IRS Opportunity Zone Updates: Spring 2019
Since the Opportunity Zones program was announcing in 2017, the buzz around investing in Opportunity Zones has grown significantly. However, many of the rules of the program have not been particularly clear, leaving many investors confused. In an attempt to clarify things, the IRS released a new set of Opportunity Zone regulations on April 17, 2019, which, ideally, will increase investor confidence in the program, making it much easier for business owners, investors and Opportunity Fund managers to know what types of investments do and do not qualify.
- IRS Clarifies Opportunity Zone Investing Rules With New Regulations
- What Investors Already Knew About Opportunity Zones
- What The IRS Clarified About Opportunity Zone Investing
- Property Leasing Rules and Opportunity Zones
- Raw and Improved Land Considerations and Opportunity Zones
- When Do Opportunity Fund Investors Have to Pay Capital Gains Taxes?
- Commercial Real Estate Loans and Capital Gains Tax Considerations
- Related Questions
- Get Financing
IRS Clarifies Opportunity Zone Investing Rules With New Regulations
Since the Opportunity Zones program was announcing in 2017, the buzz around investing in Opportunity Zones has grown significantly. However, many of the rules of the program have not been particularly clear, leaving many investors confused. In an attempt to clarify things, the IRS released a new set of Opportunity Zone regulations on April 17, 2019, which, ideally, will increase investor confidence in the program, making it much easier for business owners, investors and Opportunity Fund managers to know what types of investments do and do not qualify.
What Investors Already Knew About Opportunity Zones
Before the IRS released its new updates, it was already known that an Opportunity Fund would need to have 90% of its assets invested in a Qualified Opportunity Zone (QOZ), or stock or partnership in a Qualified Opportunity Zone Business (QOZB). Qualified Opportunity Zone Businesses would need to have 70% of their assets located in a QOZ, or meet certain other eligibility requirements. That means that an Opportunity Fund could hold 90% of its assets in businesses that hold 70% of their assets in QOZs, meaning that, from a bird’s eye level, only 63% of the fund would need to actually be invested in QOZ.
However, a lot of confusion and uncertainty arose from other requirements for QOZBs, primarily the rule that Qualified Opportunity Zone Businesses would need to earn 50% of their income from within an Opportunity Zone. This seemed unrealistic to most investors, especially considering the fact that O-Zones are generally located in economically disadvantaged areas.
In addition, the IRS stated that an Opportunity Fund would need to have acquired its assets after December 31st, 2017. In regards to acquiring shares in a business or partnership, that business or partnership would need to qualify as a QOZB under the rules mentioned above (and would need to submit Form 8996 to the IRS).
What The IRS Clarified About Opportunity Zone Investing
The IRS’s new rules clarified several things about Opportunity Zone investing-- particularly about investing in Qualified Opportunity Zone businesses. In particular, the aforementioned 50% rule was somewhat re-tooled. The new rules stipulate that:
Employees and contractors of a QOZB need to spend a minimum of 50% of their billable hours working inside a QOZ, or:
A business must have real estate located inside an Opportunity Zone, the operation of which contributed at least 50% of the businesses income, even if the business itself is not located in an Opportunity Zone; or:
50% of funds paid to contractors and employees is for work done inside an Opportunity Zone, even if the business itself is not located in an Opportunity Zone.
Lease out property within a QOZ
Build/improve property, and lease it within a QOZ
Leased property transactions must be “arm’s length”; if not, lease prepayment for more than 1 year at once is prohibited
Within 30 months of leasing the property, the Opportunity Fund or Qualified Opportunity Zone Business needs to purchase a property of equal or greater value.
The lease must begin after December 31st, 2017.
Lease-to-buy agreements are not permitted.
An Opportunity Fund is dissolved
An O-Zone investment is given as a gift
More than 25% of the ownership of an S-corp changes
An Opportunity Fund redeems shareholder interests
A shareholder dies
The organization undergoes a tax-free reorganization
Less than 25% of the ownership of an S-corp changes
What are the most recent IRS Opportunity Zone updates?
