With the recently released regulations governing Opportunity Zones by the IRS, Globest.com turned to Joshua Kaplan, corporate & tax partner at the Miami-based law firm Bilzin Sumberg for some guidance on Opportunity Zones and whether this federal program can make a real difference in the economy of South Florida.
Specifically, Kaplan discusses the new IRS regulations, what type of investments will now be incentivized by the program and the impact the Opportunity Zone program will have in specific markets in South Florida?
Globest.com: Can you tell me in general what the concept is behind the Opportunity Zone program?
Kaplan: Simply put, the Opportunity Zones Program is about long-term job creation and economic development, stemming from the creation of opportunities in blighted areas that otherwise would be overlooked and would benefit from the infusion of capital.
Federal and state governments determined collectively what they considered to be blighted areas throughout the country by looking at census data and low-income areas. When structured properly, investments in these areas get special federal income tax treatment, including a deferral of capital gains reinvested into an Opportunity Zone, a partial step-up in basis and a permanent exclusion of gains realized from an investment held for more than 10 years. In a nutshell, the tax benefit to real estate investors and developers, as well as operating businesses is the ability to defer capital gains realized in a transaction by reinvesting the gains in an Opportunity Zone and avoid paying income taxes on additional gains realized on the investment after 10 years.
Globest.com: What kinds of investment are we talking about, and what clarifications did the IRS provide regarding investing in Opportunity Zones?
Kaplan: To date, the focus in the industry has been on real estate investments within an Opportunity Zone, such as the development of a multifamily project, but the recent regulations have provided the clarity many were waiting for to expand beyond real estate into an investment in operating businesses.
One lingering question for those interested in using this new program to start an operating business was how the IRS would interpret the requirement that the business derive at least 50% of its gross income from the conduct of a trade or business within a Qualified Opportunity Zone. Before the recent IRS regulations were released, there were numerous questions, such as: what if my business operates within an Opportunity Zone but delivers to a broader base of clients and customers outside of the zone? For example, Internet sales: would it be sufficient that services performed for the business were provided within the Opportunity Zone, regardless of where the customer is located?
We now know from the IRS guidance that if at least 50% of the services performed for the business (based on hours or amounts paid) are performed within the Opportunity Zone, then the business can qualify under this program even though a majority of the sales are made outside of the Opportunity Zone. Placing the focus on the location of the services to the business, rather than the delivery of the product, should open the door for the type of job creation and economic development this program was intended to deliver.
Globest.com: What is the significance of the guidance issued April 18 by the IRS on the Opportunity Zone Program?
Kaplan: With so much uncertainty surrounding the implementation of the rules governing this program, many in the industry were reluctant to move forward to establish a Qualified Opportunity Fund and begin to deploy capital. The regulations have provided enough clarity on a number of key questions the market has been waiting on, and while further clarifications would be helpful, these regulations should be enough to open the floodgates for many of those who have been sitting on the sidelines for both real estate and operating business opportunities.
We had already begun seeing Opportunity Zone investments prior to these new regulations in areas of Miami-Dade County, such as in Overtown and the Miami River. With the additional guidance provided with these new regulations, I expect to see a significant uptick of investments in those and other areas in South Florida, including Coral Gables, Allapattah, and up the coast into Fort Lauderdale and Hollywood.
Globest.com: Everyone is still trying to understand the regulations—can you explain the biggest items that the guidance addresses?
Kaplan: The regulations are extensive and address several important issues, but a few key items of interest are the clarifications provided with respect to multi-asset funds, debt-financed distributions, the 50% gross income requirement and the exclusion of carried interest.
Until now, most Qualified Opportunity Zone Funds were established as single-asset funds, but this recent IRS guidance has provided the flexibility sponsors were looking for to create multi-asset funds allowing for the sale of individual assets by the fund, including the possibility to reinvest the proceeds into a new qualified investment.
The ability to refinance a real estate project and distribute refinancing proceeds to investors is part of the business plan for many real estate projects, and there was uncertainty surrounding the extent to which this would be available for Opportunity Zone investments. Although some limitations remain, the IRS has provided the clarity necessary for this long-standing business model to continue for Opportunity Zone real estate investments.
There was some optimism in the industry that a “carried interest” could be eligible to qualify for the tax benefits under the Qualified Opportunity Zones Program. Real estate developers and sponsors will be disappointed to see that the regulations have made it clear that a traditional “carried interest” will not be eligible under the Qualified Opportunity Zone Program.
Finally, operating businesses received an important clarification regarding the 50% gross income requirement, with the regulations providing safe harbors available for funds to rely upon. There are three safe harbor provisions, which allow for qualification based on either the percentage of services provided within the zone, the cost of services provided within the zone, or the necessary functions of management and use of tangible assets within the zone. These should provide a significant level of both clarity and comfort for investors to jump start the economic development desired by this program.
Globest.com: What types of investors will gravitate towards Qualified Opportunity Zone investments?
Kaplan: This program is ripe for investment by high net-worth individuals, family offices and smaller investment funds with the ability to generate capital gains for investment in a Qualified Opportunity Zone Fund and greater flexibility for a long-term hold, as well as a desire to create a positive social impact through their investment. Larger institutional investors, however, have traditionally focused on investments with a projected hold of no more than five to seven years, so a required hold of more than 10 years will require a slight change in mindset. I think we will see a willingness of institutional investors to modify their investment model in order to take advantage of the powerful tax benefits under this program, provided that the investment otherwise satisfies their traditional underwriting standards.