The Basics of Opportunity Zones: 2017 Tax Reform Provides Development Incentives

You’ve probably heard something recently about Opportunity Zones (or o-zones), which were established by the Tax Cuts and Jobs Act of 2017 to employ tax incentives for long-term investments in rural and low-income, urban communities.  As the first national community investment program in over 15 years, it’s a natural fit for certain types of development projects, but since it’s written as part of the tax code, negotiating the specifics is critical.

There are currently 8,760 opportunity zones nationally, which comprise census tracts (or parts of them) nominated by various states, and certified by the Department of the Treasury.  The purpose of the legislation is to encourage private investment in these low-income tracts by allowing a temporary, 5- to 10-year deferral of tax on capital gains, a reduction in the amount of capital gains tax that must ultimately be paid, and potential tax-free appreciation in qualified opportunity zone funds.

All o-zone funds must hold at least 90 percent of their assets in a Qualified Opportunity Zone Property (QOZP), which is measured every six months in a given calendar or fiscal year.  Failure to meet this 90-percent rule can result in severe penalties.  While an o-zone fund can include both capital gains and other sources, only the capital gains are eligible for the o-zone tax benefits.

So let’s say you’re a developer proposing a new multi-family property in a certified o-zone, and looking for investors wanting to take advantage of this legislation.  To qualify as a QOZP, the property must be purchased after 2017, and the tax basis of the completed property must be at least double the original basis, plus one dollar.

For redevelopment projects in which the existing structure(s) are targeted to be razed or substantially rehabbed, this should be an easy milestone to hit.  However, there’s a strict timeline of 30 months to complete these improvements, which could prove more difficult for larger projects still early in the planning and approval process. There are also time pressures for investors, with capital gains required to be transferred to an o-zone fund within 180 days from the date they are realized.

But there is some help on the way:  HUD Secretary Ben Carson recently announced that his department will offer technical assistance, as well as providing preferential treatment for grant applicants with affordable housing projects in o-zones.  In addition, the Federal Housing Administration’s pilot program for financing low-income housing with tax credits was expanded to incorporate o-zone projects.

Even better, HUD is now working with other federal agencies and programs so that developers can combine o-zone tax benefits with other programs, such as the New Market Tax Credit.  Carson also confirmed HUD’s controversial initiative, announced last August, to encourage cities to change their zoning regulations in order to build more affordable housing.

For an investor, there are several options to save on capital gains.  If a taxpayer holds its ownership interest in the o-zone fund for at least five years, then 10 percent of the gain invested is excluded from the tax owed upon the sale of the taxpayer’s interest in the o-zone fund (or 2026, whichever is earlier). If the ownership interest is held for at least seven years, an additional five percent (for a total of 15 percent) of the invested gain is excluded, and if a taxpayer holds its ownership interest for at least 10 years, then all appreciation in the investment will also be tax-free when the taxpayer sells its interest.

To take full advantage of the statute’s current benefits – including a deferral of tax until 2026 and a 15 percent reduction in taxable gain -- investments must be made by the end of 2019. Still, taxpayers can make investments after 2019, and will also be able to benefit from the appreciation exclusion that many believe is the greatest advantage of the new law.

However, the rules that normally cap 50-percent ownership as the limit for determining if companies are related parties are further limited with o-zones.  In this case, cross-ownership is limited to 20 percent, and some builders will be unwilling to give up 80-percent equity to qualify for the tax advantages.  Still, for Low-Income Housing Tax Credit (LIHTC) project developers, their familiarity with giving investors majority ownership could help boost more affordable housing at a time of unyielding demand.

Finally, o-zone funds can also include investments in existing companies, not just properties.  But, as with all things related to our very complicated tax code, seeking advice from tax attorneys, CPAs and other experts is probably the first place to start.