In April 2019, the US Treasury Department released the second round of proposed regulations related to their “Opportunity Zone” project. This was enacted as part of the Tax Cuts & Jobs Act of 2017. The initiative provides tax incentives for investors that invest in businesses or properties within the qualified, designated “Opportunity Zones.”
These areas, which were submitted by each state and reviewed by the federal government, are known as “Qualified Opportunity Zones.” To qualify for the beneficial tax treatment, an investor must use capital gains to fund the investment and the investor must also “substantially improve” the purchased property unless the property is of “original use,” meaning it has not been depreciated. To “substantially improve” the property, the investor needs to double their initial tax basis on the acquired property within thirty months after purchase.
What Are The Benefits Of The Opportunity Zone Program?
First, the tax on the capital gain used to purchase the property can be deferred by the taxpayer for up to seven years (until 12/31/2026). Second, a taxpayer can reduce the capital gains tax (the same gain that is deferred) by up to 15% if the Opportunity Zone investment is held for at least five or seven years. Finally, the biggest advantage is that the appreciation of the investment is tax-free. This holds true as long as the interest in the investment is held for at least ten years and the investment meets the improvement qualifications.
Clarifications In Regulations
The regulations proposed in April clarified a number of Opportunity Zone questions. This included clarity around buying or starting businesses through the Opportunity Zone program, the use of net Section 1231 Capital Gains to fund the investment, guidance related to Opportunity Zone fund organization, and information for the eventual disposition of fund assets and interests. In addition to property purchases and development projects, there is now a taxpayer-friendly, three-part “Safe Harbor” that would allow for the acquisition or origination of a qualified business to be eligible for tax-free appreciation through the Opportunity Zone initiative.
Revenue Ruling 2018-29
Another piece of tax guidance recently announced was Revenue Ruling 2018-29. This deemed that a taxpayer must only “substantially improve” their investment in a building rather than substantially improving both the building and the land that makes up their investment. Hence, the taxpayer does not have to substantially improve the land that the building sits on or the land acquired in the acquisition. In the Revenue Ruling, the taxpayer purchased property with 60% of the total purchase price allocated to the land and the remaining 40% of the purchase price allocated to the value of the building. The IRS concluded that the taxpayer had to “substantially improve” only the 40% of their investment that related to the physical building and not the related land. Therefore, on paper, it would appear that the IRS opened the door to purchasing land and not having to improve the land while still qualifying for the beneficial tax treatment offered through the Opportunity Zone initiative. However, the Treasury has repeatedly stated in the proposed regulations that “Land Banking” is disallowed.
From a commercial real estate perspective, the rules around investing in Opportunity Zones are now much clearer than they were before the April 2019 proposed regulations.
President Trump has expressed a desire to expand the Opportunity Zone program and allow for more zones to qualify. Whether this comes to fruition or not is another matter. However, the program as it is currently enacted does not expire until 2047. Further guidance is expected to be released in late 2019 to clarify Opportunity Zone’s application to certain industries such as agriculture. While we await this guidance, “Substantially Improving” an old building, buying land and building a ground-up retail center, or rehabbing a multi-family or student housing complex are just a few of the types of projects that are commonly being performed within an Opportunity Zone Fund structure. Given Florida’s rapidly growing population, affordable cost of living, and state tax structure, investing in a Florida Opportunity zone is something that any real estate investor should strongly consider.