On-Demand: QOZs in 2021 | What’s on the Horizon?
Our panelists discussed the 2021 outlook for investors in Qualified Opportunity Zones.
Lisa Knee: Good afternoon, everyone. My name is Lisa Knee and I'm the co-chair of EisnerAmper's Real Estate Services Group. We are happy to welcome you to this special and timely update focusing specifically on Qualified Opportunity Zones in 2021: What's on the Horizon. This will be an important year for investors in qualified opportunity zones as many filing and compliance deadlines were extended to take into account the personal and business dislocations caused by the pandemic. Under the Tax Cuts and Jobs Act of 2017, the QOZ program was created as a tax incentive to spur investment in designated low-income communities using the vehicle of qualified opportunity funds.
Today, in connection with our friends at Duval & Stachenfeld, we will explore compliance for QOFs under the CARES Act in relief provisions, and very hot off the press recent updates, the state of the QOF market, and what the outlook is like for QOFs in 2021. So we're in for a real treat because if anyone knows the ins and outs of the QOF, it's the industry experts, Ken Weissenberg, my co-chair of the Real Estate Services Group at EisnerAmper, and Jessica Millett from Duval & Stachenfeld. With that, let me welcome Ken Weissenberg and Jessica Millett. Ken, Jessica, thank you so much for being here today.
Jessica Millett:Happy to be here.
Kenneth Weissenberg:Thank you Lisa, and thank you Lexi. The opportunity zone program was part of the Tax Jobs Act of 2017 and it was basically a bipartisan provision that was added in reconciliation. The provision basically provides that if you have a capital gain that you invest in a qualified opportunity fund, and the opportunity fund buys property or businesses within the opportunity zone, which is an economically distressed area around the country and including US possessions, one, the taxpayer who makes the investment, if they hold the investment originally for seven years of five years gets a reduction in capital gains, 15% for seven years, 20% for five years. And if they hold their investment for 10 years, the gain on the sale of that investment escapes tax completely. The tax that was originally deferred is payable in 2026.
There's been a lot of changes to how the law has been interpreted over the period of time. Starting in December of '17 with tax reform, they added two code sections, 1400Z-1 and 1400Z-2. The first set of proposed regulations came out in October of 2018. Prior to those regulations, a lot of questions asked would be workable and administered. They issued the second set of proposed regulations in April of 2019 which changed a lot of the rules. And finally, they issued a final set of regulations in December of 2019 which further changed the rules. In April of 2020, there were some correcting amendments. And then we had the pandemic and the economic dislocation associated with the pandemic. So June of 2020, they gave certain relief to provisions within these rules they came out with effective because of the pandemic that were effective originally until December 31st. And now, they're effective potentially either March 31st, June 30th, or December 31st, depending on which rules they are. So I will go through that in today's presentation.
And now we also have a new change of administration, a change of the Senate. And so we have a lot of questions. What's going to happen under the Biden administration and the new Congress? Will there be changes legislatively or regulation wise to these rules? Jessica will now continue.
Jessica Millett:Thanks, Ken. So as Ken mentioned, the guidance process for the opportunity zone program has gone through a number of changes. And even when we thought we were done, and we have final regulations back in December of 2019, it turns out they weren't entirely final. Everybody makes mistakes. So Treasury then came out with some correcting amendments to those final regulations in April of last year.
Some of the corrections were very ministerial and they were fixing cross-references and typos. Some were a little bit more substantive. They were open questions regarding whether a taxpayer could rely on the proposed regulations for a period of time before the final regulations became effective. There were questions about valuation issues and some other substantive and meaningful points.
The two big corrections that were in many people's minds not entirely just corrections were really some additional guidance on circular cash flow transactions, as well as some changes to the treatment of working capital, and in particular, the 70% tangible property requirement. So I'll go through the circular cash flow ones first.
Okay. When the opportunity zone program initially came out, we got a lot of questions as I'm sure Ken did as well about investors who already owned property in an opportunity zone. So existing owners of property in an opportunity zone, and the property needed to be developed. And so there were a lot of questions about how these existing property owners could take advantage of the program.
The main rule that most people were working around when it came to those existing owners was the related party requirement because the rule stated that in order to have a good opportunity zone project, the underlying property needed to be acquired by purchase from an unrelated party. And the threshold for a related party was fairly low. It was 20% overlapping ownership. Anything more than that would cause you to be a related party. So there were some people who structured transactions in such a way where the existing owner would sell the property to the QOF or more likely to the underlying QOZB, trigger a gain on the property, take that gain, and then reinvest it into a qualified opportunity fund for use in the project. And as long as that one investor did not exceed 20% ownership in the QOF/QOZB structure, then you had complied with the related party rule. So that was the main construct that a lot of people were working around.
