Tax Facts: The Future of Opportunity Zones
Tax Facts is the newest podcast from Buchanan Ingersoll & Rooney all about the world of tax law and new changes that affect businesses and investors alike.
On our first episode, Lisa Starczewski and Lafe Metz of Buchanan Ingersoll & Rooney discuss the world of Opportunity Zones, important deadlines for the program, and what the future holds for this valuable tax-incentive-laden investment tool.
Lisa Starczewski is a shareholder at Buchanan and chair of the firm's Tax section as well as its Opportunity Zones Team. Lafe Metz is also a shareholder at Buchanan and chair of the firm’s Real Estate practice group.
In the episode, Starczewski and Metz cover:
- The history of Opportunity Zones and what the March 31, 2021 deadline actually means.
- How investors can still take advantage of this program.
- How the 2020 Census may impact the Opportunity Zones Program.
- What changes the COVID-19 relief packages made to the Opportunity Zones Program.
- How potential changes to tax rates and the OZ provisions could impact the program.
You can listen to Tax Facts in many places: on Apple Podcast, Google Podcasts, Spotify, Pocket Casts, and more.
Lafe Metz: Welcome to the first episode of Buchanan Ingersoll and Rooney's Tax Facts. This is a podcast about the world of tax law, the new changes that affect businesses and investors alike. My name is Lafe Metz, and I'm your host today. I'm a shareholder at Buchanan and the chair of the firm's Real Estate group. I'm very pleased to welcome my colleague Lisa Starczewski who's also a shareholder at Buchannan and is the chair of our firm's Tax section, as well as the chair of our Opportunity Zones team. Lisa, thank you so much for being here. I'm thrilled to be talking with you.
Lisa Starczewski: Of course, Lafe. It's a pleasure to be here.
Lafe Metz: Lisa, you are what I consider to be one of the leading experts in the world on Opportunity Zone matters, and so it's a privilege for me to get to be here and talk with you about that more. And I know there's been a lot of recent activity in the Opportunity Zone world, and there are some deadlines that are going to be important to many clients and other taxpayers. So, can you tell us what the March 31st deadline is all about and why our clients will care about it?
Lisa Starczewski: Before I do that, let me just give you a very brief overview of the Opportunity Zone (OZ) program and just make sure that all our listeners are on the same page with respect to what it is. The OZ program allows taxpayers who have realized capital gains from, for example, a sale of stock, the sale of real estate, the sale of a business, etc., to defer paying tax on that capital gain, and instead invest it in an Opportunity Zone, through an entity that we call a Qualified Opportunity Fund or a QOF.
There are several tax benefits to making this type of investment. One is the deferral itself on the tax with respect to that original capital gain that's being invested. That gain will not be taxed until 2026. The second benefit is the fact that a portion of that gain that was invested may never be taxed, up to 15% of it, depending on when the OZ investment is made.
And the third benefit, and perhaps the most impactful one, is the fact that if a taxpayer makes this type of investment and holds it for at least 10 years, none of the appreciation on the investment is ever taxed.
The idea behind the program was to incentivize the movement of money into targeted geographic areas in order to bring economic improvement and prosperity to those places. There are 8,700 designated Qualified Opportunity Zones across the U.S. and U.S. Territories.
So now let me get back to your question about March 31st. The OZ program has a number of requirements that have to be met in order for those tax benefits I just described to apply. And many of the requirements impose timetables on both the original investor and the fund and the entities the fund invests into. With respect to this original investor who has realized capital gain and wants to invest in an opportunity zone, the taxpayer has 180-day period within which to take that gain and move it into a Qualified Opportunity Fund. The 180-day rules are complicated. There are special rules that apply to pass through gain. There are exceptions, and I'm not going to get into all of that. But the March 31st deadline is important because as part of the COVID-19 relief that the IRS provided to the OZ program, it has extended that 180-day time period for investors so that a taxpayer, whose 180-day period would otherwise have been expired, may still be able to take advantage of the program if they move the money by March 31st, 2021. Gain from as far back as 2019 might still be eligible under this relief. It's important to remember though, that what has to happen by that date is movement of the money into a Qualified Opportunity Fund entity, not that the money has to be put to work in a zone. In a specific property in a specific project. It just has to be invested into the fund entity by March 31st.
Lafe Metz: Can you say again how does it work with the COVID-19 relief? So, I think you were saying this isn't just 180 days back in the past from here, so it's not like it went from September 30th, 2020 until now. It reaches further back than that. Can you say a bit more about that?
