This article is an update on the Qualified Opportunity Zone program, which was established by the Tax Cuts and Jobs Act. The article examines the program's current status, possibilities, and challenges. This article is a current snapshot of the status and possibilities of a once-bipartisan legislative program, the present challenges and obstacles internal to the program's technical requirements, and the threats posed by two Category 5 storms blowing from different directions, one now happening and the other clearly visible on the horizon.
Few recent developments in federal tax law have evoked as much speculation and scholarly froth as the law and regulations creating Qualified Opportunity Zones ("QOZs") and their related benefits. The law is contained in Internal Revenue Code ("IRC") Sections 1400Z-1 and 1400Z-2 (the "QOZ Law"), added by the Tax Cuts and Jobs Act in 2017.1 Much more has now been written with the addition of the voluminous final regulations and three "guidance" precursors to the regulations. Given the ectomorphic form of the law itself, the regulations were clearly necessary. Yet, full-on pursuit of >QOZ programs and their attractive features has been hampered until recently by lack of clarity in certain key areas.
Early in 2020, it appeared that the regulations had answered the most important remaining questions, and that sponsors of both real estate and non-real estate programs had enough clarity to proceed with their plans. The outlook for both community uplift and a more generous public appraisal of >QOZ programs had improved. As of 3/1/2020, the overriding question was whether sponsors and investors would step up. The table was set. Then two outside factors intervened. First, an epic "black swan event," the pandemic, threw the entire world economy (and certainly the real estate economy) off track. Second, the outlook for >QOZ programs was cast into doubt by the November 2020 presidential election, as the originally-bipartisan >QOZ Law became weaponized. We treat each of these later in the article.
>QOZ Law basics
The >QOZ Law provides two levels of benefits: (1) on the initial capital gain recognition event, they are a means for U.S. taxpayers to both defer and (depending on timing) reduce payment of federal capital gains tax for a recognition event after 12/31/2017, and (2) they are a means of full avoidance of federal capital gain attributable to reinvestment of the original gain amount into qualifying assets. A realization of full benefits requires investment in one or more Qualified Opportunity Funds that in turn invest in Qualified Opportunity Zone business property, either directly or through qualified opportunity zone businesses ("QOZBs") operating in >QOZs, as detailed below.
Not all states have conformed to the >QOZ provisions. Thus, the tax benefits may accrue at only a federal and not state level, depending on the jurisdiction.
While the designation of >QOZ census tracts was originally expected to be fixed and immutable for the duration of the program, the overarching effect of the >COVID-19 pandemic has pushed Congress to consider stretching certain program boundaries as a tool for economic recovery.
On 6/4/2020, the >IRS released Notice 2020-39,2 which provides additional time to meet numerous requirements under Section 1400Z-2 and its now numerous implementing regulations. It also allows extensions with respect to certain >QOZ requirements affected by >COVID-19. The Notice also reaffirms the previous guidance offered in >IRS Notice 2020-233 (which also extended certain >QOZ deadlines).
Under the >QOZ Law, U.S. taxpayers who have recognized short or long-term capital gain may invest the cash equivalent of their recognized gain into a Qualified Opportunity Fund within (originally) 180 days of their gain recognition date.4 Provided that the gain is invested into a qualified asset and meets certain timing and deployment tests,5 the investor can expect deferral of their original capital gain recognition until 12/31/2026 and, if the new investment is held more than 10 years, permanent non-recognition of federal long-term capital gain on the appreciation of that asset, which must ultimately be sold by 12/31/2047. Investors who elect this course and fund their Qualified Opportunity Fund by 12/31/2021 also pay less tax as of 12/31/2026 because their basis in the asset sold is increased by 10%, which effectively reduces the amount of deferred gain recognized by 10%.
Milestones met and missed; new challenges
The legislation's original community uplift goals were primarily the establishment of sustainable businesses, ongoing sources of employment, and the creation of new housing. Not surprisingly, the institutional real estate community reacted first, drawing fire from community advocates who viewed this activity as gentrification, or more pointedly skimming the cream from the opportunities provided without adding concomitant value to the community.
The development of "going businesses" in Zones has been disappointingly slower, in part due to the paucity of legal definition until final and proposed regulations were released in December 2019. Hoped for public-private partnerships and community foundation involvement have also been slow to emerge. The regulations are generally favorable to investment, though frequently demanding in their detail.
Unfortunately, starting three months after release of the regulations, many investment initiatives beginning to gain traction were at least temporarily derailed by the pandemic's effect on financial markets, making "re-start" dates highly uncertain as lenders and investors reevaluated their positions.
Anecdotal information and industry surveys to date suggest that developers and program sponsors for the most part remain committed to their projects, but that substantial new obstacles have arisen in the form of lender-related difficulties6 and entitlement processing delays.7 Also, there are increasing reports of failure of non-simultaneous exchanges in the current environment, with intended exchangors forming and investing in Qualified Opportunity Funds ("QOFs") as drop-back strategies.
