The Tax Cuts and Jobs Act of 2017 created an economic development incentive and tax deferral program known as the “Opportunity Zone Program” (the “Program”). You have likely seen the headlines about opportunity zones come and go since 2017. The Program is back in the headlines because the long-awaited second round of proposed regulations was published by the Treasury Department on April 17. This additional guidance was well received as the December 31 deadline for investors to realize the full benefits of the Program is fast approaching.
As background, following the passage of the initial legislation, opportunity zones were designated in low income census tracts
across the country, including in Cuyahoga, Franklin and Hamilton counties in Ohio.
For the communities in which opportunity zones are located, the Program is intended to increase investment in both real estate and in business ventures. The Program offers participating investors the attractive benefit that eligible investments can qualify for the deferral of capital gains tax as well as the partial or total exclusion of capital gains from gross income when certain investment requirements are satisfied.
To provide clarity with respect to the Program, the IRS and the Department of Treasury have issued two rounds of proposed regulations. The second round of proposed regulations specifically addresses
questions related to investments in real estate development projects and in businesses. What follows is an overview of several key recommendations in the second round of proposed regulations and an overview of next steps with respect to the Program.
Land. The second round of proposed regulations provides that the Program’s "original use" and "substantial improvement" requirements do not apply to raw land. Generally, these requirements provide that to qualify for the Program improved ‘property’ must either (i) derive its original use within the opportunity zone or (ii) be "substantially improved." For the purposes of the Program, "substantial improvement" is generally defined as making investments sufficient to double the basis of the property within thirty (30) months of acquisition. For real estate investors and developers, the exemption of undeveloped land from these requirements addresses concerns that certain development sites would not benefit from the Program due to high land costs and thus difficulty satisfying the substantial improvement requirements.
Vacant Buildings. The second round of proposed regulations also exempts buildings that have been vacant for five (5) years or more from the Program’s "original use" requirement. This guidance is intended to facilitate the redevelopment of underutilized structures while also avoiding a scenario under which buildings in opportunity zones are deliberately abandoned for shorter periods of time to qualify for the Program.
Triple Net Leases. In the context of real estate development, the second round of proposed regulations expressly excludes investment in entering into a triple net lease as a qualifying investment. The rationale for this exclusion is that triple net leases are passive investments that do not meet the Program’s requirement for actively conducting a business.
Reinvestment of Funds. With respect to reinvesting proceeds realized from the sale or disposition of qualified opportunity zone property, the second round of regulations clarifies that the “reasonable” time-period for reinvestment is within 12-months of the sale or disposition of the property. For investors this means that opportunity zone investments can be deployed and redeployed in multiple projects or businesses over the course of their participation in the Program.
50-Percent Gross Income Rule. The second round of proposed regulations addresses open questions related to what is commonly known as the “50 percent gross income rule” for businesses. This rule generally provides that 50 percent of a business’s gross income must be derived from the active conduct of a trade or business in the opportunity zone. Following the release of the initial regulations, a number of concerns were raised related to this rule, particularly with respect to the ability to fund businesses that operate in an opportunity zone but sell products to customers beyond the opportunity zone. To address these concerns, the second round of proposed regulations establishes three safe harbor provisions under which businesses may operate within an opportunity zone while deriving gross income through goods or services provided outside of their opportunity zone
With more clarity following the second round of proposed regulations and the December 31 investment deadline approaching, the opportunities for potential investors to participate in the Program increased. In order to be positioned to maximize the Program’s benefits, Calfee clients should contact their relationship attorney to seek advice on pertinent questions before proceeding with any investment. In the meantime, the IRS and the Department of Treasury will issue a third and likely final round of proposed regulations before end of year 2019. Calfee will continue to provide updates related to this Program in the coming weeks and months, including with respect to private equity
and project finance applications of the Program as well as state-level legislation to further incentive investment in Ohio’s opportunity zones.