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Opportunity Zones1. CAN YOU BRIEFLY REVIEW FOR OUR READERS WHAT OPPORTUNITY ZONES ARE, AND WHAT ARE THE TAX BENEFITS OF INVESTING IN OPPORTUNITY ZONE FUNDS? Qualified Opportunity Zones (“QOZs”) were signed into law in December of 2017under the Tax Cuts and Jobs Act (“TCJA”). This is a complicated piece of legislation, which requires significant analysis and interpretation, and we are still awaiting additional guidance from the IRS.

There are over 8,700 state certified QOZs, designated low-income communities, in all 50 states, Washington D.C., Puerto Rico and the Virgin Islands. About 10 to 12 percent of the United States is in an opportunity zone. These initial Opportunity Zone Fund designations remain in effect until December 31, 2028. At that point the designations are revised for another 10 years. The designation is intended to incentivize the movement of capital into these designated areas to develop property and create and expand businesses to reduce poverty and increase employment. Under the law, the deployment of capital into these areas is effectuated through investments of cash in Opportunity Zone Funds.

The tax benefits of investing in an Opportunity Zone Fund (“QOF”) are twofold. There is the temporary deferral of capital gain recognition for invested capital gains, and the permanent exclusion of post-acquisition appreciation in the QOF if the interest is held for 10 years. From the time of realizing capital gains, taxpayers have 180 days to invest cash up to the amount of the realized capital gains into the Opportunity Zone Fund. These deferred capital gains are not taxable until December 31, 2026. If the opportunity zone fund investment is held for at least 5 years, 10% of this deferred gain is permanently excluded. If the Opportunity Zone Fund is held for at least 7 years, 15% of the deferred gain is permanently excluded. The intent is to keep capital deployed in these areas over a long-term period. So, the invested capital gains are deferred until December 31, 2026, at which time these deferred gains become taxable. If the investment in the Opportunity Zone Fund is held for at least 10 years, any gain on the sale of the opportunity zone fund interest is excludable from taxable income.

8 Q U E S T I O N S W I T H F R I E D M A N L L P ’ S S T E V E B O K I E S S

STEVE BOKIESSPartner and QOZ Consulting Practice Leader Steven Bokiess is a partner at Friedman LLP and leader of the firm’s Qualified Opportunity Zone Consulting practice. He brings more than 20 years of experience and specializes in advising prominent real estate organizations involved in a wide range of properties. Steven has an extensive background providing tax consulting and compliance services to a variety of real estate and asset management clients, including REITs, real estate partnerships, private equity funds, hedge funds, investment advisors, broker/ dealers and mutual funds.

2. HOW WOULD SOMEONE FORM A FUND OR FIND ONE TO INVEST IN? WHAT IS THE BEST STRUCTURE FOR THESE FUNDS TO TAKE ADVANTAGE OF THE TAX INCENTIVES? There is a list of third party Opportunity Zone Funds soliciting investors that can be found on various websites and through investment advisors; however, all of the clients

and prospects I have spoken to have a greater interest in forming and sponsoring their own.

An Opportunity Zone Fund must be either a partnership or corporation, including S corporations. The entity elects to be a QOF by attaching Form 8996 to its tax return for the year the QOF election is to take effect. The entity doesn’t have to go through any specific

approval process or vetting process. The organizing documents of the QOF need to include a statement that the purpose of the entity is to invest in Qualified Opportunity Zone Fund Property (QOZP) and to include a description of the Qualified Opportunity Zone business that the QOF expects to engage in. At least 90 percent of a QOF’s assets must be QOZP. QOZP includes:

1. qualified opportunity zone stock2. qualified opportunity zone

partnership interests3. qualified opportunity zone business

property

3. WHAT IS QUALIFIED OPPORTUNITY ZONE BUSINESS PROPERTY?QOZ Business Property is tangible property used in a trade or business if:

• The property is acquired by purchase after December 31, 2017;

• EITHER (a) the original use of the property in the zone commences with the QOF (or the qualified opportunity zone business (QOZB)) or (b) the QOF (or QOZB) substantially improves the property; and

• During substantially all of the holding period for the property, substantially all of the use of the property is in the zone.

The substantial improvement test is met if, during any 30-month period beginning after the date of acquisition of the property, additions to basis with respect to such property in the hands of the QOF exceed an amount equal to the adjusted basis of such property at the beginning of that 30-month period.

If a taxpayer purchases land and a building, the land itself does not have to be separately improved and the basis in the land is not part of the basis that needs to be doubled in order to meet the substantial improvement test for the building.

4. WHAT IS QUALIFIED OPPORTUNITY ZONE STOCK, A QUALIFIED OPPORTUNITY ZONE PARTNERSHIP INTEREST, AND QUALIFIED OPPORTUNITY ZONE BUSINESS (QOZB)?QOZ stock is defined as a domestic corporation acquired by a QOF after December 31, 2017, at its original issue solely in exchange for cash if, as of the date of issue, the corporation is a QOZB.