Another layer of complication lies in the evolving tax proposals of the Biden campaign platform. Discomfort is felt by many high-income and high net worth taxpayers arising from the Biden campaign's >QOZ Law motif that the law should "not exacerbate wealth inequality." Counterbalancing this, many potential investors who exited the equity markets and recognized 2020 gain around the early-year market downturn (and possibly casting a weather eye on post-election market volatility) now have reason to weigh the advantages of a >QOZ investment against the probability of uncertainty in equities (and probably also tax law) in the years ahead.
The pandemic has also raised concerns about the percentage-testing framework for operating businesses defined in the December 2019 regulations and elsewhere in >QOZ Law. With high percentages of employees and independent contractors working from home for the indefinite future, including offsite use of intangible property, major new compliance issues are presented. Luckily, new guidance released in May 2020 eased one burden. When applying the 90% asset test, ensuring that a >QOZF qualifies under the >QOZ rules, >QOZFs do not need to take into account investments made in the preceding six months as long as the new assets are held in cash, cash equivalents, or debt instruments with a term of 18 months or less.
Where are the opportunities?
In light of improved understanding of how to utilize >QOZ benefits in more diverse situations, this article encourages pursuit of innovative business models that align community needs with business goals. This value is core to the legislation. Enrolling local government and community stakeholders in the vision and correcting misconceptions about >QOZ Law are not just desirable but critical. In building local alliances, nonprofit organizations can play a key mediating role as trusted proxies for underserved demographic groups in these communities to better gain acceptance and leverage results.
For >QOZ investors, there is no substitute for thoroughly understanding the needs of the local community in order to create sustainable investment. Most investment opportunities in Zones will require some form of public agency approval, including development entitlements, use permits, and perhaps zoning changes.
Each Zone locale typically has at least four distinct groups of opinion leaders or gatekeepers: elected officials, agency staff, "stakeholder" organizations, and local residents. These officials and opinion leaders must be aligned with the investment goals and development vision. Parallel programs (for instance, New Market Tax Credits or available property tax exemptions) may be "stacked" atop >QOZ benefits, and there can be considerable local expertise brought to bear.
Because by this time many cities and counties have fixed preferences for the kinds of investment they wish to see, early engagement and quality communication are important. Nonprofit involvement can hasten and smooth the process, reducing friction.
Perceived gentrification and loss of existing housing stock should be addressed at the earliest possible date, including through interviews with occupants who may be displaced. For >QOZ residential development programs, these concerns can be mitigated by such initiatives as moving existing houses to vacant lots and renovating them, creating a mixed-use element for neighborhood retail space, and partnering with a nonprofit job development program for employee training.
With the creation of new jobs, Zone payroll may leave the area if employees live elsewhere. Coordination with other >QOZ developers may increase the opportunity for those workers to both live and work in the area, a double benefit.8
Another essential element is the extent to which the energy and creativity of millennial and younger residents and entrepreneurs can be harnessed. Micro-businesses, popups, and artisanal businesses generally require less capital and less startup time. They are uniquely attuned to neighborhood needs and can be grown in a Zone.
1 P.L. 115-97, 12/22/2017.
2 Notice 2020-39, 2020-26 IRB 984.
3 Notice 2020-23, 2020-18 IRB 742.
4 However, for instances in which the 180-day rule falls between 4/1/2020 and 12/31/2020, Notice 2020-39, issued 6/4/2020, unexpectedly extended the final date in all such cases to 12/31/2020, providing additional flexibility for some.
5 These have also been liberalized for some by Notice 2020-39.
6 Many lenders have reassigned loan processing staff to new workout cases, forbearance requests, and portfolio evaluation. Underwriting standards have been stiffened throughout the industry and financing for a number of asset classes requiring intense public use (retail, restaurants, theaters as examples) has been seriously curtailed or made altogether unavailable. The pandemic backwash in the lending industry now appears likely to hamper financing for two years or more.
7 Public agency staff may have been depleted by furlough, reassignment, or diversion of funding. Hearings and application and plan processing are frequently delayed or rescheduled. Public hearings held online are clumsy at best and running behind schedule. Pandemic-related matters take priority on the agendas of elected bodies.
8 Unfortunately, the prospect of a prolonged pandemic has created another level of uncertainty arising from "shelter-in-place" ("SIP") orders and the prospective inability of workers in a QOZ-located business to continue to work within the Zone to the extent required to satisfy the "50% of gross income" revenue requirement of the regulations. It is hoped that Treasury will soon enact guidance providing that the 50% rule is tolled for the period of time that a particular QOZ was under a State of Emergency, whether federal, state, or local.
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Originally published in Practical Tax Strategies (November 2020) and Taxation of Exempts (November/December 2020), Thomson Reuters journals.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.