The IRS and Treasury Department recently released proposed regulations providing guidance for investors looking to take advantage of the capital gains deferrals available in the opportunity zone program created under the 2017 Tax Act.
The 2017 Tax Act designed these opportunity zones (see map of Virginia’s designated qualified opportunity zones) to spur investment in distressed communities throughout the country through deferrals of tax on almost any capital gain up to Dec. 31, 2026, through an appropriate investment in a qualified opportunity fund (QOF).
While opportunity zones are a product of federal income tax law, they create a number of strategic development and investment opportunities specific to Northern Virginia’s real estate markets. The location and configuration of Northern Virginia’s opportunity zones include significant amounts of equally strategic real estate that also benefit from local planning and zoning recommendations — such as Embark Richmond Highway — that, in many cases, support significant redevelopment and/or value-add opportunities.
What Is a Qualified Opportunity Fund?
A QOF is any investment vehicle that is organized as a corporation or partnership for the purpose of investing in qualified opportunity zone property — with the exception of another QOF — and that holds at least 90 percent of its assets in qualified opportunity zone property. Such property includes qualified opportunity zone business property or certain equity interests in an entity that qualifies as a qualified opportunity zone business.
To satisfy this 90 percent asset qualification under the proposed regulations, a QOF can invest in an equity position in a qualifying trade or business within the opportunity zone, or may operate a trade or business directly. To qualify, a trade or business must be one in which “substantially all,” otherwise specified as 70 percent, of the tangible property owned or leased by the taxpayer is qualified opportunity zone business property.
Investors placing deferred capital gains into a QOF and holding that investment for longer than five years may exclude 10 percent of the deferred gain from inclusion and income, with investments longer than seven years allowing an investor to exclude 15 percent of the deferred gain. Investors who hold their QOF investment for at least 10 years also may qualify to increase their basis to the fair market value of the investment on the date it is sold (which frequently results in no taxable gain to the investor).
Who Is Eligible to Take Advantage of a Qualified Opportunity Fund?
Eligible taxpayers — individuals, C corporations including RICs and REITS, partnerships and certain other pass-through entities, S corporations, and certain trusts and estates — may defer recognition of some or all of their eligible capital gains through investment in a QOF. The election to defer gain into a QOF typically must occur within 180 days of the date of the sale or exchange that gives rise to the gain.
Opportunities exist for property owners within a qualified opportunity zone to consider a sale or ground lease of their property to — or arrange a joint venture with — a QOF that can bring together the resources and expertise necessary to entitle and successfully develop a property.
These joint ventures can be critically important, since a qualified opportunity zone business — to qualify under these proposed regulations — can share no more than 20 percent common ownership between the qualified opportunity zone business and the seller of land.
Additional opportunities exist for revitalization of buildings within a qualified opportunity zone, where “substantial improvements” are made. “Substantial improvements” means spending an amount equal to the basis of the buildings acquired.
Developers with experience identifying and implementing improvements — whether revitalizing existing buildings or developing underutilized land — can benefit from lending their expertise to help property owners and QOFs leverage qualified opportunity zone property and capital into realized developments.
Existing, even recently constructed, buildings within an opportunity zone that are “substantially improved” can be a qualifying investment for a QOF.
Whether as an existing sophisticated fund with capital gains to defer or as an entity with experience raising funds, an investor stands to reap significant benefits, not only on existing capital gains taxes — but also on gains realized after the sale of an investment held for a minimum of 10 years.
With only 180 days after a relevant sale or exchange to invest in a QOF, every day lapsed could cost investors the opportunity to exclude 10-15 percent of deferred capital gains.