Thought Leader Forum: Opportunity Zones

The Puget Sound Business Journal recently held a Thought Leader Forum on the topic of Opportunity Zones and the benefits they can provide to investors in our region. The Thought Leader panel was composed of Jeff Feinstein, Partner, Pinnacle Partners; Rod Fujita, CPA and principal, tax practice director of real estate services for Bader Martin, PS; Joe McCarthy, Partner, Stoel Rives; and Eugenie Rivers, counsel, Cairncross & Hempelmann. Emily Parkhurst, Market President and Publisher for the Puget Sound Business Journal, led the discussion.

Parkhurst: Let’s start out by outlining how this program works, and what people need to know before they jump in. Who wants to start off?

Fujita: The Opportunity Zones (OZ) program was created by the Tax Cuts and Jobs Act of 2017 (TCJA), which was designed to spur economic development and job creation in distressed communities by providing tax benefits to investors. Investors must adhere to various requirements put in place by the statute and proposed regulations, including who is eligible to benefit from the OZ tax incentives, what gains are eligible for deferral, when investments in Qualified Opportunity Funds (QOF) must be made, timeline of the tax benefits, operational requirements of the fund, and exit strategies.

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Rivers: What’s become very clear is that the typical real estate investment structures that we use don’t mesh well with these rules. There’s a lot of angst and going back and forth on how do you overlay this set of tax rules on typical investor expectations.

Feinstein: When the TCJA was introduced there was a lot of political controversy and a myriad of tax implications. This particular piece of the tax code was added but not well publicized. We began to study the Opportunity Zone legislation and we saw that this program was potentially a generational opportunity to compound wealth and defer and ultimately eliminate tax. We saw it as a tremendous opportunity.

In 2017 as it was introduced, there was a lot of ambiguity. Clarity was improved through 2018 and now we believe there’s sufficient guidance to execute on the program. In the macro it’s intended to take taxable gains, estimated to be $6 trillion, and redeploy those gains to spur economic development in designated communities.

McCarthy: Congress allowed each state governor to designate up to 25 percent of the low-income census tracks in its state as qualified opportunity zones. If a qualifying investment is made in that zone, the investors are entitled to tax favor. The way it generally works is you have to take capital gain from a previous investment and invest it in a qualified opportunity fund (“QOF”).

The QOF has to invest in a qualified Opportunity Zone business (“QOZB”), which is located in the zone and that derives 50 percent of its revenue from the active conduct of business in the OZ. It also must meet other tax qualifications, including not keeping much extra capital around and actively engaging in a real business, with the intent that capital is going to flow into these qualified OZs to create jobs and economic growth in them. The investors get two things: to defer their capital gain, the gain that they’ve invested, and during that deferral process they get to erase a little bit of it. If you hold your investment for five years, you erase 10 percent of your gain. If you hold it for seven years, you erase another 5 percent of the gain. In 2026 you have to pay the tax - so you’re getting a deferral until 2026. After you’ve held the interest in the QOF for 10 years - then you don’t pay tax on any gain in your second investment ever.

Feinstein: What you can’t do is just buy and hold. The program requires you to substantially improve upon the real estate asset. That’s the economic catalyst.

Parkhurst: When you say improve it substantially, what does that mean?

Fujita: In order for property to qualify as a Qualified Opportunity Zone Business Property (QOZBP), there are a couple of requirements. The property must be purchased after December 31, 2017 and, in addition the original use of the property in the QOZ must either commence with the QOF or Qualified Opportunity Zone Business (QOZB), or the QOF or QOZB must substantially improve the property. Real property other than land that has been placed in service (for purposes of depreciation or amortization) by a person other than the QOF or QOZB is not considered original use. However, property that has been unused or vacant for an uninterrupted period of at least five years can still satisfy original use. Essentially, property is treated as substantially improved if, during any 30-month period beginning after the date of acquisition, the additions to its basis exceed the adjusted basis of the improvements (excluding land) at the beginning of the 30-month period.

