IRS, Treasury Start to Clarify Qualified Opportunity Zone Regulations
By: Trey Barrineau
Winter 2018 2019
Proposed rules for the tax incentive plan could dramatically boost real estate investment in regions that are struggling economically.
IN LATE OCTOBER, the Internal Revenue Service (IRS) and the Treasury Department released the first proposed rules for the Qualified Opportunity Zone tax incentive plan that aims to increase investment in economically disadvantaged areas. While a lot of questions remain unanswered about the complex program, many in the commercial real estate industry said they liked what they saw in the first round of guidance.
“The recently issued Opportunity Zone regulations were generally favorable to the commercial real estate industry and provided much-needed clarity in several key areas,” said Randy Barrus, CPA, a partner at Baker Tilly’s Washington, D.C., office. “We expect many real estate companies to quickly begin strategizing on how they will participate in Opportunity Zones while we await additional regulations that will focus on operational issues, such as the sale of an Opportunity Zone asset.”
Qualified Opportunity Zones were created as part of the tax overhaul legislation that was signed into law at the end of 2017. Since then, the program has generated significant interest in the commercial real estate industry because of the potential investment opportunities it presents.
“I have spent a lot of time geeking out on Opportunity Zones as it is the topic du jour in commercial real estate,” said Jordan Angel, senior director with HFF in San Francisco. “We are already working on a number of Opportunity Zone sites across the country from both a sales and equity-raising perspective. We have seen a huge demand for Opportunity Zone deals and overall knowledge on the subject.”
What is an Opportunity Zone?
In June 2018, nearly 9,000 census tracts in 50 states, the District of Columbia and five U.S. territories were named Qualified Opportunity Zones, a designation that will last for 10 years. According to the IRS, Qualified Opportunity Zones are economically distressed areas where tax benefits will be used to increase investment and job creation across a wide range of businesses — not just commercial real estate.
Those who invest in properties or businesses within Qualified Opportunity Zones can defer most capital gains taxes until December 31, 2026.
To meet the deferral requirements, the capital gains must be invested in a Qualified Opportunity Fund (QOF) in which at least 90 percent of assets are invested in Opportunity Zone businesses or properties. The guidance issued in October by the IRS clarifies that cash can count toward the 90-percent test if it is working capital, and the election to defer or eliminate gains can be made at the entity level (partnership or corporation) or the individual level.
“These clarifications provide far more flexibility on the type of investments and type of investors that can take advantage of the program,” said Barrus.
The IRS says investors who hold QOF investments for at least 10 years will be able to permanently exclude their capital gains from taxation.
Businesses should be able to find Qualified Opportunity Fund investors who will accept a less-than-normal return because of the favorable tax treatment they will receive later, said Gerard Mildner, director of the Center for Real Estate at Portland State University.
“The places within the zones that receive the investment will be the Goldilocks sites,” he said. “They’re those with stronger market fundamentals, but not too strong, so that some capital gains potential still exists.”
Properties and businesses within Qualified Opportunity Zones will likely see an immediate rise in asset values, given that tax relief should drive greater demand for those sites, Mildner said. He added that it is analogous to how crop prices rise after the government announces a new agricultural program.
John McDermott, executive director, industrial practice leader with SVN Chicago Commercial, believes that the ability to exclude capital gains after 10 years is the most important provision of the Qualified Opportunity Zone program. It will do the most good for the commercial real estate industry, as well as for those who live and work in the affected areas.
“A long-term-hold mentality usually translates into better properties and better maintenance thereof,” he said. “That’s all good for the neighborhood.”
A Possible Boost for the CRE Industry
Because at least 70 percent of the tangible assets of a business must be located in an Opportunity Zone, those investing in real estate could be among the primary beneficiaries of the new program, Mildner said.
“Most real estate development is done through a single-purpose LLC, shielding the investors’ balance sheet from any liability,” he said. “Hence, the ‘asset’ is typically constrained to a single site, which is then either inside a Qualified Opportunity Zone or not. With investment in an operating company, you can imagine the offices, factories, warehouses and sales outlets being in multiple buildings and multiple neighborhoods. Some of those buildings might be outside the Opportunity Zone. Hence, the 70-percent rule is more likely to become a critical constraint with that kind of investment.”
Mildner said the tax advantages of Qualified Opportunity Zones should boost investment in commercial real estate.
“This provision creates a favored avenue for investing capital gains that have accumulated, without the 1031 exchange criteria,” he said, referring to Section 1031 of the Internal Revenue Code, which lets an investor defer capital gains taxes if he or she sells a property and puts all the proceeds into a new property. “And after 10 years, there’s an exit strategy with permanent exclusion of the capital gains. With 1031, the only exit strategy is death.”
McDermott gave an example that illustrates the profit potential of Opportunity Zones for investors.
“I have an industrial property listed in Chicago that’s $8.6 million for 264,090 square feet on 6.5 acres,” he said. “Prior to the Opportunity Zone designation of the neighborhood in which the project is located, interest was not great. We now have an Opportunity Zone investor with a great track record in redeveloping industrial-to-industrial versus the popular mixed-use or loft conversions so prevalent here in Chicago. Should they move forward based on the clarifications by the IRS, they could invest a very significant amount of capital gains capital ($8.6 million), spend up to $2.6 million on the property, which it likely needs to be repurposed or re-tenanted (this assumes that the land is worth $6 million today, which it is), hold the asset for 10 years and have an exit strategy value of what may very well be over $20 million.”
While the rules for Qualified Opportunity Zones look very favorable for the commercial real estate industry, Mildner warned that they could inspire speculative behavior from many investors.
“After 10 years, there will be funds withdrawn from these zones, unless the statute stays on the books,” he said. “Hence, there could be a 10-year bubble in these sites, assuming that Opportunity Zone investing is the dominant investment form in those areas.”
Additionally, Angel said there are some misconceptions surrounding the Qualified Opportunity Zone designation.
“Not all of them are created equal,” he said. “There are states where zones are located in areas that justify development, and the inclusion of the tax benefits will be a boost to development. There are other states where there will be limited development opportunities, and the tax incentive may actually lead to some poor real estate decisions being made.”
Developers could also face organized resistance from poorer communities, said Mark Stapp, executive director of the Master of Real Estate Development program in the W.P. Carey School of Business at Arizona State University.
“So many of the Opportunity Zones are in underserved areas of communities, and a lot of times those areas have substantial political capital that they like to bring to the table,” he said during CRE.Converge in Washington, D.C., in October 2018. “The idea of ‘are you going to cause gentrification, are you going to displace us’ is going to change the dialogue in the approvals process. You may find it difficult to get the necessary approvals.”
Angel said areas in his home state of California that could benefit from Qualified Opportunity Zone investments include parts of Los Angeles, San Jose and Oakland. He said other U.S. markets that could see a substantial boost from Opportunity Zones include northeast Houston, Boston, Portland and Philadelphia.
Trey Barrineau is the managing editor of Development magazine.