As real estate developers and investors, we are presented with opportunities to explore and utilize incentive programs, tax credits and investment tools which can make otherwise unviable projects a realistic option. Often, the hardest part of taking advantage of these programs is staying informed of new programs as they become available. Recently, a new tool was added to our arsenal, Qualified Opportunity Zones, designed to spur economic development in distressed communities . The following explanation comes from our long-time legal counsel and partner, Polsinelli, and explains the parameters, uses and benefits of this new program.
New Federal Program Provides Tremendous Opportunity, Tax Benefits for Real Estate Investors
Last December, Congress passed a major tax reform bill that, among many other changes, created a new program called “Opportunity Zones” to promote long-term investments in low-income areas by providing the opportunity for taxpayers to re-invest capital gains and defer and/or reduce capital gains taxes. Although we are still awaiting official guidance from Treasury and IRS on the program, early signs point to Opportunity Zones being one of the most important tax changes of the last few decades for investors and businesses. Polsinelli is part of a coalition helping to develop the administrative rules and guidance regarding these investments, and we believe strongly in the future of Opportunity Zone investing. Below is the information you need to know about this program and how it can affect real estate investment for years to come.
What, When, Where, Why, and How: Understanding Opportunity Zones
What Are Opportunity Zones? Opportunity Zones are disadvantaged areas in each state that are designated for special treatment under the new Tax Act. Investors get significant tax advantages for investing in real estate and businesses in the Opportunity Zone, with the goal of the Tax Act being to incentivize economic development in the disadvantaged areas and help create jobs there.
Where Are The Opportunity Zones? All states have designated their Opportunity Zones, and a map of the Opportunity Zones is available here. Many Opportunity Zones are located in major metropolitan areas across the United States, including the Kansas City area.
Who Should Care About Opportunity Zones? In short, everyone who pays taxes. Under the new program, individuals and companies making long-term real estate and business investments in Opportunity Zones can earn capital gains on those investments and never pay taxes on that money. In addition, investors with existing taxable gains from the sale of real estate or another business can reinvest the gains in an Opportunity Zone, never pay taxes on 15% of the existing gain, and defer the remaining 85% of the gain until 2026. Importantly, there is no cap on the amount of tax savings that can be achieved through Opportunity Zones.
How Do Investments In Opportunity Zones Work? Investment in Qualified Opportunity Zones centers on long-term investment of capital gains into Qualified Opportunity Funds (a “Fund”). A Fund is an intermediary that an investor can create and own that buys real estate or other business property in Opportunity Zones, or buys stock or partnership interests in businesses that operate on real estate in an Opportunity Zone.
Specifically, investors that would otherwise be required to recognize capitals gains on their taxes can defer payment of such taxes by investing the capital gains in a Fund within 180 days of the date such capital gain was recognized (i.e., the date of a sale or exchange). If the capital gain investment is held within a Fund for at least 5 years, the investor would reduce their tax burden by 10 percent; if the investment is held for 7 years, the burden would be reduced another 5 percent. Finally, if the investment is held within a Fund for at least 10 years, the investor would not be required to pay capital gains tax on any gain generated by its investment in a Qualified Opportunity Zone (i.e., the taxpayer would only be required to pay tax on the initial capital gains invested with the 15 percent stepped-up basis).
Can I Create An Opportunity Zone Fund? Yes. Even with the lack of existing guidance from the Treasury, there are some applications that are likely to be reasonably safe in achieving tax savings now. For example, if you are a developer about to acquire and develop real estate in an area that has just been designated as an Opportunity Zone, you should consider creating a fund now and structuring the deal through your fund in order to preserve the option of tax forgiveness. If you are a business looking to acquire and improve property, you should consider property in an Opportunity Zone, creating a Fund, and structuring the deal through the Fund. Individuals or business investors with large gains should consider investing in an Opportunity Zone Fund.
What Can I Do With Opportunity Zones While We’re Awaiting Guidance? You can do a lot. You can begin identifying properties and businesses in Opportunity Zones that are good potential targets for investment. You may be able to execute options or contracts for their purchase, while you await further guidance on the Zones. If you are a developer about to develop property in a Zone, or a business about to purchase property in a Zone, you may want to create a Fund now and even raise additional capital. If you are an investor with a large capital gain in 2018, you may also want to create a Fund to preserve your deferral options. If you want to create and manage a Fund, while it is not advisable in advance of guidance to raise money and begin investing (and it is not clear yet whether funds will need to be closed or can be open-ended), you may begin talking to your investors informally to generate interest in the pending new Fund, and you may begin to prepare materials and business plans around a new proposed Fund.