When the final regulations came out, there was some language in the preamble that indicated that these circular cash flow transactions would potentially be problematic and could be recharacterized. But the example in the final regulations at that point in December of 2019, it had the same fact pattern where property was sold in and the individual reinvested in the qualified opportunity fund. But in that example in the final regulations, the investor had an intent to own more than 20% of the qualified opportunity fund. So after the reinvestment, the original owner would be a related party. And the example in the final regulation says, "No good, that's going to be problematic. The property is not good property because it was acquired from a related party and the individual does not have a qualifying investment."
Now, most people looked at that example and they said, "Okay, that's probably telling me something I already know because we've always had the 20% related party rule. However, in the correcting amendments in April, they revised the example and they said, "Well, if you have this circular cash flow with the property being sold to the QOZB and the cash being reinvested into the deal, then you have a circular cash flow problem and it doesn't matter if the investor ends up owning more than 20% of the QOF or not. You have the same recharacterization risk regardless of the percentage of ownership of the original order in the whole structure."
So it's taking that 20% related party requirement out of the picture. And under step transaction principles and a circular cash flow doctrine, because the cash is ending up going in a circle, you have a couple adverse consequences that results from that. The property instead of being treated as having been sold to the QOZB is treated as having been contributed by the individual to the QOF contributed from the QOF and to the QOZB. Now, this invalidates the investor's investment in the QOF because it was a contribution in a property and not a contribution of eligible gain. It also invalidates the qualified opportunity fund's equity in a QOZB because that equity in a QOZB was not acquired for cash, it was acquired at least partly in exchange for property. And lastly, it also invalidates the property in the hands of the QOZB because it has been partly contributed instead of fully acquired by purchase.
So at this point, I think most people are aware of the IRS's position on these transactions. But just make sure that if you are an existing property owner or if you're working with one, keep in mind you cannot have an existing property owner recycle cash from the sale of that property back into a qualified opportunity fund. That's something that the IRS has made clear is on their radar and they will attack it.
Ken is going to talk about working capital, right?
Kenneth Weissenberg:Yes. So under the working capital rules, these apply to qualified opportunity zone businesses, not to the funds themselves. So an opportunity zone fund does not have a working capital excuse. Basically, 90% of their assets have to be in qualified opportunity zone property, or in qualified opportunity zone businesses. The qualified opportunity zone business has different sets of rules. So only 70% of their assets have to be in tangible property located within the zone, or actually 70% of the tangible property. They can have intangible property and tangible property. The tangible property has to be 70% located within the zone. So there's a lot more flexibility in the opportunity zone business. They, clients, having their building project in the zone makes life easier because you know where the property is located. But very often, you're going to be doing a development activity on that building. So you'll start off. You'll buy piece of land, capital to redevelop it.
The working capital safe harbor basically says that if you have 70% of your tangible property for this purpose, basically, the test is deemed satisfied if you're in a working capital period. So the working capital period is a 31-month period began at the election of the taxpayer at any time. And for that 31-month period, they can use pursuant to a written plan that cash to develop the property. The cash has to be in cash, cash equivalents, or short-term debt. But it gives you the flexibility to hold the working capital to build your project or to start up a business. You can't have more than 5% of the QOZB's assets in property other than cash short-term. So stocks, bonds, that kind of thing, you can't go more than 5%.
So if a partner contributes raw land to a QOZB and the QOF contributes cash for development, the QOZB would fail the 70% test because the contributed property would not be considered to QOZB. And the working capital assets don't count for the 70% test. But if you're in a working capital period, we think that the correcting amendments say that you satisfy the working capital requirement even if the land doesn't qualify because it was contributed in. At the end of the day, the land has to be less than 30% of your finished project. But you look at the end of the day during that 31-month period or if there's additional contributions of cash, a 62-months period can be applied at the maximum. So if there's additional capital raised at the end of the 31 months to finish the project, you have an additional 31 months to spend that as part of your same working capital plan.
Sounds very simple, right? But the clarification that the cash and the property by the 70% test during the working capital period up there in this area.
Jessica Millett:One note that I will make about this working capital correction in the correcting amendments is that the language that actually came out in the regulations from Treasury is kind of been widely viewed as incredibly poorly drafted because the language that actually showed up in the regulations does not really say what the IRS has asserted that it says. So this is something that's part of, I think, a continuing dialogue between the IRS and some opposite of stakeholders because people have really been clamoring for guidance and clarification really on how the 70% test is supposed to work during the working capital safe harbor period. I have heard informally that Treasury may be thinking about making changes to the preamble to really evidence what they intended to get across with this correction, but that still remains to be seen.
