Opportunity Zone Investors Get Answers
Flexibility and clarity are two welcome takeaways from the second set of proposed Opportunity Zone (OZ) regulations. In April, the Internal Revenue Service and Treasury Department issued this follow-up to the first set of proposed regulations, which were introduced last October. Investors, developers, legal and accounting advisors and community leaders now have many of the answers they need to confidently move forward with real estate and business investment in OZs. This second set reads like, and is meant to be, a complement to the first round. It has answered many questions raised since October and provides greater guidance, which will bring investors off the sidelines.
Ever since the OZ program was first outlined in the Tax Cuts and Jobs Act of 2017, the bulk of the conversation and investment has been in real estate, though business investment is equally represented in the legislation. For real estate investment, the foundation was set early on, with modest additions and many clarifications in round two of the proposed regulations. To review, an investor sells an asset, which can be real estate, stocks and even art, that would normally trigger capital gains tax. The gain is rolled into a qualified Opportunity Fund (QOF) within 180 days. Next, those funds are used to purchase real estate in an OZ (low-income areas that qualify for this program.) The initial capital gain is deferred until Dec 31, 2026 and potentially reduced up to 15%. The real estate is held for at least 10 years to avoid capital gains tax on the appreciation of the OZ real estate. The second set of regulations doesn’t change that, but it addresses a number of questions surrounding “original use,” property that straddles an OZ, depreciation, exit structuring, leases and timelines (including the relaxation of some of those timelines). For example, it is now clear that a property that has been vacant for more than five years and is put back into service falls under “original use” and is exempt from triggering the cost of “substantial improvement.”
Since the first set of proposed regulations came out last October, there have been many questions about how to invest in qualified Opportunity Zone business (QOZB) and stay within the lines. For example, one of the initial key requirements for businesses to be eligible was that half of their gross income must be derived from business activities in an opportunity zone. That leaves a lot up for interpretation. After conducting public comment sessions and gathering feedback, the Treasury listened and responded. In response, it created three safe harbors that clear up the confusion and provide flexibility. Essentially, businesses qualify if half of the hours worked take place within the OZ, half of the compensation paid is for services performed within the OZ or if significant management and operational functions are in the OZ. Answering another question, businesses may use the working capital safe harbor to use cash for business development. That can range from obtaining a fast-food franchise to paying software engineers in a new technology company. The upside for businesses in OZs is substantial. No question: business owners are turning to their advisors and considering the move.
The first set of proposed regulations laid the initial groundwork. The second set, enhanced by community feedback and comment, has addressed many questions, added flexibility and provided needed clarity. Treasury has another public hearing set for July 9 and, perhaps, another set will follow this summer, but there will likely to be tweaks rather than significant new material. The good news is that the guidance is here now. That’s good for investors and good for communities.
(This story was originally published in the Charleston Regional Business Journal on June 10, 2019. Gerry Schauer is a vice-president in Avison Young’s Charleston office. He specializes in office and investment real estate leasing and sales.)