The most recent IRS Opportunity Zone updates were released in December 2019. These updates clarified the rules for Opportunity Funds, including the requirements for investing in real estate. Specifically, the updates clarified that an Opportunity Fund must invest in new construction or substantial rehabilitation of properties, and that all construction and rehabilitation work must be completed within 30 months of a property’s purchase. Additionally, the updates clarified that an Opportunity Fund must invest more in a building’s rehabilitation than it originally invested in the building’s purchase.
You can find more information about the Opportunity Zones Program and the most recent IRS updates in the following sources:
What are the benefits of investing in an Opportunity Zone?
The benefits of investing in an Opportunity Zone include the ability to defer capital gains taxes until the investment is sold or by December 31, 2026, whichever occurs first. Additionally, investors who keep their money in an Opportunity Fund for at least 5 years will receive a 10% reduction of their capital gains tax liability, while those who keep their investment in the fund for at least 7 years will receive an additional 5% discount, for a total 15% capital gains tax discount. Lastly, investors who keep their money in an Opportunity Fund for at least 10 years will not have to pay any capital gains taxes on any additional appreciation their investment has experienced since it was placed in the fund.
For more information, please see Commercial Real Estate Loans and Multifamily Loans.
What are the requirements for investing in an Opportunity Zone?
In general, most experts believe that it’s not worth investing in an Opportunity Fund unless you have a minimum 10-year investment horizon. This way you can take full advantage of all of the tax benefits of Opportunity Fund investing. Therefore, if an investor is elderly, in poor health, or may need to use their funds within a few years, investing in an Opportunity Fund may not be the best choice. For commercial or multifamily real estate investors who wish to start their own Opportunity Fund, it’s generally recommended that they have at least $1 million in assets to invest. Otherwise, the operational and administrative costs of opening a fund may negate the potential tax benefits.
To be eligible, a property must either be new construction, or if it is a rehabilitation project, the Opportunity Fund must invest equal or greater funds into property improvements than it did to initially purchase the property. However, a recent regulatory ruling posits that this only applies to the cost of the building, not the cost of the land. For instance, if an Opportunity Fund invested $1 million into an outdated apartment building, and it was found that the building was worth $600,000, while the land was worth $400,000, the Opportunity Fund would only need to invest $600,000 into property improvements, not the full $1 million. In addition, all construction or rehabilitation projects must be completed within 30 months.
For an Opportunity Fund to invest in a business, the business must not be in a prohibited category. Prohibited business categories include liquor stores, massage parlors, gambling-related businesses, golf courses, tanning salons, and several other types of “sin” businesses. Despite this, an Opportunity Fund can generally own property that is being leased to these businesses, they just cannot own shares in these types of businesses themselves. Plus, the business must do at least 70% of its business inside the Opportunity Zone in order to qualify. This rule has caused serious concern for many Opportunity Funds, and is part of the reason why most initial O-Zone investments have gone toward commercial and multifamily real estate, not businesses.
What are the tax incentives for investing in an Opportunity Zone?
The Tax Cuts and Jobs Act of 2017 created a new tax incentive program to encourage capital investment in economically distressed areas of the U.S. Via the use of opportunity funds, investors can qualify for the tax incentives offered by the Opportunity Zones program. If an investor keeps their money in an Opportunity Fund for at least 5 years prior to December 31, 2026, they will reduce their deferred capital gains tax liability by 10%, while if they keep funds in for seven years before that date, they can reduce their tax bill by 15%. In some cases, investors may even reduce their tax liability to zero on any profits they generated by investing in an Opportunity Fund, though they will need to hold their investment in the fund for at least 10 years in order to qualify.
Source: A Guide to the Opportunity Zones Program for Commercial and Multifamily Real Estate Investors
What are the risks associated with investing in an Opportunity Zone?
Investing in an Opportunity Zone can be a great way to take advantage of tax benefits, but there are some risks associated with it. For example, the investment may not generate the expected returns, or the area may not experience the expected revitalization. Additionally, the Opportunity Zone program is relatively new, so there is still some uncertainty about how the program will be implemented and enforced. Finally, investors should be aware that the tax benefits of the program are only available if the investment is held for at least 10 years.
Source: Commercial Real Estate Loans and Multifamily Loans
How do I find an Opportunity Zone to invest in?
