By J Dana Tsakanikas
Before going into what the program does not do, let’s discuss what it does do. The program was the brainchild of successful Silicon Valley entrepreneurs (with bipartisan support in Congress), to tap and unlock the tremendous amount of capital gains currently “trapped” in existing investments in the U.S. (as high as $6 trillion by some estimates), and encourage those wealthy individuals to reinvest those private dollars into areas of the U.S. that are in need of redevelopment or reinvestment.
To that goal, it allows those individuals to sell their positions in existing investments and reinvest those proceeds into QOZ projects in lower income neighborhoods. The incentive is that the investor can defer the tax on that initial gain on sale of the existing investment until 2026, or obtain a step-up in basis of that initial gain, and most of all benefit from tax-free gains on such new investment after 10 years.
For the developer, it allows them to underwrite projects to initially lower rates of return, because of the value of the tax-free dollars that the project could realize upon exit after 10 years. So, take for example a developer that expects (for example purposes only) a 12 percent return for a real estate project. However, due to the rents in a QOZ, the project only generates an 8 percent return currently. The developer understands that, while it would otherwise be too early to develop or re-develop in the current cycle of that neighborhood, he could realize several percentage points of additional yield after 10 years due to the potential tax-free nature of the gains, and that if the neighborhood continues to redevelop, that tax-free benefit could be extraordinary.
That’s the simplicity of the program. However, many misconceptions have developed over the past several months.
At the fund-level and investor-level, the program is not just about raising the money - it’s about deploying the money.
Raising the fund is only part of the process. Deploying the funds per the regulations within certain timelines and within profitable projects, is arguably more critical – in particular with penalties that can be incurred by the funds for not meeting certain tests such as the timing of the deployment of capital. Experience and track record counts - this is no different than when considering any other fund investment or fund manager.
The program is not a grant or related type of program.
The incentives are purely economic and designed to encourage private individuals with capital gains to reinvest into areas and businesses that they might not otherwise invest in. Even though we all have a responsibility for one other, the program has no social impact requirement; at the same time, through the simplicity of the incentives, it has the potential to create meaningful social and societal impact.
The program was not specifically designed nor created to develop affordable housing; frankly, it was not specifically designed to develop any particular class of real estate.
Contrary to some of the political rhetoric and chatter, the program was developed to encourage private investment that would create jobs and improve neighborhoods that need it the most. While improving the stock of affordable housing can contribute to those ends, it is not the focus of the program.
The program does not allow the circumvention of SEC or related laws surrounding fundraising.
With very few exceptions (such as perhaps a family office that does not intend to raise outside funds and will invest on its own behalf), QOZ fund promoters are subject to the same laws and regulations as the rest of the private equity fund community. The two-page IRS form 8996 is for self-certification that the fund is and meets QOZ regulations for tax purposes - not a license to widely raise money without regard to accreditation or otherwise.
If you have owned a property for several years, that is now designated as being within a QOZ, you do not automatically qualify for the tax benefits.
To participate in the tax benefits, the property must be acquired by an unrelated party after Dec. 31, 2017. Unrelated is defined as less than 20 percent ownership. So, as an existing land or property owner, in general, you would need to sell to an unrelated partnership, then buy back into that partnership but for not more than 20 percent. You could then take the balance of your gains from such sale and reinvest those in a QOZ Fund.
The step-up in basis of your original dollars in years 5 and 7, and the deferral of those payments until 2026, while attractive, is not the primary incentive or benefit of the program.
The attractiveness of this program, from a fund-level investor perspective, is that every dollar above your potentially stepped-up basis (original investment) is tax-free from federal income tax (and in many states, from state income tax), if the investment is properly invested, executed, and held for at least 10 years. Said another way, if you invest $1 million and 10 years later that $1 million generates an additional $3 million of gains, your tax on that $3 million by Uncle Sam is zero.
To qualify under the “substantial improvement” test, you cannot simply build a second stand-alone building (like a hotel) of equal or greater value than an existing building ( like an office building) on the site, if excess land exists.
If the QOZ land has existing vertical improvements, for example an office building, the improvements must be made to those existing vertical improvements for one dollar more than those existing improvements (or rebuild for one dollar more than such existing value, if you raze the building). However, if the second building, for example a hotel, is connected to and integrated with the existing building, it could qualify as an improvement to the existing building for purposes of meeting the substantial improvement test.
As an investor, you can invest your capital gains from the sale of a recent property, asset or business - it is not limited to the cash proceeds from such sale.
For example, in very simple terms, if you sold a building for $10 million that you originally purchased years ago for $1 million, and the building is fully-depreciated, your gain is $9 million (land value aside). If at the time of sale, the building had $5 million ( interest-only debt during your hold period) of debt such that you only realized $5 million of cash upon sale, you could invest that $5 million plus another $4 million that you have in a money market fund, into a QOZ fund.
You are not required to sell your interest or investment in year 10 or 2029.
The outside exit date is 2047. While you have to hold the investment for at least 10 years to attain the tax-free benefit of gains above your original investment, you can continue to hold and create tax-free value until 2047.
Contrary to much of the rhetoric, this program is unlike previous or existing government incentives designed to foster community redevelopment - let’s give it a chance.
The aforementioned is based on the regulations and clarifications issued by the Treasury Department in October 2018.
Disclaimer: Opportunity Zone Expo events and conferences are open to the public and may include persons residing in the U.S. or foreign countries who may be interested in investment opportunities. Attendees, exhibitors and speakers at our events and conferences should consult with their own legal counsel regarding compliance with securities laws for any ongoing or planned securities offerings. Opportunity Zone Expo provides no legal advice concerning compliance with securities laws by attendees, exhibitors and speakers at its conferences, or content on its web sites.