18 Nov 12/31/19: What It Means to OZ Investors
December 31, 2019 marks the first of several Opportunity Zone Program deadlines. ESA contends that missing this milestone will have minimal impact on Opportunity Zone investors. Here’s an explanation of why we hold this view and what you need to know about the impending deadline.
Background
The Opportunity Zone Program (OZP), part of the President Trump’s Tax Cuts and Jobs Act passed in December 2017, is designed to foster jobs and economic prosperity in economically depressed areas of the country. These areas (collectively known as Opportunity Zones) were selected by the governor of each state by identifying low-income areas in their respective 2010 census tracts. For example, New Jersey has identified 169 zones and New York State has 514. Nationally, there are 8,764 zones (including Washington DC and the American territories).
The OZP incentivizes investors by offering three financial benefits. The first two benefits pertain to capital gains from the sale of a qualified asset. You are not restricted to selling just real estate in the OZP. An OZP asset can be real estate, stocks, bonds, stamps, coins, art, antique cars or watches, or almost any other asset with an unmonetized capital gain. The federal government estimates that there are more than six trillion dollars of unmonetized assets in the United States, and the OZP is designed to monetize some of these assets, generating a capital gain.
There are two benefits to the OZP in regard to the taxes owed on capital gains. The first is deferral of the capital gains for up to seven years. The second benefit is a step up in basis by as much as 15 basis points. To qualify for these benefits, the realized capital gains must be invested in a qualified Opportunity Fund within 180 days of the sale. The fund must then deploy those funds by investing in an OZ within 180 days of their date of investment. If the investor holds that asset for 5 years, the federal government gives the investor a 10-point step up in basis. Then, if you hold the investment for two more years, you receive an additional 5-point step up in basis, for a total of 15 basis points. (Thus, to get the full 15-basis point step-up, you need to sell your asset by December 31, 2019.) Investors are cautioned to be certain that they have the free cash to pay their capital gains tax when it comes due by April 15, 2027.
The third OZP benefit could be the most lucrative. If you hold your property for another three years (for a total of 10 years) and then sell it, the OZ investor will pay zero federal income tax on all capital gains from the original OZ investment. Note that the OZ asset must be sold by 2047.
What Happens If I Miss the 12/31/19 Deadline?
Some investors have the false impression that, if they do not sell their asset by December 31, 2019, then their window of opportunity will have passed. Not true.
Selling an asset by the December 31, 2019 enables the investor to qualify for the full 15-basis point adjustment on their deferred capital gains tax. But if you are not ready to sell by the end of this year, you still have an additional two years to realize a 10-basis point adjustment. That is, you must sell your asset by December 31, 2021. And, of course, if you hold your property for a full 10 years, no federal income will be owed on the capital gains derived when you sell.
What Are My Obligations After Making an OZ Purchase?
For many investors, this may be the trickiest compliance aspect. After the qualified Opportunity Fund has purchased an OZ asset, the investors have 30 months to substantially Improve (i.e., upgrade) their purchase by 100% plus one dollar of the improved value. For example, if a qualified Opportunity Fund purchases real estate valued at $1 million, with the building (the improved portion) and the land valued at $500,000 each, then the investors must improve the building by $500,001 within 30 months.
What Qualifies as Substantial Improvement?
Substantial Improvement as defined by the federal government is complex. However, in general, it is described as improvement to the structure. So, using the hypothetical values above, improvements to the structure (such as tenant fit-out) must be at least $500,001. But other expenditures could count as well. For example, environmental consulting and remedial costs could qualify as substantial improvement and count towards the substantial improvement monetary threshold. While the federal government has not explicitly stated that environmental costs count towards substantial improvement, several prominent tax attorneys who have dedicated themselves to OZ issues for the past 18 months are confident that environmental costs will qualify, and that the government will so state in their next set of OZ regulations.
What if Environmental Compliance Requires More Than 30 Months?
Many environmental compliance activities can be completed well within the 30-month timeframe. And ESA recently published an article on how to accelerate the time required to effect environmental compliance. However, in most instances, groundwater impacts often require more than 30 months to achieve compliance. Therefore, current OZ regulations create a stumbling block for those OZ properties that have groundwater impacts. It remains for the U.S. Treasury to address this issue, hopefully in their next set of regulations.
What Should an Investor Do to Take Full Advantage of the OZ Program?
First and foremost, identify an OZ property or business that makes sense. Developers unanimously state that an OZ deal must first make financial sense even in the absence of OZ benefits. That is, do not assume that the program will make a poor redevelopment project good. Regarding the timing of substantial Improvement, address your environmental compliance issues as early as possible in the process so you can render environmental compliance a non-issue. Environmental compliance is not always complex or expensive. Speak with ESA early in the process so we can provide the information needed to foster your financial success.