Okay. So let's talk about COVID relief. Ken and I had put these slides together last week. And then just this week on Tuesday, we got some new guidance on the COVID relief. So it's kind of broken up into two spots in the deck, but we're going to try and tackle it all at once. So as Ken mentioned in the intro, back in June, we got our first round of COVID timing relief explicitly focused on opportunity zones. And the relief was really welcome. I mean, nobody really knew what was going to happen with COVID and the pandemic. Deals were slowing down and people were scared to invest. So there was a lot of back and forth trying to figure out how flexible the opportunity zone rules would be given that there were some real strict deadlines inherent in those rules, which we'll talk about, and it was going to be very difficult to meet those deadlines given what was happening.
So the first level of relief that they gave to taxpayers was really at the investor level. So investors typically have a 180-day period to invest their eligible gain into a qualified opportunity fund. For most individuals, it's the 180-day period beginning on the date of sale. For partners who are in a partnership and receive their eligible gain via a Schedule K-1, they have more time to invest. You have a little bit more flexibility, but it's still fashioned in this 180-day period framework. So what they said back in June is they said, "Well, if your 180-day period would end in between April 1st and December 31st or before December 31st, I guess, December 30th, then your 180-day period was extended until December 31st of 2020. And I think that was really welcome news for people because it gave them some breathing room. For anyone with K-1 gains that were going to expire either at the end of June or early September, they knew they had until the end of the year. And I actually had a number of clients who Mid-December clients who realized they only had a couple weeks and we set up qualified opportunity funds for them so they could invest by December 31st.
Then what happened just on Tuesday with respect to this investor level release is that the IRS pushed that December 31st, 2020 date to March 31st of this year. So anybody now with the 180-day period that otherwise would have ended on April 1st of last year and March 30th of this year has until March 31st to invest into a qualified opportunity fund. It's very welcome relief. It would have been a little bit more welcome, I think, about a month ago because I said I had clients in mid-December who thought they had to invest by December 31st and many of them did. So they sort of rushed and now it turns out maybe they didn't have to rush so much. So it's a really good-
Kenneth Weissenberg:The interesting thing is that this applies to 2019 gains.
Kenneth Weissenberg:They were basically incurred in the fourth quarter of 2019 or came from a K-1 for 2019. And the IRS didn't give any relief in terms of paying the tax on those gains if you didn't make the investment in a QOF prior to your filing of your tax return. And they wanted people to pay the tax associated with those gains and then file an amended return when they actually make the investment.
Jessica Millett:Right. Which is impractical, of course, because then you have to wait to get your refund from the IRS. But it is kind of crazy the timing because if you are a partner in a partnership and the partnership realized the gain back in January of 2019, two years ago, that investor receiving the gain on the K-1 now has until March 31st of this year to investigate. So it's like over two years that they have to investigate, which is quite a bit of flexibility. So this level of relief in particular, I think, is helpful for sort of two categories of investors. One is investors who just missed the boat on December 31st. Either they forgot or something didn't happen. But you now have another bite at the apple. So that's helpful. And it is also helpful for investors whose gain is expiring in January, February, or early March. You do have a little bit more time until the end of March to investigate.
But I do agree, Ken, with your point that even though you have this flexibility, if your 2019 tax return even on extension had to be filed by September or October of 2020, there was no real artful way to file that return and be in compliance, and then subsequent to that, make a qualified opportunity fund investment. So that was sort of a tricky thing, I think, for people to navigate.
Okay. The next level relief for qualified opportunity funds, the qualified opportunity funds each have a 90% test that they need to meet twice a year typically on June 30th and December 31st. And what they said back in June is that you have your two, sorry, let me back up. You have a 90% test that needs to be met. And if a QOF fails to meet that test, then there's a penalty imposed on the value of the QOF's asset that caused it to be out of compliance. And there is an exception to paying that penalty if the QOF's failure to meet the test is due to reasonable cost.
So what the notice said back in June is that if a QOF failed to meet the 90% test on either of its testing dates in 2020, that failure would automatically be deemed to be as a result of reasonable cause and no penalty would be imposed. Again, very helpful. If a QOF was sitting on a cash, they did not need to sort of rush and go find a QOZB to invest in or go and find property to acquire. They had the time to sit on the cash and wait for the pandemic and see how things would possibly shake out with their investments.
