a primer on opportunity zone investing

June 18, 2019

A PRIMER ON

OPPORTUNITY

ZONE

INVESTING

2 A Primer on Opportunity Zone Investing

With you today

MARLA MILLER

Tax Managing

Director

[email protected]

215-636-5520

GRANT KEPPEL

Tax Managing

Director

[email protected]

904-224-9904

TRACI PUMO

Tax Managing

Director

[email protected]

561-207-3239

TIM SCHRAM

Tax Managing

Director

[email protected]

312-730-1276

3

Federal Opportunity Zones


Overview

Created through the passage of

the Tax Reform Reconciliation Act

of 2017

New §§1400Z-1 and 1400Z-2 of the

Internal Revenue Code

Designed to encourage long-term

investments in economically

distressed communities

Bi-partisan effort

Used 12/31/26 to score revenue,

but may be extended

Intended to release the private

investment potential of over $6

trillion of captive capital gains

Treasury Secretary Steven

Mnuchin stated: “I think there’s

going to be over $100 billion

dollars in private capital that will

be invested in Opportunity Zones

… ”


Overview

Tax preferential treatment provided for investing in designated

Opportunity Zones through investment vehicles called Opportunity Funds

Opportunity Zones will benefit the real estate, retail, private equity,

and other industries

This will have a major impact on high net worth individuals,

corporations, and fund managers


Treasury and IRS guidance

On October 19, 2018, Treasury and the IRS released its much anticipated

guidance regarding Qualified Opportunity Funds (“QOF”), including

proposed regulations, a revenue ruling, and a draft IRS form

The Regulations are only proposed, as such they are subject to further

revisions

Treasury has stated that taxpayers may rely upon many of the proposed

rules, providing that the taxpayer applies the rules in their entirety and

in a consistent manner

The public hearing on the proposed regulations was held on February 14,

2019

Final regulations are anticipated to be released in late-April to mid-May

A second set of proposed regulations were issued on April 17, 2019

There may be a third set of proposed regulations or additional guidance


Opportunity Zone designations

Opportunity Zones are census tracts

Opportunity Zones were nominated by the states and approved by

Treasury

8,761 census tracts were designated in all 50 states, the District of

Columbia, and five possessions

Census tracts need to be in low income communities or contiguous to

low-income communities (limited to 5% of nominations)

Notice 2018-48 lists the population census tracks approved by Treasury

as qualified Opportunity Zones

The list is final and essentially unchanging


Opportunity Zone map

9

Capital gain


Capital gain required

Eligible taxpayer includes individuals, C corporations (including

RICs/REITS), partnerships, S corporations, and trusts and estates

Triggering event is the realization of capital gain

Must be treated as capital gain for Federal income tax purposes (short or

long term)

• Unrecaptured Section 1250 gains

• REIT and RIC capital gain dividends

• Collectible gains

• Certain Section 1256 contracts


Capital gain required

Capital gain must be from an unrelated party

Ordinary gains do not qualify (e.g., §§ 475, 1221, 1245, 1250)

The tax attributes of the initial gain invested into a QOF are preserved

When a taxpayer disposes of its fungible interests in the QOF and cannot

determine the tax attributes of the gain being recognized, the taxpayer

should use the FIFO method. To the extent that the FIFO method does

not provide a complete answer, then the taxpayer should apply a pro-

rata method

Taxpayer will elect to defer gain on Form 8949 which will be filed with

its tax return


Capital gain deferral

Investment in a QOF must occur within 180 days of

liquidation/disposition/sale to third party

Taxpayers cannot invest in opportunity fund property directly – all

investments must be made through QOF

Either a partnership or its partners (amount of eligible gain included in

the partner’s distributive share and resulted in an increase to the

partner’s tax basis) may roll-over gain into a QOF

• Partnership investment – date of sale

• Partner investment – end of partnership tax year or date of sale (if partner

notified)

• Note – on the K-1, the gains and losses will be a net number

Similar rules apply to S corporations and decedent’s estate


Capital gain deferral – Section 1231New

Determination of tax treatment of Section 1231 gains/losses cannot be

determined until year-end

If the net Section 1231 amount is a gain – it will be treated as a capital

gain

If the net Section 1231 amount is a loss – it will be treated as ordinary

Section 1231 gain can only be invested in the 180 days beginning on the

last day of the taxable year of the sale



All of the realized gain does not need to be invested for the deferral

Can invest in more than one QOF

Ability for the investor sell complete QOF interest and invest in another

QOF

Capital gains must be invested in the equity of the QOF – includes

preferred stock and a partnership interest with special allocations

Can use equity for collateral

Mixed funds permitted, but only capital gain portion reaps the tax

benefits

15

Qualified Opportunity Fund



QOFs are self-certified and can be created by the taxpayer or you can

invest in an established QOF – all investment must be through QOFs

A QOF must be an “investment vehicle”

