By Adam Hooper
The buzz about Opportunity Zones has grown louder since the regulation was first created by the Tax Cuts and Jobs Act of 2017. The legislation encourages investment in regions of the country the federal government has determined are underserved and in need of economic revitalization.
RIAs especially, being very much in tune with the capital gains positions of their clients, will no doubt be hearing a lot about opportunity zone investments over the next several years. Their position also makes them susceptible to pitches of subpar projects, so it’s important for them to keep a keen eye out for qualified deals. It can’t be overstated that you can't let the tax tail wag the dog into a marginal deal just because of the benefits—deals still need to pencil on their own merit, and the tax incentives should just be the icing on an already delicious cake.
Aside from the humanitarian aspect of these transactions, real estate investors were immediately incentivized by the capital gains tax benefits the new law promised but were wary about jumping in until the IRS fleshed out some of the specifics. The first round of guidance was released in October 2018, answering some questions but still leaving many unanswered; a second round was just released in April 2019. As in the first round, the latest round affects how wealth managers and RIAs should advise their clients on investing in opportunity zones.
Most significantly, last month’s guidance gave some clarity to how operating businesses can comply with the opportunity zone rules, particularly regarding multi-asset fund structures, exiting an asset within a fund without penalty, timelines for safe harbors on initial deployment of capital, and timing to meet the first 90% test.
Here’s how the new rules break down and what RIA’s and wealth managers should know about them.
Relaxed Definition of Multi-Asset Fund Structures
The new guidelines state that only assets that have been in the fund for at least six months need to be considered as part of the fund’s qualification as a Qualified Opportunity Zone Fund (QOF). This gives fund managers some breathing room to deploy capital into well-vetted assets rather than rushing the process in order to remain in compliance. Nevertheless, this break doesn’t guarantee that all QOFs will do their homework properly on all deals, which means that RIAs, wealth managers, and investors need to apply the same level of due diligence to opportunity zone investments as they would to any other type of investment.
No Capital-Gains Tax on Exiting an Individual Asset After 10 Years
The new rules also clarified that the sale of individual assets within a QOF after the 10-year holding period can be recognized by the individual investors on a tax-free basis. Investors wouldn’t have to sell their interest in the QOF itself, but would be able to realize the gains from the sale of individual investments held by the fund and wouldn't face a tax consequence. QOF managers can sell the assets in the funds, and those gains will retain the benefits of the gain exclusion. Based on this rule, RIAs and wealth managers should emphasize to their clients the value of holding individual investments in QOFs for the full 10-year period.
QOFs Have a Full Year to Deploy Capital Without Penalty
Also, these funds have a year with which to deploy their capital into qualified opportunity zone investments without triggering capital gains to its investors, a rule that also applies to reinvesting capital after the sale of an investment. Advisors should be aware that this rule means some QOFs may take longer to invest capital than some investors may be used to, and that this is not necessarily a bad thing as long as the funds meet the 12-month deadline.
90% Asset Test Only Applies to Properties in QOFs for at Least Six Months
We now have more information about the 90% asset test—which requires that 90% of a QOF’s assets consist of opportunity zone property. Under the new rules, this test only applies to properties acquired by the fund prior to six months before the testing date, which allows the QOF to accept investor funds right before the asset test date without needing to invest those funds immediately. This rule should open more doors for opportunity zone investors rather than having them blocked out of certain investments due to test timing.
Stricter Guidelines on Carried Interest, Triple Net Lease Investments, Transfers by Gift
While most of the new rules provided a degree of leniency for investors and QOFs, others tightened up on some of the previous regulations. Opportunity zone benefits now apply to the cash investment and not to the carried interest that has been earned for services, triple net lease investments do not apply to opportunity zones, and deferred gains may become taxable if an investor transfers opportunity zone interest by gift, but not by inheritance or, upon death, to an estate or revocable trust. Advisors should make sure their clients are aware of these restrictions and invest accordingly.
Caution on Substantial Improvement Rules Regarding Property Five Years Vacant
One new rule that has questionable takeaways regards the substantial-improvement requirement as it relates to buildings that have been vacant for five years prior to acquisition. The new regulations exempted those buildings from the requirement, allowing QOFs more time to implement changes to those properties. Since those properties are likely obsolete or have deferred maintenance issues, this rule is a plus for QOFs. However, further review is required on the full impacts of the rule.
Although the latest round of guidance dispelled some confusion about the legislation, some questions remain. Language on reporting requirements was not in the report, and further guidance may be forthcoming on this area in future rounds.
However, with each new round of IRS guidance on opportunity zones, investors’ concerns are assuaged. More firms are beginning to launch QOFs every day, and there continues to be tremendous opportunity within the space.
Adam Hooper is the Co-Founder and CEO of RealCrowd, a real estate equity crowdfunding company.