The guidance that we got just a couple of days ago extended that December 31st date until June 30th of 2021. So for a qualified opportunity fund with its testing date on June 30th, 2021, if they fail to meet the 90% test on that testing date that's due to reasonable cause. The interesting thing with the way the notice was drafted that people are still trying to figure out exactly what was intended is that under the terms of the notice, if a QOF has a testing date in the first half of the year, and the QOF fails its 90% test for that taxable year, then the failure for that entire taxable year is deemed to be due to reasonable cause. So it sort of implies that even though the date of relief ends on June 30th, there's a technical reading of that notice which implies that a QOF can get a pass on all of 2021.
Now, I'm not sure if that's entirely what was intended and people are still scratching their heads about this. We've had a little more than 48 hours to to be thinking about it. So stay tuned on that point. But in any event, it does give qualified opportunity funds some additional relief in terms of trying to figure out where they're going to invest their money, in which QOZB or which property.
Ken, I'm not sure if you've thought at all yet about that 2021 point and how-
Kenneth Weissenberg:I would want to meet the test on December 31st of '21 just to be on the safe side. And hopefully by December 31st, we'll have economy again and people can actually do business.
Jessica Millett:Yeah. Exactly, exactly. So there's one more QOF relief, which is the 12-month reinvestment period. So generally for a qualified opportunity fund that sells property or otherwise gets a return of capital and is sitting on cash at the QOF level. There was a concern, over a full 10-year period, a qualified opportunity fund may change investments, may do other things, and they didn't necessarily want to have that qualified opportunity fund fail its 90% test if it received cash from a prior investment and was looking for a new home and a new place to invest. So the original regulations gave qualified opportunity funds this 12-month reinvestment period to be able to sit on the cash without blowing their 90% test while they looked for another investment.
Now, the regulations had some provisions baked in that in the event of a federal disaster, a qualified opportunity fund could actually have an additional 12 months to reinvest that cash for a total of 24 months. So the notice back in June clarified that the emergency declaration that was made back in March of last year triggered those federal disaster provisions. So qualified opportunity funds that were sort of in the midst of a 12-month reinvestment period that included January 20th of 2020, then they could have an additional 12 months to reinvest the proceeds.
The notice that we just got a couple days ago pushed that January 20th, 2020 date to June 30th of 2020, which basically sort of gave qualified opportunity funds in the midst of their reinvestment periods a little bit more time. So if you received cash back in between January 21st and June 30th, now all of a sudden, you have that full 24 months to go and find a new home for it, which again, I think is helpful in the event that qualified opportunity funds were trying to had cash for whatever reason as a result of the pandemic, exiting investments or whatever they were doing. They now have more time to invest that cash without worrying about their 90% test.
Kenneth Weissenberg:Great. There was also relief granted to qualified opportunity zone businesses basically for substantial improvement. You have to double your basis in acquired improvements within a 31-month period. And under the original notice for the period beginning April 1st, 2020, and ending December 31st, 2020 is disregarded. They extended that substantial improvement period or the substantial included I believe it said December 31st of 2021. So this is further down on the slide. But they thought about that because you have to basically double the basis of assets. And if you can't do construction work, you can't double the basis of your asset. And a lot of the construction activity was curtailed during the pandemic and lockdowns and there's still disruption across the country. So they took that into account.
So also the working capital plan that was disrupted. And because of the disruption, you can't have a working capital plan if you can't actually expend the money because there's no activity going on. So they basically gave you a 24-month in the event of a federal disaster, which the entire country is now in a federal disaster to complete your 31-month period and totaling up 31 months. It's not you have to have another plan in place for those 24 months. You're given extra. You don't have to do it.
And that was a thing that started in 2020 after April 1st and before December 31st. They extended that I believe to June 30th, Jessica correct me if I'm wrong, for the extra 24 months. So if you had a working capital plan in the period April 1st, 2020 to June 30th, 2021, you have an extra 24 months tolled on that plan. That gives you 55 months for a straightforward single 31-month period and for a startup business, 86 months. The 62 months maximum plus the 24. And that was a clarification that you actually got the extra 24 months on a 62-month plan as well.
So it also said that the relief is automatic for the 24 months tolling which is a good thing. And here's the slides showing the current extensions both for the QOFs and for the 90% relief and the working capital safe harbor. Is June 30th, I did have it right.
Jessica Millett:Absolutely. One point I'll make about the working capital safe harbor and the tolling, it is a good idea generally given the fact that to the extent any of these projects are going to be audited, they're going to be audited probably years from now. And nobody's memory is going to be as good as we all hope it will be. So keep a robust file of everything that's going on with the project. Delays that your project is suffering, when lockdowns happened, when shutdowns happened, when your construction was not allowed to go forward, dates you submitted applications, when things were closed and delayed. Because there are ultimately going to be questions about that about the timing and the tolling and the delays. So just make sure that you keep a robust file on your project in case you ever have to answer questions about that.
