By Sean M. Aylward and Bozena M. Diaz, Chiesa Shahinian & Giantomasi PC
Since being unveiled as part of the Tax Cuts and Jobs Act of 2017, the Qualified Opportunity Zone Program has piqued the interest of savvy real estate investors and developers intrigued by the Program’s tax incentives and prospects for new sources of capital.
While nebulous at first, many of the provisions governing the Program were clarified on October 19, 2018 when the Department of the Treasury issued guidance in response to the many questions posed by the real estate community. One would expect the release of this long-awaited guidance to clear the path to investing in Qualified Opportunity Zones (“QOZs”). And it has – to a degree.
The guidance has unlocked the immediate logjam of investors and developers looking to tap into the Program, but there are still loose ends we hope will be addressed by the Treasury in the near future.
Let’s begin with the most critical provisions that were clarified.
Original Use and Substantial Improvement
One of the most significant takeaways from the guidance is clarification on the application of the “original use” and “substantial improvement” tests.
By way of background, to take advantage of the tax incentives offered by the Program, the taxpayer must invest in a Qualified Opportunity Fund (“QOF”). In turn, the QOF must hold at least 90% of its assets in QOZ property, which includes tangible property used in a trade or business of the QOF if either (1) the “original use” of the property in the QOZ commenced with the QOF, or (2) the QOF “substantially improves” the property. To “substantially improve” the property, the QOF must spend at least as much to improve the property as the QOF spent to acquire it during the 30-month time period following acquisition.
The guidance clarifies that, if a QOF purchases land with an existing building in a QOZ, (1) the original use of the building will not be considered to have commenced with the QOF, and (2) the requirement that the original use of tangible property in a QOZ commence with the QOF will not apply to the land. Therefore, the QOF must satisfy the “substantial improvement” test.
For purposes of determining how much the QOF must expand to satisfy the “substantial improvement” test, the portion of the QOF’s basis in the acquired property attributable to the land is disregarded. For example, if a QOF purchases land with a warehouse for $1M, and the cost is allocated $400K to the land and $600K to the warehouse, the QOF must only more-than-double the cost allocated to the warehouse to satisfy the “substantial improvement” test. By excluding the basis allocated to the land, the threshold to satisfy the “substantial improvement” requirement becomes lower, a concept critical to many real estate investors, particularly in areas where land can be a significant portion of a project’s cost.
The 90% Asset Test
Another important question answered by Treasury is whether a QOF may hold cash reserves in order to acquire, construct or rehabilitate tangible property in a QOZ without violating the 90% asset test. For this purpose, the guidance established a safe harbor for a reasonable amount of working capital. Generally, working capital will be treated as reasonable in amount if:
(1) the amount is designated under a written plan for acquisition, construction and/or substantial improvement of the tangible property; (2) there is a written schedule consistent with the ordinary start-up of a trade or business to spend the funds within 31 months of its receipt by the business; and (3) the business substantially complies with the schedule.
The creation of the working capital safe harbor allows the QOF to satisfy the 90% test and deploy capital in accordance with a more traditional real estate development timeline. This clarification is hugely critical to those operating in real estate and construction – and has provided sufficient clarity into the Program’s logistics to ease the minds of most still on the fence.
However, a few areas of uncertainty remain:
There is a lack of clarity regarding how a QOF satisfies the “substantial improvement” test if the QOF purchases vacant land without any improvements, and whether any newly constructed buildings would satisfy the “original use” test;
The Federal tax treatment of gains recognized within a QOF from interim sales or similar events, whether the QOF can reinvest such gains and what constitutes a “reasonable period” for purposes of such reinvestment are all still in question;How much time a QOF has to invest cash received from an investor; and the definition of “substantially all” for purposes other than determining how much of a QOZ business’s property is QOZ business property.
The Program represents the most comprehensive expansion of tax-advantaged real estate investing in years and provides a wide range of investment opportunities in areas across the country where previously such investments were hardly contemplated. While there still are open questions that may cause some to be hesitant toward the Program, the clarity afforded on the issues outlined above will likely spur significant activity from real estate investors and funds that had thus far placed their decisions regarding investments in QOZs on hold.