McCarthy: Not only do you have to improve the depreciable assets, but you can’t just be a passive investor. Triple net leasing is not going to qualify for an actual business; an apartment building you’re actively managing may be okay, but this program won’t work for someone who wants to be a passive landlord and doesn’t touch the building.

Parkhurst: How does this affect land owners who already have property in the opportunity zone?

Feinstein: Here’s an example of an OZ project we just invested in. We have acquired in partnership with Nitze-Stagen a vacant lot and an abandoned building, and so we’re going to raze the building and construct an 80-unit workforce housing multifamily project. We will comply with all Opportunity Zone requirements and accelerate the revitalization of Pioneer Square, which is in need of continued investment and improvement.

Parkhurst: And you owned that property before, or not?

Feinstein: No. It was owned previously, and they determined they wanted to sell it to somebody that could take advantage of the OZ opportunity

Fujita: There are several options for property owners to participate in OZ investments when they own existing property in an OZ. However, while not all result in property owners owning an investment that qualifies for the OZ benefits, some can assist other potential investors in obtaining OZ benefits.

Parkhurst: Let’s go into what happens if you do make these investments and the business fails. Or you decide to sell off the property in the first 10 years.

Rivers: One of the things that we always try to stress when a project comes in is that you shouldn’t invest in it purely for the tax benefits. There may come a time when it may be worth it to forego the tax benefits and sell the project.

McCarthy: The tax benefits are potentially juicy under this program so it’s drawing people’s eyes. They’re very eager to learn about this and participate in it. But the tax benefits won’t be there unless you make money. It is probably wise to look at good, steady, rock solid projects.

Feinstein: I think the government did well with some of these parameters. You’ve got to substantially improve the project and hold it for 10 years. So it discourages flipping. You’ve got to go long on the asset.

Parkhurst: And that was intentional.

Feinstein: Yes, generally real estate has a five to seven-year life cycle before it’s traded, and this is a 10+ year hold period. You’ve got to ask, “is this solid real estate with reasonable returns that have longevity that you can ultimately exit and get full benefit?”

Fujita: You can sell the property before the 10-year period, but that triggers recognition of the gain on the sale of the property. The fund has 12 months to reinvest the proceeds into other Qualified Opportunity Zone Property (QOZP), thus maintaining the benefits for the OZ investors. So, if the QOF sells property for $10 million that was purchased for $6 million, the $4 million of gain still needs to be picked up by the OZ investors. But the QOF can reinvest that $10 million into other QOZP within a 12-month period as long as the proceeds are held in cash, cash equivalents or short-term investments. If the reinvestment of proceeds is delayed by waiting for government action the application for which is complete, that delay does not cause failure of the 12-month requirement.

If the investment is failing but still held as of 12/31/2026, the gain recognition would be the lesser of the original excluded gain or the fair market value of the investment over the taxpayer’s basis in the investment. If the investor abandons, sells, or claims a loss for worthlessness, it would be an inclusion event resulting in the acceleration of tax on the deferred gain.

Parkhurst: Does that restart the clock?

Fujita: No. However, if I sell my entire equity interest in a QOF and then purchase an equity interest in another QOF within 180 days, that restarts the clock. But that’s different than selling the property in the QOF itself where the QOF could reinvest those proceeds in a 12-month period and maintain the deferral of tax for the OZ investors.

Rivers: You have this incredibly complex set of tax rules and you’ve got a very short window of time in which to maximize benefits. As a securities lawyer, I always am looking at what kind of disclosure and risk factors you have to disclose to your potential investors so that they understand this isn’t a slam dunk.

Feinstein: From an investor point of view, given that you need to substantially improve upon the project or property, and you’ve got a 10-year holding period, then you take those two parameters and you look at all the opportunity zones. We said, “Okay, what types of products would be attractive and could we underwrite as good, high quality real estate that we’d be happy to own for 10 years and we believe there’s some significant improvement opportunity?”

For example, when you think about Sodo, and the path of progress coming from Lake Union through the Central Business District and then continuing south, look at what exists there. They’re low-rise, 90- to 100-year-old buildings that are not optimized for modern warehousing. There’s a lot of opportunity there.