Kenneth Weissenberg:Right. That includes delays in receiving materials which disrupted supply chain.
Jessica Millett:Right. Okay. So let's talk about the new administration. Biden, when he was campaigning back over the summer, it was back in August, his campaign posted on their website their plan with respect to opportunity zones. And at that point, the immediate reaction to Biden's plan on opportunity zones was widespread relief. There were concerns that if there was a democratic sweep, that there could be a number of changes in the tax laws generally and with opportunity zone specifically. And there were concerns about the program going away entirely, or what could possibly happen?
So when Biden released his plan, which we'll run through in a second, you'll see that it's focused on reforms and trying to make the program better as opposed to dismantling it entirely. So the opportunity zone community as a whole was quite happy, I think, when I saw this. And we really haven't gotten a whole lot more out of Biden's administration to date. I mean, he's only been in office for a couple days, and he has a few more pressing things to worry about. But we're still wondering exactly how these goals are going to be implemented because a lot of them are very aspirational and it's not entirely clear exactly how he's going to implement them, even with the very razor thin majority he has now in the Senate.
So the first goal was incentivizing qualified opportunity funds to partner with nonprofit and/or community oriented organizations. And while this is certainly sort of a laudable goal, it's not entirely clear, the verb here is incentivize. So what are you going to do to incentivize these qualified opportunity funds to partner with these local organizations? It's certainly something that I think most people agree is critical to the long-term success of the program to make sure that the communities that qualified opportunity funds are investing into are really part of the discussion about what happens in those zones and what kind of projects happen. But it remains to be seen exactly how this one is going to be implemented because even with the razor thin the majority in the Senate, I don't think many people are expecting sort of a widespread democratic overhaul of the opportunity zone program. As Ken mentioned, initially, it was a bipartisan program initially, and I think it continues to have bipartisan support. It has its critics as well, shall we say? But in any event, that's one that we're going to be watching closely to see exactly what Biden decides to try and accomplish there.
The second goal here is to direct Treasury to review the program to ensure that the tax benefits are only allowed where there's clear economic, social, and environmental benefits to the community. And again, this is along the same theme of making sure that the community in which the project is being developed is actually benefiting from the project. There were some congressional proposals over the past few years aimed at trying to put some guardrails on the types of projects that could be done in opportunity zones. The statute has that small sin business list, but the proposals that were floating around in Congress over the past few years had more limitations. For example, no luxury rentals for housing. No self-storage facilities because they were, you don't really need a lot of employees to operate a self-storage facility.
I do expect Treasury to take a look at this. Whatever happens in Congress, Biden's got a new treasury secretary. And I think many people are expecting changes to the self-certification form for qualified opportunity funds. Right now, it's on form 8996 and it's basically a check-the-box form. You say, "Yes, I want to be a qualified opportunity fund." And you have to report compliance with the 90% asset test. There's not really a whole lot else on there. And so I would expect Biden to try and implement this second goal by having Treasury and the IRS change that self-certification form. They're going to have to be careful to do it in a way that does not sort of challenge congressional intent from the Internal Revenue Code. But in terms of where I expect to see kind of Biden's first move, that's where it's going to be.
The last goal here is to introduce transparency and bring back the reporting requirements. And this is one that I do think Congress can get through once they deal with the global pandemic and an impeachment hearing that they have to tackle. But Senator Tim Scott introduced some legislation, I think it was last year to bring back the reporting requirements that were initially stripped out of the bill.
Jessica Millett:If Congress is going to do anything on opportunity zones, especially in the short-term, I would expect to see that on the reporting requirements because there's been chatter on both sides of the aisle that that's something that they view as necessary in order to keep the program going.
Kenneth Weissenberg:Right. The regulatory rounds were stripped out during conciliation of the original bill in 2017. And the IRS right now doesn't have statutory authority to require that reporting that you're talking about. So I think you need a legislative fix for that, but that shouldn't be too hard to accomplish.
Jessica Millett:Yeah, yeah. I think as opposed to some of the more controversial issues around the program, the reporting requirements, everyone seems to universally understand that those are critical to really understand, "Well, is the program actually working? Is it accomplishing what it's meant to accomplish?" So I'm hoping that we'll see that in the next year. Hopefully a year, maybe longer.