You can find an Opportunity Zone to invest in by visiting the Opportunity Zones website. The website provides a list of all 8,700 Qualified Opportunity Zones (QOZs) across the country. You can also use the website to learn more about the Opportunity Zones program and the tax benefits associated with investing in an Opportunity Fund. Additionally, you can read this guide to the Opportunity Zones program for Commercial and Multifamily Real Estate Investors to learn more about the program and how to qualify for the tax incentives offered by the Opportunity Zones program.
In addition, business can hold 5% (or sometimes more), of working capital reserves, but need to have a working plan to utilize these funds.
Property Leasing Rules and Opportunity Zones
In addition to clarifying aspects of the 50% rule, the IRS’s new rules also added useful information about property leasing in regards to the O-Zones program. In particular, investors/business may qualify for Opportunity Zone benefits if they:
However, investors may not build property and lease it out with a NNN lease. The lease must involve a higher level of activity from the landlord/owner (as an Opportunity Fund or Qualified Opportunity Zone Business). In the eyes of the IRS, leasing property with full service leases, net leases, and double net leases qualifies as the operation of a “trade or business,” while leasing a property with a triple net lease only qualifies as holding a passive investment (at least in regards to the Opportunity Zones program.)
Despite this increased freedom to lease property, there are certain restrictions and rules that investors/businesses must follow when leasing property out. In particular:
Raw and Improved Land Considerations and Opportunity Zones
In addition to having a variety of questions about Qualified Opportunity Zone Businesses and business leasing, investors were also left wondering about many of the rules about raw and improved land and O-Zones investing. In regards to improved land, initial IRS rules stated that current buildings must be improved with an investment equal to or greater than the cost basis of the existing building (pre-improvement) in order to qualify. And, in regards to raw land, the IRS already stated that any qualified land must not have been previously utilized in a Qualified Opportunity Zone, or, alternatively, needs to have been substantially improved. However, despite this information, certain questions still lingered.
Fortunately, the IRS issued clarifications involving many of these areas of concern. First, the IRS stated “use” begins when a project has first been depreciated, so projects that are unfinished and have not yet received a certificate of occupancy may be eligible as a QOF or QOZB investment. In addition, any properties that have been vacant for 5+ years are not counted as having been “previously used,” and will therefore also be eligible as a QOF or QOZB investment.
While funds and businesses cannot simply purchase and hold raw land, properties that consist of a large portion of land with one or more buildings will be treated somewhat differently. In fact, these types of properties will generally receive a separate cost basis for both the land and building. And, in these scenarios, land will not need to be improved by an amount equal to the cost basis of the entire plot of land, only by the cost basis of the building.
When Do Opportunity Fund Investors Have to Pay Capital Gains Taxes?
The main benefit of Opportunity Zones is the deferral of capital gains taxes-- and the new IRS information release details which specific O-Zone activities trigger mandatory capital gains tax payments, and which do not.
Capital gains taxes are typically due when:
Capital gains taxes are typically not due when:
Commercial Real Estate Loans and Capital Gains Tax Considerations
Fortunately, the new IRS rules confirm that taking on debt will not negatively affect an Opportunity Fund’s capital gains tax benefits. Plus, Opportunity Funds can purchase and improve property, sell it, and purchase a new property with the proceeds, without immediately having to pay capital gains taxes (given they are holding the property for at least 10 years). However, they will have to pay taxes on any gains they make by the property sale that are in excess of the initial tax basis of the property. In essence, funds cannot simply keep flipping properties and avoiding taxes. In general, funds will not have to pay taxes immediately upon their dissolution, as long as the eligible assets and/or businesses still remain inside an Qualified Opportunity Zone.
Unfortunately, Opportunity Fund investors may only defer their original capital gains until December 31, 2026. And, in order to get the full 15% capital gains discount, an investor needs to hold the investment for a minimum of 7 years-- which, in essence, means they must invest by December 31, 2019, in order to get this entire benefit. Of course, the other tax benefits of Opportunity Funds still make them a desirable investment vehicle, but, in the eyes of many experts, this strict timeline does limit the full potential of the program.