Tax Considerations for Real Estate Investors Mini Series: “The Land of OZ” Opportunities with the New Opportunity Zone Incentives

You may recall that the “Tax Cuts and Jobs Act” enacted last year was a comprehensive tax bill impacting businesses of all sizes in every industry, as well as all individual taxpayers. As with many tax bills, there were several changes that were more riveting as the legislative process unfolded. There are, however, other less publicized provisions in the bill that many are beginning to discover. One such item may provide an “opportunity” to many taxpayers, including (but not limited to) those in the construction and real estate industry. The new “Opportunity Zones” (“OZ”) incentive offers savings for taxpayers to invest in certain areas.

Opportunity Zones Background

Congress wanted to provide incentives for taxpayers to invest in certain lower income and impoverished areas. These OZ areas, described further below, are established in every state and in Washington, D.C. To obtain the tax break, taxpayers must invest in businesses or other property located in these OZ.

The OZ investment is actually made into an Opportunity Zones Fund (“OZ Fund”). The OZ Fund is defined as an investment vehicle organized as:

1. a corporation; or
2. a partnership (presumably an LLC will qualify for this purpose),
3. an entity that is organized for the purpose of investing in “qualified opportunity zone property,”
4. a fund that must hold at least 90 percent of its assets in qualified opportunity zone property.

Qualified Opportunity Zone Property is further described as ownership in a corporation or a partnership of a company located in an OZ. It also applies to tangible property used in trade or businesses in an opportunity zone. The company and this property must be acquired after December 31, 2017. The OZ Fund makes the determination as to whether it satisfied the rules to qualify as an OZ Fund. Again, the taxpayer-investor makes their investment into the OZ Fund. All of these steps will need guidance and clarification from the IRS.

Where are These Opportunity Zones?

As with any situation in real estate, the answer is location, location, location. The new provision allows for the designation of certain low-income community population census tracts as qualified opportunity zones. A “census tract” is an area with approximately 4,000 residents, but it could have as few as 1,200 or as many as 8,000 residents. In order to be on the list, a census tract must have a poverty rate of at least 20 percent and household income lower than 80 percent of their state’s median level. There are approximately 42,000 such communities now in the country.

The new law left it partly up to each state (mostly the governor of the state) to determine the OZ within their state, and these were submitted to the IRS this past spring. The IRS then evaluated these state submissions and on June 20, 2018, the IRS issued Notice 2018-48 (please click here for a copy of this Notice, and here for more information issued by the Department of Treasury’s CDFI Fund). This Notice 2018-48 listed the OZ in each state, and this was further broken down by county within the state. Each OZ is designated by its census tract number. Operators of OZ Funds will need to carefully evaluate and analyze the specific geographic coordinates to make sure they know the boundaries of the census tract, so that the OZ business and its property can then be located within the census tract. Again, location, location, location.

Finally, it should be noted that once population census tract is designated as a qualified opportunity zone by the IRS, this designation remains in effect for ten years.

Tax Breaks with OZ – the “Yellow Brick Road”

Congress again is seeking to encourage investment and business development activity in these OZ. Investors, in turn, receive a tax incentive to make their investments in OZ Funds. The tax breaks can be summarized as follows:

1. Temporary deferral of capital gains that are reinvested in qualified OZ property: Taxpayers can defer capital gains tax due upon sale or disposition of property (presumably non-OZ) if the capital gain on the disposition is reinvested within 180 days in an OZ Fund.
2. Step-up in basis for investments held in OZ Funds: If the investment in the OZ Fund is held by the taxpayer for at least five years, the basis on the original gain is increased by 10 percent of the original gain. If the OZ asset or investment is held by the taxpayer for at least seven years, the basis on the original gain is increased by an additional 5 percent of the original gain.
3. Permanent exclusion of capital gains tax on qualified OZ investments held for at least 10 years: Investments maintained: (a) for at least 10 years, and (b) until at least December 31, 2026, will be eligible for permanent exclusion of capital gains tax on any gains from the qualified OZ portion of their investment when sold or disposed.

So, taxpayers can save in several ways by investing in an OZ Fund. Each of the above three tax savings methods will need some further clarification by the IRS, and the operators of the OZ Fund will need to monitor these rules for each of their investors. Hopefully this guidance will come soon, as taxpayers recognizing capital gains can reinvest these gains into an OZ Fund within 180 days, and they need to know how this reinvestment is handled, as well as other details.

Takeaways

Little attention was paid to OZ when tax reform was pushed through Congress last year. But, many are now exploring: how this provision works; what tax benefits are available; and where these OZ are located. Then businesses and investors can look to package up their resources to make investments in the properly designated areas. As noted, further guidance is needed from the IRS. The IRS has identified the location of each of these opportunity zones, and now they need to provide more details on the mechanics of how the OZ Fund works and how to reap these tax benefits. Please contact your Sikich advisor with any questions on this new OZ incentive.