2017 solely in exchange for cash. At the time, the partnership must have been a Qualified Opportunity Zone Business, or in the case of a new partnership, it must have been organized for the purpose of being a Qualified Opportunity Zone Business. As with direct investments and with the holding of stock, during substantially all of the QOF’s holding period of such partnership interests, the partnership must remain qualified as a Qualified Opportunity Zone Business.
1 Admitted in NY and Massachusetts only
2 26 U.S. Code Section 45D(e)
3 Rev. Rule Section 1400Z-1
4 Includes depreciable property and real property used in a trade or business and held for more than one year, such as buildings, equipment, certain types of livestock, coal timber and domestic iron ore.
5 IRC Section 6621 (a)(2)