Kenneth Weissenberg:Right. So looking at what's going on in the marketplace for 2021, how's it been going so far? That there was definitely a disruption in 2020 in the amount of funds going into opportunity zone funds and the type of projects that were going on that deal with many clients who were forming funds, investing in properties, trying to make deals happen. 10% gain reduction if you only hold the investment for five years, and that ends at the end of 2021.
Now, Congress may because of what's gone on change that rule and make it a four-year hold or change the 2026 date to pay the tax. But so far, that would require a legislative change. They couldn't do that with administrative change. So because the 10% reduction is kind of attractive, you're looking at potentially a lot of investment happening in 2021 for opportunity zones. I'm speaking to a lot of people who are very interested in doing it. I don't know what you're hearing, Jessica, but I would think that you're probably hearing the same thing.
Jessica Millett:Yeah. I think 2020 has certainly had its ups and downs and obviously COVID kind of sort of amplified that. But I think that the combination of the extra relief that we just got out of Treasury in terms of the timing and the fact that that 10% expires at the end of this year, I do expect to see a lot of activity generally. I mean, in the real estate market overall, I think a lot of people are sitting on dry powder and just waiting to pull the trigger and find the deals. And I think that opportunity zones can kind of ride that wave and with additional funds being pumped in and hoping to get that benefit by the end of the year. So yeah, I certainly expect to see that.
Kenneth Weissenberg:Right. Now, the other concern is that capital gains taxes have been proposed to increase ordinary income rates as part of the reform of medical insurance and coverage. And if that happens, the 10% reduction certainly won't be enough. I know as part of the overall discussions within Congress, within people looking at this, they're talking about if they do have a capital gains rate increase so that the opportunity zone program isn't destroyed, they would grandfather the tax rates on opportunity zone deferred gains, which would be a good thing.
Certainly, if you have a short-term gain, you can't lose anything by putting it into an opportunity zone and getting the benefit of a 10% reduction and a five-year deferral. But for long-term capital gains, I would think that Congress would try to grandfather them if they want to preserve the program. I've heard that they're looking into that.
Jessica Millett:Yeah, I've absolutely heard the same thing. Whether or not they'll be able to get that across the line remains to be seen. But I think if you think about the fact that you have the deferral period until the end of 2026, if you combine the 10% complete elimination of the initially deferred gain plus time value of money until the end of 2026, most people now seem to be thinking that economically, it's still worth it even with the potential capital gains rate increase. But once you hit 2022, I'm not sure if people will have that same economic analysis. Obviously, the numbers change there.
Kenneth Weissenberg:Yeah. Also, you're also looking at the other great escape from taxes is a 1031 exchange. And that is also on the block potentially to be repealed, or at least for taxpayers with incomes over $400,000 a year or for transactions over 400,000 a year. Basically, unless you're selling a very small studio in and out of borough in Manhattan, you wouldn't be able to do a 1031 exchange. So that is something that probably people will say, "Okay, if I have to pay tax on a sale of real estate, maybe this program is something that I want to look into." So I think that's also going to increase the demand for opportunity zones if the repeal of 1031 happens. It's something that we're all keeping an eye on. I have a lot of clients that do 1031 exchanges, a lot of clients that have 1031 investment properties for taxpayers to buy into. So that's something that's really important out there.
So let's talk about what's going to happen in the legislature, what they could potentially do. You already mentioned the increased reporting of the economic impact. I think that's something that really will happen because of the feedback from the social communities. Social impact communities is very strongly saying, "You can't build a luxury hotel in an opportunity zone and think that that's a great project for the neighborhood." Even the people that live there aren't going to be the ones working at the hotel. So jobs are created and people will come in for the jobs and leave the area. And people who are in the area will be displaced. So that kind of economic impact or restriction of the type of projects is something that they're really going to have to look at pretty strongly.
A lot of the projects I've seen have been affordable housing not for the low income housing tax credit, but more for the workforce housing in areas that are being improved. The projects aren't going on where existing buildings are. Most of them are going on vacant land or abandoned buildings that are empty. So it's really adding vitality to neighborhoods. I don't know what you've seen in terms of those kind of projects.
Jessica Millett:Yeah. I mean, we've seen everything all over the map, but I think that the program is well-suited towards either mixed use projects that include multifamily, or as you've mentioned, a lot of workforce housing. And I think that inherently, I think that developers who are spearheading or sponsors who are spearheading opportunity zone projects, they could see the writing on the wall. And rather than risk potentially disqualifying the entire fund by doing a luxury hotel or something like that, I think most people tend to be choosing projects that are more within the spirit of the law. I mean, obviously, it's not universal, but in terms of multifamily office, retail, things that the community is actually going to need and use, those are the projects that I tend to see although I have seen a few outliers as well.
