Proposed regulations for the brand-new Opportunity Zone (OZ) program appear to offer good news for affordable housing developers.
The Oct. 19 Internal Revenue Service guidance is still being scrutinized, but everything indicates that OZs and low-income housing tax credits (LIHTCs) will work well together, says Forrest Milder, a partner at the Nixon Peabody law firm and expert in tax-advantage investments.
“They both contemplate the need for a ‘developer’ and ‘funds,’ and the OZ rules may facilitate a money source that is cheaper than debt, which can only be a good thing with projects that generally need all the resources they can get,” Milder says.
Created by the 2017 Tax Cuts and Jobs Act, the OZ program was initially overlooked among the many other big provisions in the tax reform legislation.
“OZ legislation was a bit of an iceberg,” says Joseph B. Darby III, a partner at the Sullivan & Worcester law firm. “Nobody really knew how huge and massive it was when it was first adopted.”
About 10% of the program could initially be seen with the rest hidden under water, he says. However, people have begun to realize how big the program may be, according to Darby, noting that Treasury leaders have estimated that $100 billion in capital investments could be made in distressed communities through tax benefits under the OZ program.
Under a nomination process completed earlier this year, 8,761 communities in all 50 states, the District of Columbia, and five U.S. territories were designated as qualified OZs. The OZs retain their designation for 10 years. Investors may defer tax on almost any capital gain up to Dec. 31, 2026, by making an appropriate investment in a zone, making an election after Dec. 21, 2017, and meeting other requirements.
Many people, including affordable housing developers and investors, have been keeping a close eye on the emerging program. They recognized that it was very exciting, but it was hard to decipher the complexities of the program by looking at the law that was passed, Darby says.
“After we read the law, there were a ton of questions,” he says. “These (proposed) regulations provide about a half a ton of answers. They answer a lot of important questions, but there’s more we need to know.”
Still, the initial guidance should be enough to begin getting some money off the sidelines, according to Darby. There’s probably enough information to structure a significant portion of some deals, he says.
However, the largest amounts of money will probably remain parked until further elaboration and certainty is received from Treasury on key issues, according to Darby.
The Local Initiatives Support Corp., National Equity Fund (NEF), and New Markets Support Corp. are working together to create funds that invest in projects in OZs that will create a social impact in neighborhoods and communities, says Karen Przypyszny, managing director, special initiatives, at NEF.
“The draft regulations from Treasury, based on our initial review, provide much-needed guidance on key provisions, which we think may help spur investors to start financing OZ investments,” she says.
Key issues addressed
There’s new clarity on who can invest, what “gain” qualifies, and other important issues as the highly anticipated program moves forward.
The proposed regulations clarify that almost all capital gains qualify for deferral. In the case of a capital gain experienced by a partnership, the rules allow either a partnership or its partners to elect deferral. Similar rules apply to other pass-through entities, such as S corporations and their shareholders, and estates and trusts and their beneficiaries, says the IRS.
Generally, to qualify for deferral, the amount of a capital gain to be deferred must be invested in a Qualified Opportunity Fund (QOF), which must be an entity treated as a partnership or corporation for federal tax purposes and organized in any of the 50 states, Washington, D.C., or the five U.S. territories for the purpose of investing in a qualified OZ property.
The QOF must hold at least 90% of its assets in qualified OZ property (investment standard). Investors who hold their QOF investment for at least 10 years may qualify to increase their basis to the fair market value of the investment on the date it is sold, according to the IRS.
There’s also clarification on the “substantially all” test for a qualified OZ business. The guidance indicates “substantially all” means 70% of a partnership or corporation’s tangible property owned or leased must be qualified opportunity zone business property. If the tangible property is a building, the proposed regulations provide that “substantial improvement” is measured based only on the basis of the building (not of the underlying land).
Darby and others say 70% is good news. Many feared the mark would be set higher. However, more clarification is needed on how to calculate the percentage.
What the proposals mean for affordable housing
The proposed rules offered several notable clarifications for the affordable housing industry.
“From an affordable housing perspective, the new guidance provides that land is not included in the amount of expenditures required for projects involving used property,” Milder says. “This will be important for resyndications, especially in areas where land is an expensive component of a project’s cost, making it easier to do those transactions (and other projects involving used property).”
Still, even as revised, the OZ rule continues to be much tougher than the Sec. 42 housing credit rule (which would otherwise require a far smaller expenditure of just 20% of the taxpayer’s basis in the building, or $6,000 per unit), he says.
The guidance also adopts two proposals that were made in a letter on behalf of the American Bar Association’s Forum on Affordable Housing and Community Development Law, says Milder.
“First, partnerships with capital gains can either invest in OZ transactions as partnerships, or their partners can be the investors themselves,” he says. “A nice plus — if the partner does the investing, he/she/it can have until 180 days after the partnership’s year ends to make the investment, potentially providing a lot more time than people had been expecting.”
Second, the IRS provided that projects (whether new construction or rehabilitation of a used building) should have slightly more than 30 months in which to develop a project, provide they have a written plan for the development to which they "substantially comply." This can be important to LIHTC projects that often have long-time horizons, and now hopefully they won’t have to worry about the IRS having insufficient patience, Milder says.
“The regulations mesh reasonably well with similar Sec. 42 provisions, meaning that we may see Sec. 42 projects taking advantage of the new incentive,” he says, noting that the 10-year period to not pay tax on OZ investments and the 10- and 15-year periods associated with the LIHTC align better than almost any other investment.
In answering a big question, the proposed regulations clarify that taxpayers eligible to elect deferral under the code are those that recognize capital gain for federal income tax purposes, including individuals, C corporations including real estate investment trusts, partnerships, and certain other pass-through entities, says Darby.
In addition to the proposals regulations, the IRS also issued Revenue Ruling 2018-29, which provides guidance for taxpayers on the “original use” requirement for building or land purchased after 2017 in qualified OZs.
This helps clarify issues around a situation where a Qualified Opportunity Fund (QOF) purchases an existing building, says Beth Mullen, partner and affordable housing group leader at the CohnReznick accounting firm.
The ruling finds that the original use of the building is not considered to have commenced with the QOF, and the original use requirement is not applicable to land so it also excludes the tax basis of the land in determine whether there has been “substantial improvement” in the real estate.
The ruling even includes an example of a factory building being converted to rental housing, suggesting that this is an eligible business for a QOF.
Mullen also points out that the guidance clarifies that it’s capital gains that are eligible for OZ investment and deferral benefits. This can be useful for an affordable housing developer if he or she has capital gains it wants to reinvest in properties.
However, it may be challenging to find investors from the usual LIHTC investment pool, noting that many financial institutions such as banks do not have capital gains, according to Mullen. “We may be looking at a different pool of investors,” she says.
Potential OZ investors may include insurance and other life companies, according to Mullen.
“There has been no bigger topic within the affordable housing industry since the program was included in last fall’s Tax Cut and Jobs Act,” adds Bob Moss, principal and national director of governmental affairs at CohnReznick. “The developing ‘OZ community’ should be pleased that the guidance has finally been released. The 60-day timeline has now started for written comments and outlines of topics to be discuss at the public hearing scheduled for Jan. 10, at which time a clearer picture will emerge on how the proposed regulations can be utilized.”