Lisa Starczewski: It does. It reaches all the way back to 2019 and in fact, if it's pass-through gain, if it's gain that was generated in a partnership or an LLC or an S-Corp, or a certain trust, it can be gain that was realized as far back as January 1st of 2019. So in many instances this can be old gain. And it can be gain that the taxpayers already paid tax on, but will be allowed to amend those returns and be refunded that tax if they make the decision to move the money by March 31st, and they move the money into the fund by that date.
Lafe Metz: If I'm an investor, how do I know if something is a Qualified Opportunity Fund?
Lisa Starczewski: So, there is not anything magical about a Qualified Opportunity Fund entity versus any other business entity, so a fund can be organized as a partnership, as a corporation, included in a partnership, of course, in an LLC or as an S-Corp. So, it's just an entity. There is nothing magical about it. It doesn't have to have any certain number of owners, other than the fact that it cannot be a disregarded entity.
Lafe Metz: Thank you. And so, let's imagine that I'm somebody who has some gain that I would love to invest in an opportunity fund, but I haven't found one yet. Is it possible to just create one myself and park the money in there and then later further invest it in a different fund or in a zone if I figure it out later?
Lisa Starczewski: The answer is yes. The investor could create their own, let's say partnership or LLC, because that is the most-often-used type of entity in this scenario and park the money there by March 31st to meet the deadline and then a couple of different things could happen. The money could be backed out of that entity and into a different Qualified Opportunity Fund, and there would be different requirements that have to be met in terms of the timing for that. It would restart their clock in terms of a 10-year hold for the gain exclusion after 10 years. What also could happen is that fund can then look for entities out there that are developing projects in opportunity zones. Because the fund is allowed to then invest in another entity that acts as the qualified opportunity zone business. In fact, that two-tier structure is what applies almost all of the time. So, the thing that fund cannot do is invest in another Qualified Opportunity Fund. That is not allowed under the rules.
Lafe Metz: OK, got it. So, with the March 31st deadline, we started talking about that because it was relief that the IRS had offered in response to COVID-19. They’re trying to relax some of the deadlines. Is there any other type of relief that the IRS has made available for the OZ program?
Lisa Starczewski: Yes, there absolutely is. So, the relief to investors was just one part of the relief the IRS provided in this recent notice. They also provided relief to the fund itself, as well as to entities into which the fund might invest, which we refer to as Qualified Opportunity Zone Businesses or QOZB’s, which you might hear about.
So, the fund itself is subject to a 90% investment standard. Pursuant to which 90% of its assets have to meet certain requirements. Essentially, they have to be put to work in an opportunity zone, either through direct ownership of property or ownership of qualified opportunity zone businesses. If the fund fails to comply with that 90% test, which generally applies every six months, there is a financial penalty that's imposed on the fund. And it's been really difficult for funds that were created back in 2018-2019 and early 2020 to get work done. Construction halted in some instances because of the pandemic. It was difficult to get permitting done. It was hard to visit to go to other geographies and look for viable projects. And so, the IRS has decided to give significant relief with respect to that 90% test. As an example, for a calendar year fund entity, all of 2020 and all of 2021 is essentially not going to count for purposes of that 90% test. The fund is not going to have to meet the test for those years.
In addition, there's a number of tests and requirements at the Qualified Opportunity Zone Business level. And there are requirements to substantially improve certain property that's purchased either by the fund or by the business. All of those timetables that are involved in those requirements have been alleviated to some extent in the relief. I'm not going to get into all of the nitty gritty of those rules, but the moral of the story here is that funds and qualified opportunity zone businesses have been given significant breaks and have much longer runways to properly invest the money that's been invested and to develop projects in opportunities zones. For anyone who wants more information on the relief, I have a client advisory that I wrote on that topic.
Lafe Metz: Switching gears a little bit, the Opportunity Zone program was created in the Tax Cuts and Jobs Act of 2017 during the Trump Administration. What's your feeling about how the public is perceiving the program? Is this perceived as a Republican program? Is it something that the Biden Administration favors and wants to continue?
Lisa Starczewski: I think you just have to look back at the history of the program to realize that, no, this is this is not a partisan program, and this was not a Republican program, and it was not a Trump program. The OZ program has been highly politicized over the last couple of years for a variety of reasons. But the reality is that the idea behind this program originated several years ago with Sean Parker of Facebook fame, and a think tank that he created called the Economic Innovation Group. And the point of that group, and of Sean Parker back many years ago was to try to analyze how a change in tax policy could address and impact inequity. The OZ program received bipartisan support from its inception, and its inception was not in the Tax Cuts and Jobs Act. Instead, its legislative inception was in a separate piece of legislation called the Investing and Opportunity Act that was introduced prior to tax reform by Republican Senator Tim Scott and Democratic Senator Cory Booker. So, there is absolutely a bipartisan history to the program, and I believe there is continued bipartisan support for the program.