Kenneth Weissenberg:Yeah. I've seen a lot of different types of projects from logistics facilities and office. I had a client that wanted to start a trading business within the zone. Very little assets, but economic activity. So one of the things that they might be looking at also is to extend the program. I think it's a little early for extension myself because we want to see a larger amount of activity that's kind of been, I think originally, it was forestalled because the guidance was very few and far between and you really couldn't figure out what to do with the project and what's really new rules that worked? So that happened at the end of 2019. And then boom, the pandemic hit and derailed everything for 2020.
I don't think the program has reached near its full potential. But because of the delays, I think they should look at extending the final deadlines to do this. The final deadline, by the way, to invest in an opportunity zone program that gives you the benefit of the 10-year step up, eliminating your gain on the investment is December 31st, 2026. So even though you lose the five-year hold 10% reduction in gain, you can still make the investment through 2026 and get the benefit of the gain elimination. Yes, I make the investment in 2026. I still pay my tax in 2027 like I would if I didn't make the election. But 10 years later, I don't have to pay tax on my gain on the investment. So it's still at the program for that.
Jessica Millett:Yeah. An investor can invest into a qualified opportunity fund with any gain that is realized as late as December 31st, 2026. So that means that, for example, if a partnership sells an asset on December 31st, 2026, the partners can invest their K-1 gain as late as September of 2027 and actually still get the benefit. So that December 31st, 2026 deadline is a deadline for triggering the gain, but you may actually have well into 2027 to actually invest into the qualified opportunity fund.
Kenneth Weissenberg:Right. And I think the zones expire on the eight for some reason. I don't know why, that dichotomy. And I guess another thing they're going to be looking at is a lot of the zones they started with have gotten benefits of being opportunity zones. And they've basically been improved, gentrified to some degree, and they might not qualify today. And other areas that didn't qualify or weren't selected are really in need of investment, and they're starting to attract some attention, but they're not zones. So I think adding additional zones, eliminating some of the zones from the program but grandfathering the projects that were started, that's something I think the legislature is also looking at and talking about.
Jessica Millett:Yeah. I've heard a lot of chatter about once the results of the 2020 census are done, those census lines may move in terms some census tracts may be eliminated entirely. They haven't really come up with a clear plan on how they're going to tackle that or what they're going to do. I do agree with you that I would fully expect any projects that have begun to be grandfathered in, but it remains to be seen whether or not they're going to be able to, for example, if a census tract goes away, will a governor be able to replace that with a new opportunity zone? And what does that process look like? So I think that's something that we're all going to be watching over the next year or so once we figure out how the lines move. But there's been certainly a lot of requests to expand the zones, open up for new zones.
And given that the selection of the zones was baked into the code, it was in 1400Z-1 which nobody bothers to look at anymore, will Treasury have some authority to do that on their own? Or are they going to have to go back to Congress and ask? So those are all open questions.
Kenneth Weissenberg:Right. And they left it basically to the states to pick their own zones. And it's interesting. Some states probably needed less economic development than others, but they all got zones to pick. So we'll see how that all works out with the current and the next Congress in two years.
Kenneth Weissenberg:Right. We have a couple of questions. I just want to hit one of them. There has been no, as far as I see, proposals to limit capital losses that can offset opportunity zone gains when they're triggered in 2027 or earlier if you dispose of your interest. Basically, it's a deferral of the gain recognition. Kind of like if you have an installment sale, you'll pick up the installment gain when you get the cash. Same with the opportunity zones. You're picking up the deferred gain at the end of 2026 unless you dispose of the project earlier or have a triggering event. I don't think they would limit capital losses that could be used to offset it. I don't think that makes sense. But they should consider grandfathering, as I said earlier, the tax rates associated with that.
Zachary asked us a lot of questions. We just covered the census tracts. Covered that one. Here's one, if you buy a business in a qualified opportunity zone, so you're buying the assets of a business, and one of those assets is real estate. And let's say 90% of the price is allocable to the real estate in the qualified opportunity zone business. You do have to substantially improve that real estate in order to be qualified opportunity zone property. So you can't just say, "Okay, yes, the building is just" Unless the building was just finished and now placed in service by the person who built it in which case it's brand new property, which is good. Or if the building was vacant for three years prior to your acquisition, or one year from the date that it was declared his own, it'd be declared as an opportunity zone. That is treated as a new asset. But otherwise, you would have to substantially approve real estate or other assets associated with the business.
I think I covered the rest of the questions earlier.
