How the Latest IRS Opportunity Zone Regulations Help Real Estate Developers Qualify for Opportunity Zone Tax Benefits
By Catherine Holmes, Brad Cohen and Jamie Ogden
The latest IRS Proposed Regulations Released April 17, 2019 provide greater flexibility to real estate developers seeking capital from investors for Opportunity Zone projects.
Some of the problems posed for real estate developers and others under the new Opportunity Zone (“OZ”) tax incentive program, codified as Sections 1400Z-1, and 1400Z-2 of the Internal Revenue Code, have been potentially solved by the latest round of IRS proposed regulations. In particular, the proposed regulations now provide helpful guidance and assurance regarding:
- development of property that was acquired by a developer prior to December 31, 2017;
- clarification regarding when real property will be considered to meet the “original use” requirement;
- capital contributions received from new investors in a “qualified opportunity fund” (or “QOF”) with multiple closings;
- distributions of debt financed proceeds by a QOF to investors during the 10 year required holding period;
- greater flexibility to deal with “real world” problems (such as delays in governmental permitting);
- sales of assets by QOFs before the 10-year holding period for investors and reinvestment of proceeds of sale;
- sales of assets by QOFs organized as limited liability companies or limited partnerships after the 10 year holding period for investors;
- clarification that a property rental business is considered an active trade or business (other than a triple net lease); and
- clarification that depreciation recapture should not be taxable upon a sale of property by a QOF .
This article explains how these new proposed regulations help real estate developers and their eligible investors qualify for the tax benefits under the OZ program. For information regarding the potential benefits to investors in a QOF and the basic requirements necessary to qualify as a QOF, see our prior article “How Real Estate Developers Can Use Opportunity Zone Funds to Finance New Real Estate Projects.”
Real property acquired before December 31, 2017 can now qualify for development by a QOF through a ground lease arrangement between a real property lessor and an affiliated real property lessee.
One of the requirements for a real estate development to achieve the status of “qualified opportunity zone business property” (“QOZBP”) under Section 1400Z-2 is that the property being developed must have been purchased after December 31, 2017. Developers who acquired their properties before that date were prevented from qualifying for the OZ tax incentives unless they sold at least 80% of the property to an unaffiliated purchaser, and retained no more than a 20% capital and profits interest. However, the latest proposed regulations offer another option to a developer in this situation – it can form an affiliated QOF, enter into a ground lease with the QOF as lessee, and have the QOF finance the development of the property. The requirements for ground leases between affiliates under the latest OZ regulations are that:
- the lease is entered into after 2017;
- the lease is on market rate terms when it is entered into;
- the lease does not contain a prepayment of more than 12 months;
- there is not a plan, intent or expectation that the QOF would purchase the property for other than fair market value to be determined at the time of purchase.