By: Michael Van Someren
One of the most exciting new topics in real estate is the creation of opportunity zones as part of the Tax Cut and Jobs Act of 2017. Recently, the IRS issued additional guidance on the use of opportunity zones in the form of proposed regulations. Based on the proposed regulations, the excitement surrounding opportunity zones appears justified. While opportunity zones are a compelling opportunity for developers, there are many nuances that must be taken into account when structuring an opportunity zone project.
What Is an Opportunity Zone?
An opportunity zone is a census tract designated as such by the federal government. There are a number of census tracts designated as opportunity zones in each state. Opportunity zone census tracts are geographic areas that the federal government has identified (with the help of the individual states) as economically distressed. The government wants to encourage redevelopment and investment in these census tracts by providing preferential tax treatment for investments. Initially, 25% of all census tracts were designated as opportunity zones meaning that 25% of census tracts in the United States may qualify as an opportunity zone project where a developer could decide to pursue a project.
Why Engage in Opportunity Zone Projects?
Projects located in opportunity zones provide tax advantages to investors that significantly enhance the overall return for investors.
- Gains. Investors in opportunity zone real estate projects invest only their gains in opportunity zone projects and retain their initial investment that generated the gain (i.e., their basis).
- Deferral. Investors defer the payment of any tax obligations arising from the sale of a capital asset until 2026.
- Safe Harbor. Investors that invest capital gains in a qualified opportunity fund by December 31, 2019 and keep the investment in the qualified opportunity fund until December 31, 2026 pay capital gains tax on 85% of their initial capital contribution to the qualified opportunity fund (i.e., the gains from the sale of a capital asset). Investors that invest capital gains in a qualified opportunity fund by December 31, 2021 and keep the investment in the qualified opportunity fund until December 31, 2026 pay capital gains tax on 90% of their initial capital contribution to the qualified opportunity fund.
- Basis Step Up. Investors maintaining their investment in a qualified opportunity fund for 10 years and 1 day pay no capital gains on the sale of their interest in the qualified opportunity fund (e.g., if a $100,000 investment in a qualified opportunity fund is sold for $300,000.00 the investor will have a $200,000 gain that is not subject to capital gains tax).
- Diversification. Investors may invest any capital gains, including gains from the sale of stocks, bonds, and the sale of businesses.
The benefits to investors dovetail with the benefits to developers.
- Lower Annual Returns. Developers can pay a lower annual or preferred return and still offer an attractive investment due to the after-tax return to investors in qualified opportunity zones. If the sale of an interest in a qualified opportunity fund in a significant gain realized by the investor, the investor is able to capture all of the upside without losing any to tax payments.
- Long-Term Investors. Developers will have investors that need to stay invested in projects for a longer period of time. This can allow developers more time to realize the full benefit of a project and reduce the need to generate returns quickly.
- Non-Exclusive. Developers can use a qualified opportunity fund in conjunction with traditional equity structures. This allows the developer to use the qualified opportunity fund as a component to the capital stack. It can also allow a developer to increase returns to traditional investors while still providing an attractive gain for the investors in the qualified opportunity fund.
How to Benefit from Opportunity Zones
To take advantage of opportunity zones, the first step is to locate a property in a census tract designated as an opportunity zone. Various map resources exist to find these properties. Within Wisconsin for example, resource maps are included on the City of Milwaukee’s website and the Wisconsin Housing and Economic Development Authority website. The property can be vacant land or an existing building, but if the investment is an existing building, then the investment must include substantial improvements at least equal to the purchase price of the building (e.g., purchasing a building for $500,000.00 will require an investment in the building of at least $500,000.00 to qualify for favorable tax treatment).
Second, investors that wish to invest in an opportunity zone project and realize the benefits that come along with such an investment sell an asset to generate the capital gains to invest. The capital gains can be short term or long term, and as noted above, can be derived from nearly any sort of asset, including stocks and bonds. Further, an investor does not need to involve a qualified intermediary or other party to facilitate the investment. The investor simply sells his or her asset and invests the gain in the opportunity zone project within 180 days of such sale. When the investor files his or her tax return the following year, he or she will then include a form confirming what portion of his or her capital gains were invested in a qualified opportunity fund, which is explained below.
Structuring an Opportunity Zone Investment
Structuring an opportunity zone investment is not significantly different from a traditional real estate investment, and as noted above, can be utilized in conjunction with a traditional real estate investment. The major difference between an opportunity zone project and a traditional real estate project is the need for a qualified opportunity fund and, of course, the required holding period. This will often take the form of a limited liability company or limited partnership. The developer, or sponsor, will often be the manager of the qualified opportunity fund. The qualified opportunity fund will then accept investments of capital gains from investors, preferably in accordance with a private placement memorandum or similar disclosure.
Once the qualified opportunity fund has taken in all of the gains that its investors wish to invest, then it has 30 months to deploy its invested capital in the qualified opportunity fund into the opportunity zone project. At the end of its first tax year, the qualified opportunity fund entity must certify to the IRS that 90% or more of its assets qualify as opportunity zone property.
Opportunity Zone Project with only Capital Gains Invested:
Opportunity Zone Project with Capital Gains and Non-Capital Gains Invested:
The examples above are just a couple of potential structures for opportunity zone projects. There are other investment structures that may be utilized depending on the needs of the particular project.
Other Related Laws
Opportunity zone projects, and the investments in them, are still subject to federal and state laws, including securities laws and corporate law. It is important that sponsors and developers prepare disclosure materials in the form of private placement memoranda or subscription agreements that set forth the risk of investments in opportunity zones. The consequences of failing to complete an opportunity zone project can mean more than just a loss of investment. Failure can result in tax-related consequences, including penalties and interest.
Understand Your Investment and Act Accordingly
Opportunity zones provide substantial benefits to developers and investors with minimal extra regulatory compliance. However, time must be taken prior to the investment being made to ensure that the requirements will be met. The investment into a qualified opportunity fund is yet another potential layer in the capital stack. If you think you may have a project that could qualify as, and benefit from, being an opportunity zone project, contact your Davis|Kuelthau, s.c. attorney, the author linked above, or the related practice group co-chairs linked here.