A curving fenced in trail near North Pond with snow in Lincoln Park Chicago
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Opportunity Zone legislation just got better and clearer. Potentially, the legislation will become even more favorable in the future. For whom did it get better? Investors AND communities. Is it perfect yet? No. Would it be a mistake to simply sit on the sidelines and wait for it to get better? Yes.
Quick background: The major tax legislation from December 2017 created Opportunity Zones allowing investors to defer, reduce and eliminate capital gains tax if they invest in 8,000+ very specific areas throughout the US.
The original Opportunity Zone legislation lacked a lot of details, and the first round of guidance in October 2018 created more questions than it answered. The much-anticipated second round of guidance was released yesterday, which is timely because the maximum benefit of the legislation requires an Opportunity Zone investment be completed by December 31, 2019.
By and large, investors have been excited about Opportunity Zones but slow to engage without clearer IRS guidance. Communities have been cautious because it could exacerbate displacement.
Below are the top highlights from the new guidance released on April 17, 2019:
- Opportunity Zones are now open for business(es)
The most concerning issue in the previous guidance for business investors was the 50% test, which onerously stated that a business that wants to qualify for this program must derive at last 50% of its total gross income from the active conduct of the business within a qualified Opportunity Zone. The new guidance clears this large hurdle by creating four distinct tests that can be used to qualify a business under the new 50% test:
- Total hours worked by employees and independent contractors within an Opportunity Zone must be at least 50% of the company’s total hours worked;
- Total dollars paid to employees and independent contractors for services performed within an Opportunity Zone must be at least 50% of the company’s total dollars paid for services performed;
- Both the management/operational staff and the tangible property of the business that is in the Opportunity Zone must be necessary to generate 50% of the company’s gross income; or
- Facts and circumstances.
A business can qualify under any of the four above, and “facts and circumstances” leave a lot of room for businesses to make their case to the IRS for inclusion into Opportunity Zone qualification.
Altogether, it appears that the IRS and Treasury went as far as they possibly could to make it easy for investors to make sound business investments as a part of this legislation. The concern that real estate was the only asset class that could partake in the Opportunity Zone legislation should be alleviated and hopefully reduce community misbalances and displacement.
- Integration is here and accountability is forthcoming
The most encouraging announcements for communities come from outside of the new 169-page guidance document but are of equal importance.
49 grants and specialized programs across 14 federal agencies, from the Small Business Administration to the Department of Justice, added preference points, acknowledgements or tie-breaker considerations for projects and applicants in Opportunity Zones for 2019.
This was done through a council of nearly 20 federal agencies called the White House Opportunity and Revitalization Council, which were glued together by a Presidential Executive Order on December 12, 2018, explicitly to eliminate federal bureaucracy related to Opportunity Zones. This group published a report of their collective work since December, stating that, in addition to the nearly 50 programs where action has been taken, there are over 100 more programs where targeting and added support could be granted.
Five work streams (or work groups) make up this council: Economic Development, Entrepreneurship, Safe Neighborhoods, Education and Workforce Development and, finally, Measurement, which will be starting a national listening tour in the summer.
The work of this group could be particularly encouraging, especially as the new guidance highlights a request for information on data collection from Qualified Opportunity Funds, specifically related to job creation, poverty reduction and new business startups. If they can combine data on jobs, income and businesses with information that proves displacement was not a result of qualified investments, Opportunity Zones might just turn out to be a winner for most, if not all.
- A path for funds is emerging
The Treasury and IRS are trying to make it easy for a fund to (a) hold multiple assets without an administrative burden and (b) sale a single asset in the same fund structure without recognizing a gain. The only problem is that they haven’t figured out how to do it yet. The good news is they clearly express their intent to move in this direction, which would be very helpful for investors.
For context, nearly all real estate investors that have created Opportunity Funds have done so only for individual properties thus far, with the exception of a vocal few REIT offerings. Prior to the new guidance, there was no real mechanism to enter, substantially improve and then exit a group of Opportunity Zone investments as a portfolio. It has been safest to limit your risk by having individual funds per property or asset.
However, as stated in the new guidance, “The Treasury Department and the IRS have considered the possibility…that an asset-by-asset approach might be onerous for certain types of businesses [and] might cause operating businesses with significant numbers of diverse assets to encounter administratively difficult asset segregation and tracking burdens.”
Additionally, the IRS made it clear that there is not a penalty or tax inclusion event to an investor if the Opportunity Fund they purchased sells an asset. But exactly how to exclude that from taxation is still being determined by the IRS.
- Favorable timelines for investment and reinvestment just alleviated a lot of risk
Originally there was a 31-month safe harbor, or allowance period, that new Opportunity Funds could use to hold onto cash, but for real property only. In other words, one could invest in an Opportunity Fund, enjoy the tax deferral and take up to 31 months to fully invest those funds into real estate assets. As of this new guidance, the 31-month safe harbor is available to the development of businesses as well as real estate assets.
Treasury reduced the risk to investors in Opportunity Funds, by allowing funds to eliminate cash they have received within six months of its annual 90% asset test to be excluded. Newly contributed cash assets into a fund need not be counted for six months, which provides an additional security blanket to investors who want to utilize the Opportunity Zone program but are unwilling to make early mistakes.
Investors now have one year to reinvest funds that were in an Opportunity Fund and then sell without taking a tax penalty. This gives flexibility to investors to exit particular investments if they really need to without completely interrupting their tax status.
Of equal importance, the 31-month safe harbor and the one-year reinvestment period can be extended if the delay in deploying the funds is due to the government. This singular function of the new guidance alleviates significant risk for real estate developers, in particular, and business owners overall.
- Original Use is well defined, but with one loophole
The legislation was meant to spur investment and increase economic activity in the 8,000+ Opportunity Zones. Consequently, if an Opportunity Fund buys a building, it must substantially improve it, or, if the fund buys a piece of land, it can’t just sit on it.
However, a (likely unintended) loophole was created in the latest guidance. If an Opportunity Fund buys a building that has been vacant for an uninterrupted period of five years, it does not appear as if the fund must improve it. Investors can’t land-bank, but they may be able to purchase properties that have been vacant for five years and not improve them. Let’s hope that is not the case.
Exactly 64 days passed between the Valentine’s Day IRS public hearing and the release of this new guidance. With the next hearing set for July 9th in Washington, D.C., mid-August would be the earliest time to expect the next round of updates, if they are to come quickly. For now, there should be enough guidance available to make a positive impact in communities and economically.