Developers have an outstanding opportunity to help develop distressed communities through newly created qualified opportunity zones (QOZ), which were included as part of 2017 tax reform. The program creates qualified opportunity funds (QOF), which are corporations and partnerships that invest in the opportunity zones.
QOZ funds can be an attractive investment for individuals looking to defer capital gains. As we know, investors who have capital gains can participate by investing their gains into these funds and, as long as the gain is held within the fund, they can defer it until 2026. If the investor holds their investment in the fund for at least five years, they get a 10 percent step up in their basis, thereby reducing their gain by 10 percent. If the investor holds the investment for two additional years (seven years total), then they get an additional 5 percent step up in basis for a total reduction in gain of 15 percent. Lastly, if the investor holds their investment for 10 years, their basis increases to the fair market value at the time.
See related blog: Investors: Highway to the Opportunity Zone
Based on all the aforementioned tax advantages available to investors, developers should be clamoring at the opportunity to get their hands on property within the designated QOZ. Let’s take a look at how developers can maximize their involvement with these funds.
As the mechanics of the program started to unfold, governors of every state identified low-income areas within their state that they determined should be designated as QOZ. With this designation, governors intend to provide long-term private sector investments in low-income urban and rural communities nationwide. In June, the IRS received all the governors’ recommendations and published a list of 8,700 approved QOZ, which are designated by census tracts. These QOZ will retain their status for 10 years, after which they can be modified.
A QOF must have at least 90 percent of its assets invested in qualified opportunity zone property (QOZP), which includes one of three things: qualified opportunity zone business property (QOZBP), QOZ stock or QOZ partnership interest. Additional details include:
- QOZBP is tangible property used in a trade or business within a designated opportunity zone that 1) is acquired after December 31, 2017; 2) is either the original use of the property in the zone commencing with the QOF or the QOF substantially improving the property; and 3) is substantially all of the use of the property in the zone during substantially all of the holding period.
- QOZ stock is stock of a domestic corporation that owns a qualified opportunity zone business (QOZB).
- QOZ partnership interest is an interest in a partnership that owns a QOZB.
To qualify as a QOZB:
- 70 percent of the business-owned or leased property must be QOZBP;
- At least 50 percent of the gross income must be derived from the active conduct of the business;
- A substantial portion of the intangible property is used in the active conduct of the business;
- Less than 5 percent of the average aggregate unadjusted basis of the property is attributable nonqualified financial property; and
- The business is not a “sin business” defined as a golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack, gambling establishment or liquor store
As discussed above, QOZBP must be acquired by purchase after December 31, 2017. The buyer of the property must be unrelated to the seller of the property, and 20 percent is considered related. If a developer already owns property in a zone, they will want to structure a sale to an entity in which it owns less than 20 percent.
Substantially improved property requires that the costs of constructing, renovating or expanding the property during any 30-month period beginning after the date of acquisition of the property exceed 100 percent of the adjusted basis of the property at the start of the 30-month period.
When determining the beginning basis for purposes of this requirement, the basis attributable to the land on which the building sits is not taken into account in determining whether the building has been substantially improved. Thus, developers only need to look at the adjusted basis of the building and building improvements when considering the amount of funding needed to substantially improve the property. If the property is undeveloped, the developer is in luck. All the developer has to do is do what they do best—develop.
For developers who have complied with all the requirements there is no requirement that the QOZP be approved or certified by any governmental entity. Essentially, the developer self-certifies through a tax filing that the requirements have been met.
With that in mind, let’s take a look at tax structuring. The funds, which ultimately will hold the QOZP property, must be organized as corporations or partnerships with the investors owning either a partnership interest or stock. Investors and developers must make an equity investment as debt investments are not allowed. Developers are still allowed to obtain a mortgage loan or use other financing vehicles as needed without altering their equity investment. Developers who need financing are not precluded from participating in capital gain deferrals as investors.
Developers, investors and communities can equally benefit from the creation of QOZ. The IRS offers an opportunity zone FAQ on its website.
Watch for upcoming blogs from Skoda Minotti as we take a closer look at additional benefits of QOZs. For questions pertaining to how developers can take advantage of QOZ, please contact David Silverman, CPA, JD, at 440-449-6800.