A massive package of final rules for the 2017 tax law’s opportunity zone incentives is sure to please real estate and startup investors, banks, and conglomerates, among others.
The rules (T.D. 9889) contain numerous revisions to two sets of proposals issued in October 2018 (REG-115420-18) and April 2019 (REG-120186-18) that help investors generally. But a few sectors and types of investors—including those aiming to develop brownfield property—benefit in particular from new clarity and areas where the Treasury Department loosened restrictions.
The 2017 law allowed investors to defer tax on their profits from stocks, real estate, fine art, and other assets until 2026 if they put the gains into opportunity funds financing projects in nearly 8,800 census tracts around the U.S. If they keep the money in the fund for a decade and check numerous other regulatory boxes, the growth in value of the business or real estate financed by the opportunity fund will be tax-free.
Depending on how long they held the investment, they can shave off some of their tax liabilities on the original gains as well.
While the incentives have come under scrutiny in recent months, with lawmakers proposing ways to reform them, narrow the scope of beneficiaries, and even repeal them, the new regulations are sure to draw new market entrants in 2020, according to those who advise on them.
Recent estimates from the Joint Committee on Taxation indicate that this market is already expanding: The nonpartisan panel’s new projections for the government’s revenue losses resulting from individuals deferring their capital gains taxes—and later reducing those tax liabilities—nearly doubled from October forecasts.
Dec. 19 publication of final rules “removes the risk that the rules are going to change,” said Steve Glickman, who helped create the tax breaks and now advises on them as CEO of Develop LLC. Referring to investors, he added, “They no longer can say, ‘We’re waiting for more clarity from the IRS.’”
A big plus for investors in the final rules was a rollback of a requirement for certain profits that can be put into opportunity funds.
Under the April proposed rules, only net gains under tax code Section 1231, stemming from sales of real estate and pieces of business property, could be invested—unlike for other types of taxable gains, in which gross profits can be plugged into opportunity funds. Those investors therefore would have to wait until the last day of the year to compute their net gains for that tax year before putting it into a fund. That was a big issue for those trying to shield 15% of their gains from tax, as they had to invest the gains by Dec. 31, 2019 to get that perk once the gains are finally taxed in 2026.
Under the final rules, investors can use their gross Section 1231 gains, and no longer have to wait until the end of the year to tally them up.
“Not being able to invest until 12/31 was a big deal,” said Brian Newman, a CPA and partner at the advisory firm CohnReznick, in Hartford, Conn., adding that many real estate clients had been eagerly awaiting a change to this rule.
Investors must also “substantially improve” assets they buy, if they aren’t building up a piece of real estate or a business from scratch, by doubling the value of their investment, or basis, in the property. Under the April rules, they needed to measure that improvement asset-by-asset, rather than in aggregate. Critics said this would be practically impossible, wondering how a desk, for instance, can be improved and how to quantify that improvement.
The final rules allowed some flexibility, permitting investors to measure improvement in aggregate in certain circumstances, such as for clusters of commonly-owned buildings. Hotel developers, for instance, just need to show that new property they buy—such as furniture and exercise equipment—adds to the functioning of the old property they bought.
There’s still some ambiguity for businesses that fall outside the scope of real estate, Michael Novogradac, managing partner of Novogradac & Co. LLP, said. What if, he suggested, a fund invests in a business with an assembly line, and buys a new assembly line?
“Does that second assembly line improve the function of the first assembly line?” he said.
Under the April proposed rules, properties also had to have been vacant for five years to avoid that “substantial improvement” requirement. But the final rules reduce that period to one year for properties vacant when their zones were designated and three years for others. This could boost the number of viable real estate projects for funds taking advantage of the incentives, especially in areas with their fair share of abandoned lots.
Banks and Conglomerates
The April proposed rules barred a company that’s a subsidiary or member of a consolidated group—a collection of companies taxed as a single entity, generally under a common parent—from being an opportunity fund. The corporation serving as the fund could only be the parent of the group or owned by members of a group of which the corporation itself isn’t a member.
The final rules made some exceptions, which is not only a boon for large companies generally but also for banks, which tend to form community development arms for the sort of investments made in opportunity zones.
“I think the consolidated groups were surprised by the proposed regulations and had already formed QOFs and thought, ‘What do we do?’” said Lisa Zarlenga, a partner at Steptoe & Johnson LLP in Washington and a former Treasury official, using an acronym for qualified opportunity funds. Referring to Treasury, she added, “I would be surprised if they didn’t permit the ones that have already formed to go forward.”
Investors in Startups
Startups can take a while to become fully operational, and earlier proposed rules provided businesses financed by opportunity funds with 31 months to use their capital. The new final rules doubled that period, something Michael Krueger, a partner at Newmeyer Dillion in Walnut Creek, Calif., said “is going to be a big deal,” particularly for startups.
“If you told Tesla they had to get off the ground in 31 months,” for instance, the requirement could be seen as outlandish, he said.
Previous rules also mandated that at least 40% of a business’s intangible assets, like patents, software, and copyrights, must be used in its active business—meaning not as a passive investment.
The requirement led to calls for more clarity on what it actually means for intangible property to be used in active business operations, and the final rules provide some definitions. The intangible property meets this requirement if it is used in a way that’s “normal, usual, or customary” to the business in question, and it must be used within the zone in a way that contributes to the business’s gross income.
These definitions may raise new uncertainties. But a definition is at least set in stone, and there’s sure to be more clarity needed throughout, Glickman said.
“In a brand new program, where there’s close to 550 pages of regulations, there’s still going to be a lot of questions about how this plays out,” he said.
The new rules free brownfield projects—former industrial sites where environmental contamination may be an obstacle to development—from the “substantial improvement” requirement.
Lawmakers such as Rep. Dan Kildee (D-Mich.) have proposed making these sorts of projects more viable targets of the tax-advantaged investments. The risk that automatically comes with these developments is already pretty high, due to the health, safety, and related regulatory demands, so this provision should be a game-changer, Krueger said.
“I don’t have to substantially improve that building anymore—I just have to clean up that brownfield,” he said, adding that cleanups are subject to requirements at various levels of government. “Brownfields always are going to be one of those areas where it’s a huge risk,” he continued, but those kinds of projects follow the law’s intent.
The proposed rules were a bit spotty on what happens when investors pull out their stakes after 10 years, and the new rules provided some clarity for opportunity funds that finance multiple properties and businesses.
They can now sell the assets, or the underlying business and real estate projects they’ve financed to avoid tax on the growth in value of those underlying assets, rather than just selling their stakes in the funds, or everything at once.
States, Cities, and Tribes
The rules require that opportunity funds and the businesses they finance that enter into leases pay rent at the market rate. The final rules carved out an exception for state, local, and Native American tribal governments that lease property to those funds and businesses.
Leasing government property below market rate is a common way states and municipalities attract new businesses, and this new allowance should sweeten those deals.
“There’s a preponderance of publicly owned assets that are in opportunity zones, many of which are unused,” said John Lettieri, CEO of the Economic Innovation Group, which conceived of the incentives. This rule change “allows cities to have more control over shaping what kind of investment comes in,” he said.