The Treasury Department recently issued final regulations regarding investments in so-called opportunity zones.
The Qualified Opportunity Zone program, which offers tax incentives for investing in economically blighted communities, was created under the 2017 Tax Cuts and Jobs Act.
Investment vehicles known as Opportunity Zone Funds allow investors to defer capital gains for up to 10 years, and possibly receive greater tax advantages, when they reinvest capital gains (from any investment, such as stocks, real estate or business interests) into census tracts designated opportunity zones. (There are 8,700 opportunity zones under the law.)
As of this year, opportunity-zone investments are no longer eligible for a 15 percent cost basis step-up, because the holding period will no longer be greater than seven years. (A requirement of opportunity zones is that the deferral gain be realized before the opportunity zone investment is sold or exchanged, or by Dec. 31, 2026, which is now less than seven years away.)
While the change might cool interest in the investments somewhat, the new regulations are positive for investors.
Opportunity Zone Funds have raised close to $4.5 billion to date, mostly in residential real estate, with a focus on large multifamily projects.
If you’re considered investing in opportunity zones, consult with an estate planning lawyer.
Some key points from the final rules:
Investment of Section 1231 gains allowed. As defined by the Internal Revenue Service, Section 1231 property is real or depreciable business property that has been held for more than a year. A gain from the sale of such a property is taxed at the lower capital gains tax rate, instead of the rate for ordinary income.
The final rules allow for investment of gross gains on the sale of Section 1231 property, even for investors who have net losses. That means that an investor can invest the entire amount of capital gains, not just amounts that are greater than the losses.
Under the law, investors have 180 days to invest in an Opportunity Zone Fund in order to defer their capital gains. According to the final regulations, if you are making a deferral election for a Section 1231 gain, the 180-day period begins on the date of the sale or exchange that gives rise to the gain.
Reduced length of vacancy period to allow for opportunity zone property. Proposed rules had required a five-year vacancy period for a property to qualify. Under the final regulations, the vacancy requirement is reduced to one year in some cases, and three years in others.
Option to sell single properties. A key change under the final regulations is that Qualified Opportunity Zone Funds can sell individual properties without having to sell the entire fund.
In certain cases, the final regulations allow a group of two or more buildings on the same parcel of land to be treated as a single property. In such cases, additions to the basis of the buildings are aggregated to determine whether the substantial improvement requirement is met. Therefore, a taxpayer is not required to increase the basis of each building by 100 percent as long as the total additions to the basis for the entire group of buildings equals 100 percent of the initial basis for the group of buildings.
The final regulations also make clear that, for the purposes of the substantial improvement test, the construction of a new building can contribute to the improvement of an opportunity zone property where an existing building is already present.
Foreign individuals and corporations can invest. Under the final rules, it is clear that nonresident foreign corporations and individuals are eligible to make opportunity zone investments with capital gains that are connected to a U.S. trade or business. That includes capital gains on real estate assets taxed to them under the Foreign Investment in Real Property Tax Act rules.
Working capital safe harbor created. When the proposed regulations were released, developers argued that they did not have enough time to complete a project. The final regulations extend the deadline from 31 months to 62 months.
Brownfield site development more attractive. The final rules allow developers to treat a brownfield site (meaning an industrial site that was once developed but is not currently in use) as meeting the original use requirement of the opportunity zone rules. This makes it more attractive to invest in developing a brownfield site. The rules also say that the land is considered significantly improved under the rules if contaminated land is remediated.
Investments in “sin businesses” limited. The rules state that qualified opportunity zone businesses can invest a maximum of 5 percent in “sin businesses,” defined as private or commercial golf courses, country clubs, massage parlors, hot tub facilities, suntan facilities, racetracks or other facilities used for gambling, and liquor stores.
Generally speaking, the rules are beneficial for investors, but the rules could change again, and new reporting rules might be on the way.
