In December, the Internal Revenue Service published the long-awaited regulations governing federal opportunity zones. Created under the 2017 federal tax law, opportunity zones allow investors to defer some of their taxes on capital gains, and for other types of income to be entirely exempt from certain taxes by investing the money in certain low-income communities.
Gains are deferred from taxation until Dec. 31, 2026. However, capital gains would be taxed at reduced rates in the five-, seven – or 10-year periods that they are held in the fund. Investments kept in the fund for a decade are totally exempt from taxation.
“In 2030, you sold that real estate investment and it’s double the investment, they bought it for $10 million and sold it for $20 million, that $10 million appreciation is permanently exempt,” said Michael Benguigui, senior manager at Sax LLP.
“Particular areas within the state are designated as opportunity zones. It’s based essentially on low-income, community, population census tract,” said Edward Rigby, a tax partner at Prager Metis CPAs. “The whole point is that they’re trying to spur economic development into these areas.”
There are 169 opportunity zones in New Jersey and 8,700 nationwide. Over the past year and a half, the Murphy administration and elected officials have tinkered with how to entice businesses to develop equitable projects within opportunity zones that benefit the community, such as affordable housing, a restaurant, bowling alley or grocery store.
“One of the things that impressed me early on with New Jersey is that the state was actually on the forefront of this,” said Brian Newman, a partner and practice leader of federal tax services at CohnReznick LLP. “There’s a lot of talk about making sure that you have the right local people in place for a particular development and making sure that ultimately the program works for the site and everything.”
‘Some good clarity’
The IRS’s 544-page document could have major implications for developers, investors, real estate, landowners and businesses as they calculate how to cash in on this new federal tax break.
But fear not.
“The IRS regulations provide some good clarity. They also provide some favorable rules,” Rigby said.
The new rules give investors, developers and businesses owners flexibility in how they move and spend their money in opportunity zones.
For example, the rules are less restrictive on when business owners and investors can put the money from the sale of certain business property, known as Section 1231, into a qualified opportunity fund, according to Benguigui.
The only money that can go into those funds are capital gains dollars, which stem from the sale of the property. The income from the sale of stocks can also be part of the fund, though the majority of people who invest in funds “sold their business and they want to diversify their portfolio,” he said.
Business owners have 180 days from “when the gain was recognized” to put that money into the fund, Benguigui said, as opposed to the start of the next year under the prior set of rules.
“Most want to invest right away,” he added, and the prior requirement to wait until the new year simply did not make sense “from an investor standpoint.”
“If you had a good investment the day after the sale, you couldn’t do that. You had to wait a year,” Benguigui said.
The 180-day rule applies to partnerships, Newman said. If they miss that window, then the partners would have to individually make the investments into the opportunity fund.
Another benefit is that business owners can invest the gross gains into the opportunity fund, and not the net gains, that they make off the sale, Newman said.
“If that person, a business that had $2 million profit, when they had that business, had $1 million unrelated to another business, they sold it, it was a $1 million rollover” into the fund, Benguigui said.
Now, the gross profits of $2 million could be invested into the fund.
Rigby cautioned, however, that the sale has to be to an unrelated party of the business owner and not to a family member, for example.
Another benefit of the new rules is that developers and the real estate industry have more time to actually transition the money from a fund and into actual projects, and looser requirements for just what kinds of improvements need to be made to a property within an opportunity zone.
That could be a relief for developers in New Jersey, where regulations, environmental clean-up, permitting and labor laws can extend the redevelopment process by months or years.
“If it’s a [Department of Environmental Protection] issue, it’s an [Environmental Protection Agency] issue and you’re spending money on those issues and you have sources on those issues then the IRS is going to be like ‘okay we get it,” Benguigui said.
Developers would have 31 months to put the property in service, and up to 62 months as a “safe harbor,” Benguigui said. Even after that, developers can show the IRS why the process is being dragged out.
“The regulations say ‘listen we got it, it’s a process, we just want to make sure you’re not holding the funds, the opportunity fund as some sort of tax shelter’,” Benguigui added.
Another important change is that developers can aggregate the properties they own within the opportunity zone, so that the improvement done on all of them totals 100 percent. Previously, each property needed a “substantial improvement” of at least 100 percent, posing a barrier to redevelopment.
Benguigui called this change “one of the best gems” in the new regulations, which “creates flexibility” for developers.”
“As long as [on] an aggregate basis you substantially improve the asset, then you meet the test,” Newman said.
“Basically in terms of the substantial improvement, you have situations where developers have buildings within the same property. If you have five buildings in the opportunity zone as a developer, now you have five buildings a developer can utilize, for one of the buildings you spend more than 100 percent in one project, you have excess dollars to put into the other four,” Benguigui said.
Improvements on a building which an investor or developer buys within an opportunity zone might need renovations much closer to 10 percent or 20 percent, Benguigui said, such as redoing the lobby or adding mixed-use retail on the first floor.
“If you have a portfolio of properties in your qualified opportunity zone, you can use a situation where one property needs a lot of development and the other four projects not really that much,” Benguigui said. “Now you can take those dollars, the substantial improvement and count it against those projects that would have not met individually.”