Economic Development / 04.13.2019

The Regulations Are Coming: What Happens Next in the Game of Zones?

By Stephanie M. Mercado

This Sunday night, millions of fans (including myself) will tune in to watch the much-anticipated premiere of the 8th and final season of the worldwide television phenomenon Game of Thrones on HBO. Fans of the show have had to wait almost two years since the finale of the penultimate season to find out who will survive the Army of the Dead and who will ultimately sit on the Iron Throne. Investors and real estate professionals have also been anxiously awaiting Treasury regulations expected to be released by the end of this month related to another phenomenon that is sweeping the nation: Opportunity Zones (OZ).

Just as blogs, articles and podcasts are currently recapping and previewing the fates of the Starks, Lannisters and Targaryens, in preparation of the release of the next round of OZ regulations, it would also be prudent to take a journey down the Kingsroad to understand what has previously happened with Opportunity Zone development and what to expect with the newest round of regulations. WARNING – SPOILERS AHEAD!

Opportunity Zone Recap

The Opportunity Zone program was created to help revitalize distressed areas by encouraging long-term private investments in designated low-income census tracts. In June 2018, more than 8,700 census tracts in the U.S. were designated as Opportunity Zones. Investors can defer or eliminate capital gains if they invest in Qualified Opportunity Funds that provide a new source of capital for businesses and development projects located in Opportunity Zones.

As Dragon Glass and Valyrian Steel will greatly benefit the Stark army in the anticipated Battle of Winterfell, the Opportunity Zone program provides the following benefits to investors who have realized capital gains:

  • A temporary tax deferral for capital gains reinvested in a Qualified Opportunity Fund within 180 days of recognizing the gain. The deferred gain must be recognized on the earlier of the date on which the Opportunity Zone investment is sold or December 31, 2026;
  • A step-up in basis for capital gains reinvested in a Qualified Opportunity Fund. The basis of the original investment is increased by 10% if the investment in the qualified opportunity zone fund is held by the taxpayer for at least 5 years, and by an additional 5% if held for at least 7 years, excluding up to 15% of the original gain from taxation; and
  • A permanent exclusion from taxable income of capital gainsfrom the sale or exchange of an investment in a qualified opportunity zone fund if the investment is held for at least 10 years.

While maybe not quite as riveting as when Throne’s fans discovered Jon Snow’s true parentage, the IRS released proposed regulations in October 2018, which provided initial guidance to help a corporation or partnership self-certify as a Qualified Opportunity Fund and set forth requirements that must be met by a taxpayer to defer capital gains by investing in an Opportunity Fund. Additionally, the IRS released a revenue ruling, which clarified that a real estate investment will qualify for the program only if a building is substantially improved by doubling the tax basis within any 30-month period after the building is acquired, and the value of the land is not included in adjusted basis calculation.

Cliffhangers

The release of the proposed guidelines and revenue ruling provided some initial guidance on how to structure OZ investments but also left investors and professionals with as many unanswered questions as when Hodor became Hodor. The uncertainty in guidance is causing many investors to refrain from investing in Opportunity Funds until the IRS provides further clarification on a host of issues.

Just as the Mother of Dragons saved Jon and crew in the nick of time from their ill-fated expedition north of the Wall last season, IRS regulations could not come sooner given the deadline for investors who have realized gains to invest into an Opportunity Fund within 180 days. In addition, to reap the maximum step up in basis, Opportunity Fund investments must be made by the end of this year. Prospective investors and deal makers are seeking to have the following, of many, cliffhangers resolved in the next round of OZ regulations:

  • Do long-term ground leases satisfy the property acquisition requirement;
  • Can investors carryover gains from one qualified OZ property to another without jeopardizing the tax benefits;
  • Do the costs of site preparation, environmental remediation and related activities contribute to the substantial improvement requirement;
  • What requirements must be met to qualify business operations within an Opportunity Zone; and
  • What anti-abuse guidelines must be followed related to promote interests?

Critical Reviews

Unlike the overwhelming positive reviews for Game of Thrones, initial response to the Opportunity Zone program has been mixed. Some community groups have criticized the program for a lack of reporting requirements needed to measure community impact and success of the program while other groups are advocating for smart city planning and engagement to fully harness the power of OZ investing. Some Opportunity Zone Funds have closed, typically related to experiencing an unavoidable gain or identifying a property too good to pass up; however, many investors are refraining from selling assets that would result in triggering capital gains until the regulations provide stronger investor confidence in the program.

Game of Thrones fans will be exiting an almost 10-year investment in the show with this week’s premiere; Opportunity Zone investors could be commencing a 10-year investment in their own Game of Zones with the anticipated release of well-crafted Treasury regulations.

Stay tuned for updates on what happens next in Opportunity Zone development by following Stephanie on LinkedIn or contacting her at smmercado@kjk.com or 216.736.7272. More information on Stephanie’s practice can be found by visiting KJK’s Economic Development page.

 

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