Pioneer Square has a dearth of affordable housing and so we, in partnership with Nitze-Stagen, funded Canton Lofts, which will deliver 80 units of “workforce housing” at reasonable rates. This program is also intended to make an economic and social impact. If you can create jobs and improve upon housing or infrastructure of a community, that’s a very good thing.

Parkhurst: Let’s talk more about this idea of investing in businesses. What happens when these businesses start generating profits?

Fujita: OZ benefits are really dealing with the deferred gains reinvested into the fund and then the gain on the exit. Any operating profits incurred throughout the term of the fund are taxable just as they would be if they had nothing to do with an OZ. Owners of pass-through entities (such as partnership, LLCs and S corporations) still get allocated their share of income and pay tax on it, and a C corporation still pays tax on its income. There’s nothing special taxwise in terms of the operations themselves, but there are certain requirements that the QOF and QOZBs must follow in order to remain qualified. For example, type of business, percentage of qualified property and gross income requirements, to name a few.

The second round of regulations were taxpayer friendly when it came to operating businesses. Treasury came up with a few safe harbors that further clarify the 50 percent gross income requirement for QOZBs. The safe harbors are based on hours or payment for services performed in the zone, and tangible property and management or operational functions performed in the zone that are necessary to generate 50 percent of gross income of the trade or business. There’s also a facts and circumstances test. You could have a manufacturing company that manufactures products in the zone itself and then sell its products outside of the zone.

Feinstein: What strikes me as a slam dunk to qualify would be self-storage. You’ve got a large piece of property, maybe you’ve improved upon it, now you’re operating the business there and you’re renting space. I would think that will qualify.

McCarthy: Can we talk more about inclusion events? A perplexing issue under this program relates to cash distributions during the first 10 years. Technically, the way the program works from a tax perspective is when you make that qualifying investment in your QOF, the IRS gives you a zero outside basis in your QOF interest. They carry your gain over essentially. When you have a zero basis, in your QOF interest, then when you get cash, you don’t have basis to absorb that cash distribution. So you’re going to have to recognize gain unless you have allocated debt, have a gross income allocation or you try some other techniques. But structuring the debt is going to be important because if there’s a guarantor on the debt and the debt gets all allocated to the guarantor, then the investors may not have the basis cover. This could potentially constitute an inclusion event, so you’re going to lose a portion of your tax deferral benefits.

Feinstein: Typically in real estate, once you improved the underlying value of the asset you can actually refinance the debt and take return some proceeds or, if you’re successful in leasing up, say a multifamily project, and you’re generating net operating income, that can be distributed to the investors as well.

Fujita: You also have to be cognizant of disguised sale rules.

Parkhurst: What does that mean?

McCarthy: The IRS won’t let you avoid paying tax on a sale by structuring the sale as a contribution to an LLC.

Fujita: If I have a property worth $10 million, I contribute it to a QOF Partnership and a year later I’m distributed $10 million, essentially I sold it so it’s a disguised sale. The second round of regulations specifically says that disguised sales do not qualify as qualified investment in a QOF.

Parkhurst: What was the rationale behind putting that particular regulation in place?

Rivers: Tax advisers and real estate investors are very cleverly looking for ways to avoid the consequences of having to hold for such a long period and the IRS is trying to anticipate that.

Fujita: Also, interests received in exchange for services provided to the QOF or QOZB are not qualified investments.

McCarthy: But if you had a carried interest in a prior investment and then invested your gain from that, that is a qualified investment?

Fujita: Yes. But you can’t have a carried interest in the QOF or QOZB and have it be a qualifying investment

Feinstein: We’ve been referring to the IRS extensively here. If you go to IRS.gov and google “opportunity zone FAQ,” it’s a very good site.

Parkhurst: But what if the administration changes? Is this cast in stone, or is there going to be a repeal?

Rivers: It’s legislation so it can be repealed at any time.