MARCH 1, 2019 19

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OPPORTUNITY ZONE TAX INCENTIVE

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to minimize capital gains taxes while capturing additional capital

to expand or form businesses or fund real estate developments.

A QOZ fund partnership interest is any capital or profits interest in a domestic partnership acquired by a QOF after December 31, 2017, from the partnership solely in exchange for cash if, at the time the interest is acquired, the partnership is a QOZB.

In order to be a QOZB, an entity must meet the following requirements:

• Substantially all of the tangible property owned or leased by the QOZB must be for use in the QOZBP (70%), as defined previously;

• At least 50 percent of the entity’s total gross income is derived from the active conduct of the business;

• A substantial portion of the intangible property is used in the active conduct of the business;

• Less than 5 percent of the average of the aggregate unadjusted basis of property is attributable to nonqualified financial property. Cash is considered a qualified asset as long as there is a written plan that identifies the cash as being held for a project and there is a written schedule for deployment of the cash within 31 months that the business substantially complies with.

• The business cannot include operation of a private or commercial golf course, country club, massage parlor, hot tub facility, racetrack, gambling establishment, or a liquor store.

5. THE GOAL OF THE OPPORTUNITY ZONE FUNDS IS TO DEFER, REDUCE OR ELIMINATE CAPITAL GAINS TAX ON THE INVESTMENT. WHO OR WHAT ENTITIES ARE ABLE TO DO THIS, AND HOW IS IT ACCOMPLISHED? Individuals, C corporations (including RICs and REITs), partnerships, S corporations, trusts and estates are eligible to defer gains through an investment in an opportunity zone fund. The investment in the Opportunity Zone Fund has to be for cash, up to the corresponding amount of capital gains. The taxpayer elects to defer the recognition of the invested capital gains on Form 8949 filed with the taxpayer’s income tax return for the year of the gain deferral.

Either the flow-thru entity (i.e., partnership, S corporation, trust, or estate) or its partners, shareholders, or beneficiaries (i.e., partner) can elect to defer the gain and invest into an

opportunity zone fund. If the flow-thru entity elects to defer, the respective capital gain is not reported on the Schedule K-1 provided to the partner. If the flow-thru entity does not elect to defer, the capital gains are reported on the Schedule K-1 and can be deferred by the partner. For capital gains allocated from a flow-thru entity, the 180-day reinvestment period begins on the last day of the flow-thru entity’s taxable year. Alternatively, the partner may elect to treat the partner’s own 180-day period as being the same as the flow-thru entity’s 180-day period, and it would begin on the date of the realization event.

6. WHAT IF AN INVESTOR INVESTS MORE THAN HIS CAPITALS GAINS INTO AN OPPORTUNITY ZONE FUND?

A taxpayer can invest more than the gain realized, but the tax benefits are only available with respect to the investment made with deferred gain. If the taxpayer invests both deferred gain and other funds, the investment into the Opportunity Zone Fund is treated as two separate investments, one to which the tax benefits apply and one to which they do not. The basis step-up to Fair Market Value in 10 plus years is only available with respect to the gains realized on the portion of the investment in the Qualified Opportunity Fund allocable to deferred capital gains.

7. WHAT ARE THE DIFFERENT WAYS THAT REAL ESTATE INVESTORS CAN INVEST THEIR GAINS?

The amount of the deferred gain into the opportunity zone fund has to be done with cash up to the corresponding amount of the deferred gain. At the fund level, investing in rental real estate should be fine as long as it involves the rental of multiple units. It is unclear at what point rental real estate is deemed to be an active business. However, it would be counter to the intent of opportunity zone funds, which includes a desire to provide additional affordable housing, to take the position that the leasing of residential rental property cannot meet the definition of QOZBP.

Since the purpose of the legislation is for the property investment to be a long-term hold, developing and selling property would not necessarily work.

The legislation has been written with

the goal of supporting and investing in active businesses that promote jobs.

8.WHAT ARE THE MAIN QUESTIONS INVESTORS MAY HAVE WHEN CONSIDERING AN OPPORTUNITY ZONE FUND? WHAT ARE THE HIDDEN CHALLENGES OR RISKS? As with anything, the investment has to be a good business decision. There’s no point in investing in something for tax incentives if the investment doesn’t make sense from a business perspective. When the deferred capital gains become taxable in 2026, the money is still tied up in the opportunity zone fund, so investors will need cash from other sources to pay the tax. To achieve the full tax benefits, this is a long-term 10-year commitment. Also, under the proposed regs, in order to

exclude the gain on the sale of the fund, the fund needs to be sold by December 31, 2047. Some commentators believe this 2047 timeline will be eliminated or further extended.

One point of clarification needed pertains to how to handle sales of property within the fund. Based on current law and the current guidance, the current exclusion of taxable income after 10 plus years into the future of gains on the appreciation of the QOF investment only applies to the sale of the fund shares/partnership interest itself. If a fund sells property and allocates the taxable gain to the investors, it defeats one of the tax incentives of investing in a QOF. The IRS acknowledges that it needs to provide guidance on how to handle sales of property within a fund.