Lafe Metz: So, do you think there are going to be any meaningful changes to the program during the Biden Administration?
Lisa Starczewski: Well, first, I think that Biden and his administration have a real opportunity here to correct the story with respect to the OZ program and reiterate that the program was, in fact, the result of bipartisan efforts. They were able, in a sense, to rebrand it and really encourage the use of the program to manifest the originally intended results. There was some speculation early on that the OZ program could be eliminated under Biden. But that does not seem to be the direction that Biden is going in or the Congress is going in. Instead, what they're doing is suggesting certain changes to the program that would provide greater transparency and would give people a better sense and a data-driven sense as to whether or not this program is working and where it's working and where it's not working. You know, are we moving the needle on economic metrics in low-income communities?
I think, as I said, that there's still widespread support, but there is a desire to pass additional legislation or additional regulatory guidance. And I think we're going to see that in one of four or all of four different areas. And I'm going to quickly talk about those.
- One is that Biden has said that he wants to incentivize funds to partner with nonprofits and other community-oriented organizations and to work together to create projects that are focused on job creation and other local benefits.
- The second area, and I think we're definitely going to see some form of this is increased reporting by funds and by Qualified Opportunity Zone businesses with respect to infusions of cash where the money is being put to work and then the results. How many jobs have been created? What economic metrics have changed as a result of the OZ investment?
- The other thing we might see is changes to the tracks themselves. There was a new census in 2020, and we may see some movement legislatively with respect to the actual tracks
- And then the last thing is there's been a little bit of talk. I don't know if it's just wishful thinking, or how real it really is, about extending the 2026 deadline. And just kind of extending the program out. And of course, if they did that then those deadlines, I talked about 2021 being important and we're going to talk more about that a little bit, would change because 2026 would become something later than that. The gain could be deferred for longer, and there would be more opportunity for people to invest in qualified opportunity funds and get all of the tax benefits.
Lafe Metz: One concern I've heard some people raise going back to the question of will the program change under the Biden Administration, is what happens if there's a change to the capital gains tax rate? Do you have thoughts on that?
Lisa Starczewski: There are a number of tax changes that have been floated. And there are a couple of them that may substantially impact the OZ program, but not necessarily in a negative way. So let's talk about the capital gains increase. Yes, we could see a very substantial capital gains increase. Right now, it's 20% for the most part, plus the 3.8% net investment income tax, so it's 23.8%. And it could increase to as high as 43.4% if we look at the highest income rate that might be imposed on ordinary income, which could go back up to 39.6%, then we add that 3.8%, right? So that's a really hefty change in the capital gains rate. And investors are going to pay tax on this deferred gain at whatever rate is in effect in 2026, not the rate that's in effect when the gain is realized, so they would be subject to that increased rate if the rate is in fact as high as that in 2026.
But let's remember that at the end of the 10 years, if they hold for 10 years, that all of the appreciation is tax free. That benefit ends up being worth a whole lot more economically if what they're saving is 43.4% and not 23.8%. Because if they had taken that money and they had put it to work anywhere else and they earned that same amount of appreciation, it's taxable. It’s taxed at 43.4%. So honestly, in conversations with my clients and in conversations with colleagues, we kind of talk about the negative of the impact on the deferred gain and that the rate might be increased on that. But if the OZ investment is really successful and if there is significant appreciation. That is and should be far outweighed by the benefit at the end of the 10 years.
Lafe Metz: You were mentioning a moment ago the importance of 2026 and how that relates to the importance of this year 2021. And would you mind explaining that again?
Lisa Starczewski: So, at the beginning when I talked about the three benefits, the second one I talked about was that a portion of that deferred gain might never be taxed. The only way that can be true is if on December 31, 2026, the investor can look back and say, OK, I've held my investment for seven years by 2026. And so, 15% of my gain is never going to be taxed. Or I've held my investment for at least five years and therefore 10% of my gain is never going to be taxed. So, we think about that, right? If it's the end of 2026 and I have to have held for seven years in order to get the 15% cut, I had to have been in by the end of 2019. And if it's 2026 and I'm looking for the 10% cut, I have to be in by the end of 2021. So, the end of 2021 is very important because anyone who goes into a fund after 2021, which you absolutely can still do, there are still great benefits to it. They’re still the 10-year benefit, but there won't be any forgiveness of the originally deferred gain if you go into the fund after December 31, 2021 unless the 2026 date is extended.