McCarthy: On the other hand, the IRS is behind this. They have tried hard to honor the intent of the legislation.

Rivers: If you parallel it to the EB5 program, it sunsets every year and they keep renewing it because it’s got a lot of support. The reality is programs with a good groundswell of support do tend to get renewed.

Parkhurst: You mentioned this is the last year you can get the full benefits; let’s talk about that. I know you’re hopeful that that deadline might change, but for now, what does that mean?

Rivers: That means you’ve got this first tier where you get the 10 percent discount if you hold for five years. You get the 15 percent discount off your capital gains at seven years. And so you’ve got a program to 2026, and this is 2019. If you invest next year, you can’t get to seven years.

Feinstein: You do need to be specific. That’s an additional 5 percent.

Rivers: Good point. You still get your 10 percent because you’ve held it for five years, but you don’t get the incremental increase up to the seven-year benefit.

McCarthy: But in 2022, if you add five to that, that’s 2027 so it’s past 2026.

Rivers: Then you’d lose that benefit.

Fujita: So in that case you only get the deferral. You don’t get the adjustment to basis of 10 or 15 percent, but you can still take advantage of the step up to fair market value after holding the investment for 10-years.

Feinstein: From our perspective as investors, we see the benefits as deferral and elimination. Deferral is nice, but Elimination is great. To go long, 10 years, no tax on the appreciation of the asset. So you make a sale after the holding period and there is no tax on the gain.

Parkhurst: So is there a rush right now to get in before the end of the year?

Rivers: Yes, there is. There’s a big push, and I’m crossing my fingers that the next round that comes out will give us another year at least because we have no permanent rules. A lot of people are on the fence because of that.

McCarthy: Let’s also mention the other aspect of the temporary nature of this, which is that after June 30, 2027, unless legislation has changed, you can’t make an investment in an OZ and get the elimination of gain on that investment.

Fujita: On Dec. 31, 2026 all deferred gains must be recognized. Also, that is the last date you can incur a gain and defer it with a new OZ investment. Since you have to elect to properly defer your gain in order to make a qualifying investment and benefit from the 10-year step up, gains incurred after December 31, 2026 will not qualify for reinvestment on a QOF.

Parkhurst: Are there any other areas that you want to make sure we dive into?

Feinstein: I’ve seen really proactive campaigns to attract investment. You have this ecosystem, from government, to big banks, to local developers and professional service providers, and now municipalities; are all supportive of the program. And that gives me confidence as an investor to be involved in this program.

Parkhurst: Is that because you believe that if the municipalities are behind it, they’re going to be friendlier to projects?

Feinstein: I like to think that permitting, for example, may be accelerated somewhat because the big issue in our city is affordable housing and homelessness. Does the program attend to that problem? We don’t know, but we know there’s a lot of benevolent parties, corporations and individuals willing to be generous with their capital. And we have market rate investors wanting to do good and do well. So is there a way through the OZ to marry these interests? We’re trying hard to make it work.

Parkhurst: Wrapping up, what advice would each of you give to somebody who is looking to jump in right now before the end of the year?

Rivers: Whether you jump in as a sponsor or an investor, strongly consider hiring an accounting firm familiar with OZ legislation and legal counsel. These deals cannot be bootstrapped. Sponsors tend to be very risk tolerant and often get out a little ahead of their skis in terms of the OZ structure because they think they know how a real estate deal works. So get your advisers on board and get your structure in place before you take money or buy property.

McCarthy: The juice that you’re going to get from the tax benefits is only a couple of basis points, it’s not going to save a bad project. Also, you really need to associate yourself with best-in-class partners, people who are experienced in what they’re doing and have integrity, as well as understand this program.

Fujita: Understand the rules, understand the risks, understand there are still a lot of unanswered questions, and don’t let the tax tail wag the dog.

Feinstein: It’s something to take full advantage of. I would pursue single entity investments, so you can evaluate them and look at the underwriting. Know your partners well, get great tax advice and if you’ve accomplished all of that, then this is a tremendous, generational opportunity you don’t want to miss.

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