The Future of Opportunity Zone Tax Benefits for Real Estate
A Legal Perspective on Benefits, Requirements and Criticisms
by Jenny Connors
The opportunity zone (“OZ”) tax incentive, which was enacted as part of the Tax Cuts and Jobs Act, has been a major catalyst for real estate investment over the past three years. Initiated as a bipartisan effort for economic growth and job creation, the incentive was intended to promote long-term, private investment in America’s low-income communities. The incentive, however, has long come under criticism for failing to meet its objectives. This article includes a brief summary of the incentive’s tax benefits and its requirements for qualification, as well as a discussion of the future of OZs and foreseeable changes under the Biden administration.
OZ Tax Benefits
There are three primary components of the OZ tax incentive. First, the incentive offers electing taxpayers an opportunity to defer tax on eligible capital gains if they invest those gains on a timely basis in an entity taxed as a corporation or partnership that self certifies as a qualified opportunity fund (a “QOF”). Generally, the applicable QOF investment period is 180 days following a gain recognition event. However, there are several regulatory exceptions to this rule. For instance, the 180-day period for partners allocated partnership gains begins on the last day of the partnership’s taxable year or, if a partner so elects, on the due date of the partnership’s tax return (without extensions) or the partnership’s recognition date. The deferral period for all taxpayers, though, regardless of the date of investment, ends as of December 31, 2026. Any gains recognized after that date are ineligible for OZ tax benefits.
Second, taxpayers can qualify for a partial tax reduction on their deferred capital gains if they invest in QOFs by certain dates. Specifically, taxpayers who hold their qualifying QOF investments for at least 7 years prior to December 31, 2026 get the benefit of a 15% tax reduction on their deferred eligible gains. To satisfy this timeline, taxpayers needed to invest eligible capital gains in a QOF on or before December 31, 2019. Taxpayers who missed this deadline may still be eligible for a 10% tax reduction, so long as they invest such gains in a QOF prior to December 31, 2021 and continue to hold that investment as of December 31, 2026. After 2021, the partial reduction benefit expires, and there is no option for taxpayers to reduce the tax owed on their deferred capital gains.
Lastly, taxpayers who hold their qualifying QOF investments for at least 10 years and make a valid election can benefit from a tax exclusion on the appreciation of their QOF interest. Basis adjustments taken over the life of the QOF interest facilitate this exclusion. When a taxpayer makes a qualifying investment in a QOF, he or she takes a $0 basis in the QOF interest to preserve his or her unrecognized capital gains. As of December 31, 2026, when the deferral period ends, the taxpayer’s basis is increased by the then-recognized gain, plus the tax reduction amount, if any. Upon a sale or exchange of the taxpayer’s QOF interest, and after a 10-year hold, he or she can elect to increase his or her basis in the QOF interest to its fair market value immediately prior to the sale or exchange. In so doing, the taxpayer’s amount realized (i.e., gain less basis) is equal to $0, and the taxpayer recognizes no gain on the transaction.
Treasury Regulations extended the 10-year gain exclusion election to sales of QOF assets, including sales of qualified opportunity zone property (“OZP”) and qualified opportunity zone business property (“OZBP”). In those instances, the taxpayer may elect to exclude the asset sale gain, provided that he or she has held his or her QOF interest for at least 10 years.
OZ Requirements
At least 90 percent of a QOF’s assets must be OZP. OZP includes OZBP or equity interests in subsidiary businesses. Typically, QOFs investing in real estate opt for the latter, specifically holding qualified opportunity zone partnership interests. Referred to as the “indirect” structure, the QOF holds the partnership interests in satisfaction of the 90 percent OZP requirement. Those partnership interests must be acquired after December 31, 2017, and the underlying partnership must be a qualified opportunity zone business (an “OZB”). While OZBs are subject to additional requirements, the indirect structure, which necessitates an OZB, ultimately provides QOFs with greater flexibility in deploying cash and satisfying asset thresholds.
An OZB must derive at least 50 percent of its total gross income from, and use a substantial portion of its intangible assets, if any, in, the active conduct of a trade or business within a designated OZ. Less than 5 percent of its assets may constitute nonqualified financial property, including, among other things, cash (other than reasonable working capital, including amounts to be deployed within a 31-month period pursuant to a written plan), debt, stock and subsidiary partnership interests, and no part of the OZB’s business can constitute a “sin” business. Most importantly, though, substantially all, or at least 70 percent, of the tangible property owned or leased by an OZB, if any, must be OZBP.
OZBP includes tangible property, real or personal, that is acquired or leased after December 31, 2017. For purchased OZBP, its original use in the OZ must commence with the OZB, or it must be substantially improved within a 30-month period. Substantial improvement generally requires an OZB to spend at least the amount of the property’s acquisition cost (less, in the case of real property, amounts allocated to land) on improvements. Finally, for at least 90 percent of the OZB’s holding period, OZBP must be used within an OZ.
OZ Criticism and Potential Changes
The OZB and OZBP requirements lend themselves to realty, which is stationary within an OZ. Consequently, most OZ projects are real estate based. Critics of the OZ incentive have noted that its heavy real estate usage leads to problems of gentrification and results in few, if any, jobs for residents of low-income communities. While the accuracy of such critiques is debatable, the Biden administration has already announced its intention to make changes to the OZ incentive.
Currently, the scope of any alterations to the OZ incentive are hard to determine. While Biden’s proposed tax plan references increased reporting requirements for QOFs and the creation of incentives for OZ partnerships with community organizations, other proposed legislation has gone so far as to limit the types of permissible OZ projects. For instance, parking garages, self-storage facilities, sports stadiums and health club facilities could be restricted uses of the OZ incentive. Further, residential rental property developments, which have seen significant OZ investment over the past several years, could face OZ use restrictions based on the percentage of low-income housing made available to residents. Timing is another area of uncertainty. To the extent that changes are made to the OZ incentive, it is unclear whether those changes would be made on a retroactive basis, or if current OZ participants and projects would be grandfathered under the current rules.
Uncertainty likely will temper year-end OZ activity, especially with the Senate’s balance of power undetermined until January 5, 2021. A Democrat-controlled Senate would boost the likelihood of changes to tax laws, including proposed increases to the long-term capital gains rate for certain individuals. Projected tax benefits for OZ projects are directly tied to the current long-term capital gains rate of 20%, and any change in that rate would greatly impact OZ investors and their anticipated returns. Consequently, both current and prospective OZ participants are likely to monitor the outcomes of the Georgia Senate run-offs closely.
Despite potential changes, investors and developers still should consider using the OZ tax incentive to fund projects. At this time, there is a very low cost of entry for QOFs and OZBs, especially in the case of real estate, and even a limited window of tax deferral can be beneficial. More so now than ever, though, investors should focus on good deals with a high likelihood of appreciation where any OZ tax benefits are merely a bonus. Similarly, developers should look to increase the community benefits of their projects in anticipation of reporting obligations and social impact requirements that may be coming with the Biden administration.
