In October 2018, the Treasury Department and the IRS released needed guidance related to the Qualified Opportunity Zone program (QOZ program) created by the Tax Cuts and Jobs Act. As described below, real estate investors and developers gained critical insight through the guidance.
As outlined by Cal Rose in an opinion piece in the Oct. 15 edition of the Northwest Arkansas Business Journal, the QOZ program is a tax incentive program to encourage investment in certain designated, low-income census tracts around the U.S. Locally, census tracts were designated in Fayetteville, Springdale, Rogers, Siloam Springs and Fort Smith.
The QOZ program provides gain deferral, and potentially partial gain elimination, to a taxpayer that (1) incurs capital gain and (2) invests that capital gain in a “Qualified Opportunity Fund” (QOF) within 180 days of incurring the gain. After the investor’s cash is contributed to the QOF, the QOF deploys the cash in “qualified opportunity zone property” (QOZ property) located in the designated tracts. Ninety percent of the QOF’s assets must qualify as QOZ property, which is tested semiannually. Easy enough, right?
Despite the QOZ program’s appeal to investors, developers and asset managers, the QOZ program was slow to ramp up because of uncertainties surrounding its scope and application. Many of these uncertainties were addressed in the October IRS guidance, and deal flow related to the QOZ program appears to be on the rise. I’ll touch on two areas of the guidance below.
First, which taxpayers can defer capital gain? The IRS guidance clarified that any type of taxpayer including individuals, C corporations, partnerships or LLCs can make the investment and defer capital gain. If a pass-through entity like an LLC taxed as a partnership incurs the capital gain, the pass-through entity can “push” the election out to its members for its members to make their own separate investments.
Second, after a taxpayer invests cash, how can the QOF deploy that cash to make sure its investors qualify for the QOZ program benefits? Let’s back up before proceeding on this point.
Recall the 90% test requires that the QOF invest in QOZ property. A QOF has two options to invest in QOZ property, (1) acquire equity in a “qualified opportunity zone business” (“QOZ business”), or (2) acquire a direct interest in “qualified opportunity zone business property” (“QOZ business property”). Because a business is a QOZ business only if “substantially all” of its tangible property is QOZ business property, a QOF must ultimately invest in QOZ business property, whether the QOF does so directly or indirectly through a QOZ business.
Here’s where the guidance comes into play. The IRS’ October guidance interpreted the phrase “substantially all” as used above to mean 70%. In other words, 70% of the assets of a QOZ business must be QOZ business property. That threshold is lower than the 90% threshold for the QOF — indicating a preference for QOFs to invest indirectly through QOZ businesses. Moreover, recognizing that many redevelopment projects take time to execute, the IRS guidance allows a 30-month safe harbor for a QOZ business to deploy capital pursuant to a written business plan.
The lower holding requirement of 70% for a QOZ business is helpful because QOZ business property is not just any property located in a qualified census tract. In order for property to count as QOZ business property, (1) the “original use” of such property must commence with the QOF, or (2) the property must be “substantially improved.”
Because the “original use” of real estate cannot occur within the QOF, at least based on current IRS guidance, “substantial improvement” is the sole means to qualify real estate as QOZ business property. Generally, “substantial improvement” requires money to be spent improving property in an amount at least equal to the property’s acquisition cost. So, if the QOF spends $1,000 to buy property, the QOF must spend another $1,000 improving the property.
When applying that test to land with a building on it, however, the IRS adopted a more relaxed rule. Only the portion of the acquisition cost allocated to the building will count for the test. So, if $1,000 is spent on real estate, and $600 is allocated to land and $400 is allocated to the building, the QOF need only spend an additional $400 to “substantially improve” the building. As a bonus, the IRS provided that if the building is substantially improved, the land will be deemed substantially improved as well.
The QOZ program provides tangible benefits to real estate investors and developers.
Editor’s note: Matthew D. Mitchell is an attorney at Friday, Eldredge & Clark LLP in Rogers. The opinions expressed are those of the author.