Taxpayers will file Form 8996 to self-certify

NEW: Form 8996 will be revised for 2019

If a QOF is organized in a US possession or territory, it must be organized

for the purpose of investing in Opportunity Zone property where it is

organized


Asset test

At least 90% of the assets must be invested in Opportunity Zone property

NEW: Newly contributed investments made in the preceding six months

are not included as part of the asset testing as long as the new assets

are being held in cash, cash equivalents or debt instruments with a term

of 18 months or less

The 90% test is the average of the QOZ property (average at six months

and year-end)

The first test date will be the end of the first six months in the tax year

that it is a QOF and the second test date will be the last day of the tax

year

• If the QOZ start date is May then the first testing date is November 30 and the next is

December 31

• If the QOZ start date is August (July through December), then the only testing date is

December 31


Form 8996 – Qualified Opportunity Fund


Valuation of assets

If the QOZ has applicable financial statements (typically audited

financial statements), use the value of assets reported on those

statements for the asset testing

If there are no applicable financial statements, use the basis of assets on

the date of acquisition for the asset testing

Special rules permit the use of the most favorable method for businesses

that are owned by multiple QOFs


Asset test reporting

The calculation of the 90% test will be made annually on Form 8996

Failing to meet the 90% will not result in termination

Penalty is equal to the shortfall multiplied by the underpayment rate

established under §6621(a)(2)

Can avoid the penalty if failure due to reasonable cause


Stock or partnership interest

QOFs can acquire two types of Opportunity Zone property:

• Tangible property such as building and equipment

• Opportunity Zone stock or partnership interests in domestic operating business

LLCs will qualify (must choose to be treated as a corporation or

partnership), but not disregarded SMLLCs

Pre-existing entities can be utilized if they otherwise meet the other

requirements (including the requirement that substantially all tangible

property was acquired after 2017)

QOF cannot invest in another QOF (no tiers)


Stock or partnership interest

Qualified Opportunity

Zone stock

Qualified Opportunity Zone

partnership interest

Domestic corporation acquired

after 12/31/17 as original issue

During substantially all of the

holding period, the corporation is

a qualified Opportunity Zone

business

Capital or profits interest in a

domestic partnership acquired

after 12/31/17

During substantially all of the

holding period, the partnership

is a qualified Opportunity Zone

business.


Opportunity Zone business property

Tangible property acquired by the QOF after 12/31/17

Acquired from unrelated party (20% common ownership)

Original use of the property commences with the business or the

business substantially improves the property

NEW: Substantially all (70%) of the tangible property use was in the

qualified Opportunity Zone during substantially all (90%) of the QOF’s

holding period


Original useNew

Original use of an asset starts on the date when the property is first

placed in service in the QOZ for purposes of depreciation or amortization

Used property is original use if it has not been previously used or placed

in service by any taxpayer in the QOZ

A building or structure that was vacant for at least five years prior to

being purchased by the QOF or QOZB will satisfy the original use

requirement

Leasehold improvements made by a lessee are treated as original use

property


Substantial improvement

QOF has a 30-month window (“any”) to improve the acquired Opportunity

Zone property – not original use

Basis of the property increases by an amount that exceeds the amount of the

adjusted basis with respect to the property at the beginning of the 30-month

period

NEW: The substantial improvement requirement is made on an asset-by-asset

basis

Rev. Rul. 2018-29 stated that land can never have original use; however, land

will not be required to be substantially improved if it is used in an active trade

or business

NEW: General anti-abuse provision can be used to prevent “land banking”

Invest $2M in existing building and land ($1M relates to the land) – to meet the

substantial improvement requirement would need to invest an additional $1 M

plus $1 (not the $2M)


Opportunity Zone business

For a subsidiary to qualify it must be a trade or business for which substantially

all (70%) of its tangible property (owned or leased) is qualified Opportunity Zone

business property

At least 50% of the business’s total gross income must be derived from the active

conduct of the business in the Opportunity Zone

NEW: A substantial portion (40%) of the business’s intangible property is used in

the active conduct of the business

Non-qualified financial property (NQFP) must be less than 5% of the average of

the aggregate unadjusted basis of the business’s property (e.g., cash, debt,

stock, options, warrants, partnership interests, futures contracts, etc.) – see

working capital safe harbor

“Sin” businesses are prohibited – sun tan parlors, horse tracks and casinos, golf

courses, country clubs, massage parlors, hot tub facilities, liquor stores (defined

as stores with the principal purpose of selling alcoholic beverages for

consumption off the premises)


