Federal regulators released the first guidelines for the Qualified Opportunity Zones last week, giving shape to the would-be wealth redistribution program.
After months of deliberations, the Treasury Department and Internal Revenue Service proposed regulations and basic outlines for the initiative, which will allow individuals and companies to defer, reduce and, ultimately, avoid capital gains taxes in exchange for investments into economically-depressed communities.
“Overall, the regs are pro-taxpayer and answer a lot of the questions that were out there.”
These guidelines specified what types of gains can be rolled into the program, how they can be invested into Qualified Opportunity Funds and how those funds can manage cash while still adhering to the previously-established investment quota.
Questions remain about exiting the program, eligible investments and penalties for funds—and their investors—when program requirements aren’t met. Yet, the investment and development communities remain encouraged by the refined structure, which presents a hands-off approach.
“Everyone was wondering if this was going to be a restrictive or permissive way of looking at things,” John Gahan, a real estate lawyer with Sullivan & Worcester, said. “With very, very few and narrow exceptions, when Treasury had a choice between restrictive and permissive, they went permissive.”
The 74-page document of proposed rules begins with a simple but essential clarification: only capital gains are eligible for the program. At times, the original statute, which was adopted as part of last winter’s Tax Cuts and Jobs Act, refers only to “gains,” leaving some wondering if dividends, royalties or other gains could be funneled into an opportunity fund but no, only gains from the sale of an appreciated asset will suffice.
After realizing a gain, would-be investors have six months to reinvest it into an Opportunity Fund. Taxes are deferred as long as investments remain in the fund. After five years, invested gains get a 10-basis-point reduction on their taxable value; at seven years it jumps to 15 basis points and at 10 years the reduction for the initial investment stays at 15 basis points and gains generated by the fund can be realized tax-free. All investments must be made by December 31, 2019, to achieve the full benefits of the program.
Sean Aylward, vice chair of Chiesa, Shahinian & Giantomasi’s corporate and securities group, said the proposed regulations provide direction while staying true to the free-market spirit of the program.
“Overall, the regs are pro-taxpayer and answer a lot of the questions that were out there,” Aylward said.
Another big, albeit more nuanced question, was whether funds could hold cash for future expenses without violating a key requirement of the program: that 90 percent of all investments in Opportunity Funds be reinvested into Opportunity Zone properties or businesses.
To address this, regulators allowed for the creation of a “working capital safe harbor” in which money can be held, so long as there’s a specific timeline for its deployment.
“You still have to have a plan for using that cash and there are requirements for how to make that safe harbor,” Marc Schultz, a partner at the Arizona law firm Snell & Wilmer, said. “There will be questions and probably some more guidance on how to satisfy those requirements but at least we have something to start with.”
While many investors will look to Opportunity Funds for passive investments, the funds themselves must be active. One of the pillars of the program is that the funds make a “substantial improvement” for any property they acquire.
As far as real estate is concerned, last week’s guidelines clarified that this applies to buildings, not the underlying land. Therefore, if a property is purchased for $1 million and the building on it is valued at $400,000, the fund would only have to invest $400,001 rather than a $1 million plus one.
Other clarifications include standards for businesses to qualify for Opportunity Fund investment (70 percent of its assets must be in an Opportunity Zone); transferring investments between funds (it can be done without sacrificing tax-deferred status) and ultimate exit date (2047).
Treasury and the IRS will now accept comments about proposed guidelines and they are expected to make changes by the end of the year. Jeff Kolodny, a private wealth attorney with Kleinberg Kaplan, said the biggest question left unanswered is about the consequences for non-compliance.
“What happens if one of these funds fails to meet the standards, what if they don’t account for their 90 percent [Opportunity Zone] investment accurately? Does the investor lose his deferral?” Kolodny said. “That’s a real concern because a lot of people want to invest in these funds but they need to have some assurances. There’s still a lot of ambiguity about how you qualify and how the funds will operate.”
Some companies and individuals have already liquidated assets to capitalize on the appreciation of the most recent bull market, which is already showing signs of a downturn, Kolodny said. These investors are eagerly looking for promising funds or ways to keep their 180-day reinvestment windows open.
Fortunately for them, the guidelines allow members of partnerships to invest gains separately—a key distinction from the commonly used 1031 exchange—and since those gains are technically realized until the end of the year, their six-month clocks don’t start ticking until December 31.
“I have clients that have recognized gains,” Kolodny said. “We may take advantage of this partnership rule to buy more time.”
While the program isn’t set in stone and important details need to be chiseled out, some analysts believe the initial guidelines provide enough clarity for simple, single-project funds to get off the ground.
“The gun has gone off,” Frank Giantomasi, of Chiesa, Shahinian & Giantomasi, said. “Let the redistribution of wealth begin, that’s what I see.”