The new Opportunity Zones program that came to us in 2017’s major tax reform offers investors the chance to roll the capital gains from the sale of any appreciated property into new investments, located within specially designated areas known as Opportunity Zones, and defer—and potentially partially eliminate— capital gains taxes on such sale. The program is similar to a 1031 Exchange, but with a socially conscious geographic focus, that applies broadly to investments across asset classes – not just to real estate. The tax benefits of the program will begin stepping down for investments made after December 31, 2019, so the clock is ticking on the chance to pull capital out of appreciated assets and invest it in a Qualified Opportunity Fund (QOF). The time is now to start thinking about where all this capital will be sitting when the music stops.

The stated goal of the Opportunity Zone program is to offer capital gains tax deferrals (and potentially outright forgiveness of capital gains taxes in certain instances) as an incentive to spur private investment into specific geographic areas designated by the states and territories (and certified by the Department of Treasury) as particularly in need of investment. In practice, if an investor sells appreciated assets, be they stocks, real estate, etc., which would normally generate a capital gains tax liability, the investor can now choose to invest the capital gains from that sale, within 180 days, into a QOF. The QOF then invests in qualified Opportunity Zone property or in operating businesses (which can be domestic corporations or partnerships) engaged in qualified Opportunity Zone business.

Qualified Opportunity Zone property is property that was purchased after December 31, 2017 and either:

(i) the ‘original use’ of the property is by the QOF; or

(ii) the property is substantially improved by the QOF.

A qualified Opportunity Zone business is a trade or business:

(i) in which substantially all of the tangible property owned or leased is qualified Opportunity Zone property;

(ii) that derives at least 50% of the its total gross income from the ‘active’ conduct of a qualified business within a qualified Opportunity Zone;

(iii) that has less than 5% of the average of the aggregate unadjusted bases of its property attributable to nonqualified financial property; and

(iv) that uses a substantial portion of its intangible property in the active conduct of a qualified business in a qualified Opportunity Zone.

We are still waiting to see how the IRS will interpret a number of key terms in the above definitions, including ‘active’ conduct and ‘original use’, but some are predicting that (at the least) new construction will satisfy the original use requirement. Stay tuned for an update when the IRS issues further guidance on these points – the public hearing that had been scheduled for January 10th to discuss the interpretation of the Opportunity Zones requirements was a casualty of the government shutdown but has been romantically rescheduled for Valentine’s Day!

By investing their capital gains into a QOF, an investor can defer the capital gains taxes they would otherwise owe until the earlier of the investor’s sale of its QOF investment or December 31, 2026.  Even better, if the investor keeps their tax-deferred funds invested in the QOF beyond either a five or seven year threshold, then they receive a 10% or 15% exclusion of the deferred gain (through a 10% or 15% step-up in the investor’s basis in the QOF investment when the deferred capital gains are taxed), respectively. Additionally, after holding the QOF investment for at least 10 years, the investor may step-up the income tax basis of the QOF investment to the fair market value on the date of sale and permanently exclude from taxation any capital gains on the appreciation of the QOF investment itself. This ‘two bites’ shot at reducing capital gains taxes is attracting plenty of interest. As of January 24, 2019, the National Council of State Housing Agencies reported that 97 publicly-announced QOFs had already been formed, with plenty more in the pipeline.

The tax relief offered by the Opportunity Zones program comes at a time when many investors – from high net worth individuals to massive institutional investors – are sitting on large, unrealized capital gains in commercial real estate, equities and other asset classes. Simultaneously, chatter about a potential economic downturn is growing louder (although we are not convinced), so more and more of those investors may be starting to consider their exit strategies from these appreciated assets. The ability to make a graceful, tax-advantaged exit from appreciated positions and roll the capital gains into a new type of investment (while potentially reducing or avoiding future capital gains tax liabilities as well) could pull billions of dollars out of equities and real estate and into QOFs.

The option to make qualified Opportunity Zone investments in real estate development or in a wide range of operating businesses may even present counter-cyclical investment opportunities with strong potential returns relative to the broader markets, in addition to the tax deferral benefit. For example, if the broader real estate market takes a dip at some point, the tax benefits of Opportunity Zone investments could act as a stabilizing buoy, keeping it afloat. Such relative stability could then attract even more demand, further driving a counter-cyclical surge forward. The geographic location of Opportunity Zones in areas that have been off-the-radar for many institutional investors could also mean that Opportunity Zone investments are more likely to be affected by a different set of macroeconomic factors than those driving the cycles in core markets. If the opportunity for uncorrelated returns with reduced tax liabilities doesn’t attract serious investment, we don’t know what would.

Before you start shopping for Opportunity Zone investments, remember that, in order to be considered qualified Opportunity Zone property, real estate investments in Opportunity Zones must be for either new construction or substantial redevelopment (i.e. they must pass either the original use test or substantial improvement test discussed above respectively). Likewise, under the multi-factor test for a qualified Opportunity Zone business outlined above, an operating company must conduct an ‘active’ trade or business in which substantially all of the tangible assets are qualified Opportunity Zone property in order to be eligible for QOF investment. This means we should expect to see some spillover effect into the construction industry and increased demand for acquisition, development and construction (ADC) financing. It also means that any real estate financings in QOFs could implicate HVCRE concerns. These requirements mean that if capital jumps out of equities or more stabilized classes of real estate, it will have to be directed towards the ‘heavier lift’ types of projects that will qualify for QOZ investment treatment, as opposed to stabilized real estate or pre-existing business assets that just happen to be located in Opportunity Zones. In other words, a stabilized asset isn’t a qualified Opportunity Zone property just because it’s located in an Opportunity Zone.

We’re additionally interested in what proportion of the benefits of the Opportunity Zones program will be captured by current landowners and ‘first in’ speculators in the Opportunity Zones. It’s safe to say that anyone who was already sitting on desirable property in an Opportunity Zone should be happy about what this program has already done for their property value in the short term, and they will be forced to decide between ‘taking a seat’ now or waiting to see if the music keeps on playing in Opportunity Zones over the long term. Since the full benefits of the program are realized after holding the investment for ten years, we expect many Opportunity Zone investors will try to exit their investments at that point, with such an exodus resulting in a drop in property values to their pre-Opportunity Zone levels. Of course the goal of the program is to incentivize synergistic growth within economically-distressed communities that are otherwise stagnant, so if the program succeeds, values should rise for fundamental reasons, offsetting any reset back to pre-Opportunity Zone levels.

We’ll be watching this game of musical chairs closely to see where the big players land around these questions and more, and we welcome your ideas on the opportunities and pitfalls presented by the Opportunity Zone program. For more on the details of the tax treatment and qualification requirements for this program, see the Dechert OnPoint article released by our tax department.