Jessica Millett:Yeah. There was one question I think about for partners who receive a K-1, about what date they use to invest. I'm not sure if that was in relation to the relief or not. But generally, if a partner receives K-1 gain, they actually have three different choices about when their 180-day investment period begins. If it's a small partnership, if they happen to know when the actual capital event occurred, a partner can use the same 180-day period as a partnership, which is the 180-day period beginning on the date of the sale or exchange. Or alternatively, the partner can use the 180-day period beginning on December 31st, the last day of the taxable year in which the gain was triggered. Or lastly, the partner can use the 180-day period beginning on the due date for the partnership's tax return, typically March 15th. So that pushes the end of your 180-day period all the way out until early, mid-September. I think it's usually September 10th or thereabouts. So you have a number of options as a K-1 partner about when to invest.
Kenneth Weissenberg:Right. And that's without the extensions that they did for COVID relief.
Jessica Millett:Correct. Yes, yeah. So COVID, you'll get more time.
Kenneth Weissenberg:And there's also a question that with a 10-year forgiveness of gain, you still pay your tax in 2027 on the original gain less whatever reduction you have if you've invested for five or seven years. So if you put a million dollars of gain in in 2021, 900,000 would be subject to tax at the end of 2026, paying the tax in 2027. And if you have a loss on the investment, your tax goes down. So if I put a million dollars in, and it's only worth $700,000 at the end of 2027, I pay tax on 700,000 less if I had a step up of $100,000, because I've held it for five years. I only pay tax on 600,000. So they have given you a break if the investment loses money. You don't have to realize the loss. You can still hold it in 2027, and in 2028 or '30, it's worth 1.2 million, you don't pay tax on the 1.2 million gain or the 200,000 gain. And the forgiveness of the gain applies to everything but inventory.
So there's no such thing as depreciation recapture that you pay tax on even if you took accelerated depreciation. The only thing you're paying tax on is inventory held for sale.
A lot of questions coming through.
Jessica Millett:Yeah. We got a question about whether “Do you think there's any chance the IRS will extend the deadlines again at some point this spring?” I would be surprised if the IRS allowed you to continually kick the can down the road on some of these deadlines, especially with the new administration, but that remains to be seen. The one thing that I think we might see is that there have been a lot of requests into Treasury for guidance and relief on different topics. They hit the same five this week that they hit back in June, but there are other COVID-related issues that crop up as a result of potential delays.
Two in particular, a qualified opportunity zone business has a 50% gross income requirement. And one of the ways to meet that gross income requirement is by virtue of a safe harbor that if your employees are working in the zone, then the gross income that's generated from the business is deemed to be gross income. Well, what if your employees are all remote? Right? What if your office is in the zone and they're supposed to be there, but they're all remote either because of lockdowns or maybe by choice because out of fears of COVID? There's been no relief whatsoever from the IRS or Treasury on that point, which I think is a real critical one for some operating businesses.
The other one that I would really love to see something in writing on from the IRS is the working capital safe harbor plan. You have to come up with a plan. "So this is what we're going to do. And this is how we're going to do it. And this is how we're going to spend the money." And then you actually have to execute that plan substantially in compliance with the way you said you would. But why did you have to change your plan? Logic tells you that if you have to change it for a good commercial reason because maybe a luxury hotel in downtown Manhattan maybe, well shouldn't be luxury anyway. But a hotel in downtown Manhattan perhaps is not really the best use of your money now because nobody is staying at a hotel in downtown Manhattan. You should be allowed to change your plan, I would think, but technically, the regulations don't allow you to do that. So there's other pieces of guidance that I would really like to see out of the IRS and Treasury when it comes to the COVID release.
Kenneth Weissenberg:Right. We also have a question on working capital. Yes, cash is not considered an asset for purposes of the 70% test even if it's part of a working capital plan. It's just basically disregarded. But for purposes of the working capital plan, you're deemed to satisfy the 70% test if you're in a working capital period. That's my interpretation of the regulations, though it's far from 100% clear. I think that's the interpretation that makes the most sense. So if I have a piece of land that was pre-2018 acquisition or a contributed piece of land in my fund, in my opportunity zone business, and I have cash raised, and I'm going to build a brand new building, which will cost 90% of the overall project, and the land is only 10%. At the end of the day, the land will be a bad asset, and part of my 30% bad asset. But during the construction period, I'm deemed to satisfy the 70% test and I don't have to worry that the land is 90% of my assets day one of I'm in the working capital period. So I think that they've made that a workable rule through the interpretations and the amended final regs.
Well, we're exactly out of our time. We'd like to thank everybody for participating. And if you have additional questions, feel free to email. And it was a pleasure speaking to you all.
Transcribed by Rev.com
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