Opportunity Zone business – trade or business

New

Trade or business for purposes of the QOZ rules is a trade or business

within the meaning of section 162

Ownership and operation of real property, including leasing, is

considered the active conduct of a trade or business

Entering into a triple net lease is not enough


Opportunity Zone business – 50% gross income test

New

Proposed regulations have provided three safe harbors:

• At least 50 percent of the services performed for the business, measured by

hours, is performed within the QOZ

• At least 50 percent of the services performed for the business, measured by

amounts paid for such services, is performed by employees and independent

contractors in the QOZ

• Both the tangible property of the business that is in a QOZ and the

management or operational functions performed for the business in the QOZ

are necessary to generate 50 percent of the gross income of the trade or

business

If the QOZB does not meet any of the safe harbors they may still meet

the test relying on facts and circumstances


Working capital safe harbor – subsidiary

The proposed regulations exclude from the NQFP limitation a

“reasonable” amount of working capital held in cash, cash equivalents,

or debt instruments of 18 months or less

Working capital will be considered reasonable if:

• Amounts are designated in writing for the acquisition, construction, or

substantial improvement of tangible property in the Opportunity Zone

• There is a written schedule consistent with the ordinary start-up of a trade or

business for the expenditure of the working capital assets – cash flow schedule

• Working capital must be spent within 31 months of receipt by the business

NEW: Expanded to include expenditures used in the development of a

trade or business in the QOZ

NEW: Working capital safe harbor not violated if delay is due to

government action (e.g., permits or other government approval)


Leased tangible property

New

Leased property may be treated as QOZB property

Leased property must be acquired under a lease entered into after

December 31, 2017

Substantially all of the use of the leased property must be in a QOZ

during substantially all of the period for which the QOZB leases the

property

No original use requirement


Leased tangible property

New

No related party disallowance rule if lease meets the following

requirements:

• Lease must be at FMV

• Lease cannot allow prepayments relating to a period of use exceeding 12

months

• By the last day of the lease or 30 months (whichever comes first), the lessee

must become the owner of the QOZB property whose value is at least equal to

the value of the lease and there must be a substantial overlap of time using

both the leased and acquired property

• There is a general anti-abuse rule to prevent the use of leases to circumvent

the substantial improvement requirement


Leased tangible property – valuation

New

Leased properties have two methods of valuing leases:

Financial statement - Amount of an applicable GAAP financial statement – if

leases are assigned a value

Alternative method – sum of the present value of all of the lease payments,

calculated at the time the lease is entered into

Once a method is selected, it must be applied consistently to all leased tangible

property for the taxable year


Opportunity Zone businesses – examples that qualify

Retail stores

Grocery stores

Research facilities

Hotels

Restaurants

Office buildings

Manufacturing

Mixed use developments


2019 proposed regulations – additional guidance

New

If QOZ sells an asset before 10 years, there is a 12 month safe harbor to reinvest

the cash – the regulations do not include a provision that would allow a QOF to

sell assets without recognizing gain, so the sale is a taxable event

QOFs organized as partnerships and S corporations may sell their assets and,

assuming that the investor has held the investment in the QOF for more than 10

years, the investor will pay no tax on the gain – does not apply to C corporations

Transfer of QOZ interest by gift ends the tax benefits, but transfer at death or to

a grantor trust does not

Carried interest does not receive the special tax treatment

Debt financed distributions are not taxable unless they exceed the partner’s

basis in the partnership interest

Substantial improvement is determined asset-by-asset, not in the aggregate


2019 proposed regulations – additional guidance

New

Secondary purchase of a QOF interest is permitted

Tiered partnerships are not permitted – taxpayer must invest capital

gain into a QOF

QOF stock is not stock for purposes of determining corporate affiliation

QOF C corporation can be a common parent of a consolidated group, but

not a subsidiary member of a consolidated group

Proposed regulations adopted a broad anti-abuse provision


Previously owned property

New

Property must be acquired after 1/1/18. The related party rules prohibit

owning more than a 20% common interest Here are some potential

workarounds:

Sell the property to a QOF as an asset, but taxpayer and affiliates may not

own more than 20% of the profits and capital accounts of that fund

Lease the property to a new QOF, if lease after 1/1/18. The new guidance

permits a related party lease as long as certain requirements are met (e.g.,

lease at FMV, no disguised sale, prepayments of 12 months or less). The lease

must be a true lease under Federal law. You may be the majority owner,

since it is not deemed to be a pre-existing party.

