“Opportunity Zone” legislation within the Tax Cuts and Jobs Act of 2017 makes it potentially more rewarding than ever for investors looking to spur urban and rural renewal worthy of the name.
ONE OF THE United States’ most remarkable transformations in recent decades has been the astonishing rebirth of portions of urban America. Entire districts of formerly decrepit downtown areas in cities nationwide have been revitalized thanks to the combined efforts of pioneering locals and outside investors. As a result, formerly unsightly and economically depressed areas have been resurrected as creative hubs, home to a variety of commercial and residential properties that have turned blight into bustle—broadening cities’ and states’ tax bases and revivifying a sense of comity and urban spirit many thought might have been gone for good.
The kind of investment that can cause this sort of renewal to take root in needy areas—and stay there—got a tremendous boost with the passage of the Tax Cuts and Jobs Act of 2017, signed into law by President Trump in December of that year. Among the legislation’s provisions was the establishment of “Opportunity Zones” nationwide—a community-development program (for urban and rural areas alike) designed to spur long-term investment in low-income and disadvantaged areas throughout the country.
Under the auspices of the law, the tax advantages of Opportunity Zones (OZs) are substantial, and they’re having the desired effect: prompting large institutional funds and commercial investors to make OZs a greater part of their real estate investment strategies. Investors of all types need to keep a number of important elements in mind, however, regarding existing structures and the permissible scope of the improvements one might make to them in order to take full advantage of the tax benefits.
The primary goal of the OZ legislation is to drive significant development of distressed census tracts and spur new development as well. (It’s important to note that the tax benefits on their own don’t necessarily make a modest redevelopment project fully viable, but they do offer terrific incentives to undertake substantial redevelopment that might otherwise be too financially risky for any number of reasons.)
To be deemed a Qualified Opportunity Zone Property (QOZP) held by a Qualified Opportunity Fund (QOF), a given project must satisfy one of the following requirements:
- Use of the property for the commercial purposes of becoming a QOZP is beginning with the fund in question; or
- The fund looking to make the investment must substantially improve the property as it currently exists.
“Substantial improvement” would seem the very essence of subjectivity, but for the purposes of OZ financing, it simply means that the investor needs only to invest an amount equal to his or her basis in the building—and, importantly, not the land on which it sits, during any 30-month period after it is acquired.
For example: Say the (fictitious) Lone Star Improvement Coalition Fund, a Qualified Opportunity Fund, buys Defunct Widget Factory A. The factory and its land are both fully within the Qualified Opportunity Zone, and Lone Star pays $800,000, intending to convert the factory into rental loft apartments. In this instance, 60 percent of the purchase price, or $480,000, is attributable to the value of the land, while 40 percent, or $320,000, is attributable to the building itself.
Because Defunct Factory A had a clear purpose prior to its purchase by the Lone Star Fund, its use within the QOZ is not commencing with Lone Star’s investment. As such, Lone Star, in order to satisfy the second condition and make itself eligible for the favorable OZ tax treatment, must “substantially improve” the property—which in this case means adding an additional $320,000 to its basis in the land or building. This is not a difficult bar to clear considering the scope of what most Qualified Opportunity Funds are looking to do to the properties they buy.
A subsequent edict, Revenue Ruling 2018-29, was issued by the Internal Revenue Service, which served to further clarify the “substantial improvement” stricture. It confirmed that (to return to our example above) Lone Star need not factor the value of the land into its calculations when determining the amount of investment required to meet the “substantial improvement” threshold, nor does it likewise need to make equivalent improvements to the land itself to remain eligible for the favorable Opportunity Zone tax treatment.
The particulars can get complicated but given that a tremendous amount of property and neighborhood improvement throughout the U.S. has already been occurring for the last several decades, improving the tax climate for such investments will likely spur even more of them. Aided by a predictable, friendly (and potentially lucrative) regulatory environment, committed investors around the country can take a look at the significant urban and rural improvements already made, puff out their chests and say confidently: You ain’t seen nothing yet.