Qualified Opportunity Zones: A New Tax Incentive for Existing Capital Gains Deferral

By James Lang

An important tax incentive provision for real estate investors, developers, and professionals was included in the Tax Cuts and Jobs Act that was enacted in December 2017. Known as the Qualified Opportunity Zone program, and included as new Sections 1400Z-1 and 1400Z-2 of the Internal Revenue Code (Code), this significant law has received little fanfare. The purpose of this new incentive legislation is to encourage long-term investment in designated Qualified Opportunity Zones, as defined in the Code (O-Zone). The program allows real estate investors to defer short-term and/or long-term gain upon the sale of property by reinvesting such gain in accordance with the program rules and to potentially abate existing gains in long-term investments. In addition, investors may be eligible for tax-free treatment on all post-acquisition appreciation for investments with a 10-year investment horizon.            

Deferral and Abatement of Existing Gains

Under the program, an investor may elect to defer the gain from the sale, liquidation, exchange or other disposition of its property if such investor invests such gain in a Qualified Opportunity Fund (O-Fund) within 180 days of such disposition and the O-Fund invests 90 percent or more of its capital in eligible Qualified Opportunity Zone Property within an O-Zone. “Qualified Opportunity Zone Property” includes tangible property within an O-Zone, including multifamily, office, retail, land for development, multi-use and project finance, or investments in partnerships and corporations deriving most of the entity’s income from such property. Qualified Opportunity Zone Property includes both new construction and existing facilities or businesses, subject to an improvement requirement for existing facilities or businesses.

In addition to the immediate deferral incentive, to further encourage long-term investment in O-Zones, in year five of an investment, an investor will receive a 10 percent step-up in basis on the initial deferred investment with an additional 5 percent step-up in basis in year seven of the investment. In December 2026 the deferral period ends and the investor must generally recognize gain on the excess of (x) the lesser of (i) the initial deferred investment or (ii) the fair market value of the O-Fund investment, over (y) the investor’s basis in the O-Fund investment, which shall be zero prior to year five. Advanced strategies may allow certain investors to step up the basis of the investment to equal the fair market value of the investment, thereby eliminating the gain. In short, investors may defer existing capital gains until December 2026, and in 2026 investors may reduce their gains by 15 percent or more originally deferred when compared to current liquidation.

Potential for Tax Free Treatment of Future Real Estate Appreciation

If an investment of existing capital gains is held for 10 or more years in an O-Fund and eligible O-Fund investments, at disposition or sale of the O-Fund interest, the appreciation on the initial investment would not be subject to taxation. For example, if $100 million of capital gain is invested in an O-Fund that invests in eligible Qualified Opportunity Zone Property (i.e. commercial real property) and the investment appreciates to $600 million over a 10-year investment horizon, the $500 million of appreciation would be tax free to the investor at disposition or sale of the interest in the O-Fund. This tax-advantaged treatment of long-term investments in Qualified Opportunity Zones provides significant planning opportunities for real estate, project finance, and infrastructure projects.

Investors will benefit most in O-Zone financing when the underlying assets, real property or business investment, are subject to rapid 10-year appreciation. Because of this, utilization of O-Zone financing with structured leveraged may result in substantial tax-advantaged appreciation vis-à-vis traditional real estate investment models.

O-Zone Designation Process

To qualify as an O-Zone, Governors (or Chief Executive Officers) of States and the District of Columbia must designate certain eligible census tracts to the United States Department of the Treasury by March 21, 2018, and such tracts must then be certified by the Department of the Treasury. States may designate up to 25 percent of current “low-income community” census tracts for purposes of New Markets Tax Credits under Section 45D of the Code as O-Zones. States with less than 100 eligible census tracts may designate a higher proportion of O-Zones. Many of these eligible census tracts represent attractive real estate communities and are hotbeds of revitalization in many areas around the country.

Governors may also make a subset designation in certain targeted scenarios of census tracts that are otherwise not eligible but that are contiguous to eligible tracts. Due to ongoing rebuilding efforts, subsequent legislation also designated all eligible census tracts in the Commonwealth of Puerto Rico as O-Zones.

O-Fund Utilization

O-Funds must be formed as a partnership or corporation with the purpose of investment in Qualified Opportunity Zone Property. O-Funds may be structured based on one or multiple O-Fund investors or ultimate O-Zone investments. The Department of Treasury will issue guidance on the certification process for these investment vehicles, and conceptually these funds may be managed by experienced fund managers, investors, or developers with a targeted purpose of O-Zone investment. Several structuring considerations may adapt how a group seeks to optimize O-Fund management and investment.

Synopsis of Benefits

The new Qualified Opportunity Zone legislation provides a powerful tool for real estate investors, developers, and professionals to utilize the vast captive capital gain in the real estate and equity markets and put investments to focused use in economic development activities. Investors will realize significant tax-advantaged returns based on tax deferral and abatement of existing captive capital gains and potential tax-free treatment of long-term appreciating investments. Developers may utilize this program to fill in gaps in capital stacks, increase leverage, or complete projects. Real estate professionals will discover many ways to utilize this program to make good deals happen while promoting valuable community and economic development.

James O. Lang focuses his tax and corporate project finance practice on tax credit incentive programs and related state and federal incentive programs. Lang represents investors, lenders, community development entities, and for-profit and not-for-profit projects in complex transactions where capital stacks require enhancement through incentive financing, including state and federal new markets tax credits, affordable housing and low-income housing tax credits, historic rehabilitation tax credits, renewable energy tax credits and film and entertainment tax credits.