Contribute the asset to the QOF – not considered a sale so no 20% related party

issue. Amount of your carryover tax basis in the property is deemed to be

your investment in the QOF. The value of this asset will not get the tax

incentives. But, it will not taint the QOF for others.

37

Tax benefits


Tax benefits

Tax

deferralTax deferral on capital gain invested in QOF to the earlier of an inclusion

event or 12/31/26

10% tax

reductionHold the fund for 5+ years

15% tax

reductionHold the fund for 7+ years

Tax

exemption

Hold the fund for 10+ years and appreciation of QOF investment (not the

original gain, but post-acquisition gain) is exempt from taxes (sell by

12/31/47)

Tax basis in

investmentTax basis in investment is $0


Example

On August 15, 2018, taxpayer sells stock with a basis of $1,000,000 to an unrelated third party for $2,000,000 resulting in a capital gain of $1,000,000.

Instead of paying the $238,000 (23.8% tax rate) in federal capital gains tax, the taxpayer invests $1,000,000 in an QOF

Taxpayer sells his investment in the QOF after August 15, 2028 for $2,000,000

Taxpayer defers paying tax until 2026

Tax due is $202,300 (tax basis of $150,000 (15%)) – held more than 7 years

No additional tax due on the $1,000,000 in capital gains on the O-Zone investment –held more than 10 years

Cir

cum

stances

Resu

lts


Tax considerations

If the taxpayer dies, the capital gain is still recognized on the original

investment – no step up at death

Capital gains rate when recognized – not when deferred

Combine with other Federal tax credits – low income housing, new

markets, historic tax credits

Combine with other State credit and incentive programs


QOF investment - FMV decreases

If the value of the investment decreases, then the taxpayer is taxed at

the lower value (excess of FMV in the QOF over the taxpayer’s basis in

the QOF interest)

Example: Taxpayer has a gain of $2M in 2018 and invests in a QOF. In

December of 2026, an appraiser values the investment in the QOF at

$1M. In the 2026 return, taxpayer will recognize a capital gain of

$700,000 (15% step up of original gain). With the tax rate of 23.8%, the

lower value will result in a tax of $166,600.


Other matters

State tax conformity

Structuring issues – direct or indirect

Exit strategies – one fund per property?

NEW: Treasury and IRS announced that it will provide additional

guidance on what happens if a QOF fails to meet the required 90 percent

investment standard and information reporting requirements

NEW: Revised Form 8996 will be issued for tax year 2019


Outstanding questions

The following are some of the outstanding questions or areas needing

clarification:

Identification of conduct that may lead to decertification of a QOF

Information reporting requirements

Whether the final regulations should contain exceptions to the general 180 day

rule

Whether aggregate testing will be permitted

44

Real estate industry


Real estate update

How has the opportunity zone program impacted the real estate market?

What due diligence should taxpayers perform before making an

investment in a QOF?

What are the differences between an investment in a QOF and a like

kind exchange?


Opportunity Zone vs like kind exchange

Opportunity Zone Like kind exchange

Capital gain from any investment

Property must be in Opportunity Zone

Only invest the capital gain (all or part)

No tracing and no intermediary required

Existing property – substantial

improvement required

180 days to invest in a QOF

Allows deferral only to sale or 10 years

(max of 2047)

Up to 15% basis step up on original

investment

Exclusion of appreciation of gain while in

fund

Original gain cannot be excluded via a

step-up in basis upon taxpayer’s death

Real property only

Geographically flexible within the US

Must invest all proceeds

Requires tracing of funds and qualified

intermediary

No substantial improvement required

45 days to identify replacement property

Deferral as long as a like kind exchange

No basis step up

No exclusion on appreciation

Original gain can be excluded upon death

of taxpayer

Can defer gain on sale to a related party

47

Family office and high net worth individuals


Family offices and high net worth individuals update

What investments are you seeing in the family office market/high net

worth individuals?

Does the opportunity zone program provide impact investing

opportunities?

What are the estate and gift tax planning issues that should be

considered?

What should family offices and high net worth individuals consider

before investing in a QOF?

49

Questions?

50

Thank you!

51

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a primer on opportunity zone investing

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