The federal opportunity zone program offers the potential for directing new and significant capital investment to some of the country’s areas in need of development. When describing the program, we have referred to it as the next big thing in economic development that could usher in the greatest transfer of wealth this country has seen in decades. However, as federal regulators continue to delay in issuing any meaningful guidance, many investors, fund managers and project developers are waiting on the sidelines until some of the biggest questions and uncertainties surrounding the program get resolved. Furthermore, as more examples are fleshed out and discussed amongst practitioners, investing in a Qualified Opportunity Fund may not be the optimal investment strategy for certain taxpayers depending on the specific facts involved. This is particularly true in the case of taxpayers who own appreciated real estate; for them, 1031 like-kind exchanges may still be more attractive.
For instance, one major question affecting taxpayers looking to invest in an Opportunity Fund is exactly what types of gains can be invested in a fund. Can a taxpayer invest short-term capital gain into a Qualified Opportunity Fund? What about Internal Revenue Code section 1231 property used in a trade or business or recapture income when the property to be sold has been significantly depreciated for income tax purposes?
Another major question pertains to the designation of the zones and the potential tax effects of a zone designation ending. The enabling statute provides that Opportunity Zones will maintain their designation for 10 years—meaning all designated locations cease being zones in 2028. Accordingly, if a taxpayer invests gain in a Qualified Opportunity Fund after 2018, the taxpayer will never be able to achieve the 10-year holding period required to receive a step-up in basis equal to fair market value upon exiting a Fund. While this is a harsh reading of the law that would render certain parts of the statute inoperative and effectively terminate the Opportunity Zone program before it is allowed to grow and thrive, this is another example of a major issue that requires further guidance from the Internal Revenue Service.
Another area with great uncertainty is the exact time periods for a Fund’s deployment of capital, in addition to the 90 percent asset test. There are two sets of operative dates provided in the law: (1) the first concerns property previously used in a zone, which must be substantially improved—in this case, a Fund has any 30 month period following acquisition to make the improvements to the property; (2) the second concerns the asset testing which a Fund must perform after six months and at the end of the taxable year. A Qualified Opportunity Fund must be holding 90 percent of its assets in Qualified Opportunity Zone property when undergoing the asset testing to avoid the imposition of penalties on the Fund or its partners/members.
In light of the statutory time frames for deploying Opportunity Fund capital, many fund managers and project sponsors have been awaiting additional guidance on the new program before taking investor money. In light of the IRS’s delay in issuing rules and guidance, will there be a grace period for the first asset testing period? Will Funds be permitted to rely on a capital call structure which would allow capital to enter the Fund as needed while providing the investor with the benefit of a holding period calculated from when the capital is committed? This would mitigate much of the risk associated with the Fund’s deploying of investor capital. Another related question is whether there is an advantage for Fund managers to form their management structures and market a Fund prior to it actually being organized and brought into existence under law due to the statutory time frames for asset testing?
In terms of guardrails against abusive tax structures and planning, the Opportunity Zone statute does have a related party provision that applies to an investor’s sale of property giving rise to the gain to be invested, in addition to the Fund or Qualified Opportunity Zone business’s acquisition of tangible property. Therefore, an investor cannot sell any property to a related party (using 20 percent common ownership rules) to generate a gain to invest in a Fund. Similarly, a Qualified Opportunity Fund or a Qualified Opportunity Zone Business owned in part (or wholly) by a Fund cannot acquire tangible property from a related party (using the same 20 percent ownership limitations). The structure of the law has prompted owners of properties based in the zones to inquire as to whether they can sell their property to a Fund in which they own an interest in if that interest is less than a 20 percent ownership interest. To add another layer of complexity, these same property owners have asked whether such a transaction would work if they receive additional economic benefits, such as carried interest.
Fund managers have inquired about the types of fees that can be charged and whether such fees may cause a problem under the 90 percent asset test. There have been similar questions about using additional debt to finance project, selling qualified assets to be replaced with other qualified assets, and making distributions to investors.
In addition to considering all of the outstanding questions associated with the program, careful planning and analysis must be done by advisors to ensure that making an investment in a Qualified Opportunity Fund is the appropriate move for a taxpayer seeking tax deferral. After all, investing in a Qualified Opportunity Fund does not provide a perpetual deferral of tax on the gain invested; it simply defers recognition of that gain until 2026 (with the prospect of reducing it by 10 or 15 percent).
In contrast, an IRC 1031 exchange provides a perpetual deferral in the case of appreciated real estate, provided replacement property is identified. Therefore, especially in the case of an owner of a building with significant depreciation deductions taken and leveraged with significant debt to the point very little cash proceeds would be received, a 1031 exchange may be optimal instead of investing any proceeds received in a Qualified Opportunity Fund and recognizing any gains (not in proceeds) from the sale of the property immediately.
This article does not come close to capturing all the nuances, questions and potential planning issues that can arise pertaining to the Opportunity Zone program. We do, however, stress the need for additional guidance from the IRS and careful analysis by advisors and practitioners guiding investors. We are happy to report that draft regulations are being reviewed by the Office of Management and Budget with an expectation of being released in the next few weeks. We will keep you apprised of these developments on this law blog.