Lafe Metz: I hope that those deadlines get extended because you know it's complicated. It's a complicated program, and it feels like it took the marketplace a while to get comfortable with it. And now that it's understood, some of the key benefits are not available anymore because of the deadlines having been passed or quickly approaching.
Lisa Starczewski: Yeah, that's absolutely true, but it's a really good point. I mean, if for no other reason, because it took a while to get regulations that gave us any information on how to actually apply the program. And we had two sets of proposed regulations. Then we had final regulations, then we had clarifications that made substantive changes to those final regulations. It took a long time for practitioners, investors, and taxpayers to have a real sense of how this was going to work, and prior to that they were really taking risks. You know, putting money into funds, and some people did, but not the numbers that they were really hoping for. So, I agree there's good reason to extend it.
Lafe Metz: Let's talk about the Census a little bit. You were mentioning earlier that the 2020 Census may have some impacts on the Opportunity Zone program, and maybe you can just go back a tiny bit and help us understand how the 2010 Census was important to this program and then what the 2020 Census changes might lead to.
Lisa Starczewski: Well, the tracks were designated as Opportunity Zones in the spring of 2018. The governors of every state made these designations. And there were parameters with respect to how they created, designated tracts, and whether a tract qualified and the factors that went into the decision of whether a particular tract qualified had to do with whether or not that tract met the requirements of a low-income community. Was it considered a low-income community? But the data that was used to determine that was old data. It was data from the 2010 Census.
And so, as you can well imagine, there were areas that had seen significant development from 2010 to 2018 and yet could still be designated as Qualified Opportunity Zones, and in fact, that's where some of the criticism of the program has come from. It's come from the fact that a lot of these zones, when you look at them, you kind of scratch your head and say, “how is this a low-income community?” It really isn't anymore, and therefore it's a very sweet spot to park opportunity zone investment because your chances of long-term appreciation are much higher, right? It's a much lower risk investment. So that is how the 2010 Census was relevant. The designations were made. There is a notice that lists every single tract that is a Qualified Opportunity Zone, but changes have been made, significant changes to those tracts. Either the boundaries have expanded or the tract has shrunk under the new data, or they have been split into more than one tract. And so, when you're looking at this old list of tracts and you now look at the new Census data and the new mapping, the two things are not the same, and there are questions about what's going to happen now with respect to the tracts. If it shrank, does that mean that the new boundary lines are what are relevant? What if a tract no longer exists? What if it no longer meets the low-income community requirements? Can tracts be taken off the list? What if there's already been investment in those tracts? How do we grandfather existing investment? Just drafting language for grandfathering is so complicated because think about it – what does that mean to grandfather? Are you grandfathering only the dollars that have been put to work already? Are you grandfathering the project, which might need future infusions of cash? How will that work right? And then there's the flip side. Can we add tracts? If there are other areas that now qualify as low-income communities, can the governors add tracts to the list so that now we have more Opportunity Zone areas that can be invested into? And you know, I can tell you that the Treasury's 2020-2021 priority guidance plan does include the impact of census tract changes on the Opportunity Zone Program. And so, they have prioritized coming out with guidance with respect to this issue, but there are a number of nuances to these answers, and I think that it's taking them a while to figure out what they want those answers to be.
Lafe Metz: So at least since we're a few years into the Opportunity Zone Program, and we've seen all this evolution and the different instances of guidance coming out, and then extensions from COVID-19. What's the overall feeling about the program at this point? Is it felt to be working? Is there enough investment happening? Is there good value for people to look into Opportunity Zones? What's your takeaway?
Lisa Starczewski: You know the answer to that so depends on who you ask, right? Because there are some people that are absolutely gung-ho excited about the Opportunity Zone Program, and there is some sense of disappointment that it just didn't have this enormous impact that people were hoping it would have. But you know, I think that it's really important to step back and just realize a few things.
One is that we had this pandemic happen and that you really can't even look at the last year at all in terms of assessing what this program is capable of. The second is that we saw that highly politicized approach to OZ’s in March of 2018 and 2019. And so, there was some reluctance associated because of that. And we also just did not have enough guidance to know what we were doing or how to do it. And so, I think there are reasons why it hasn't had that tremendous impact that it has the potential to have. But I think that now we are seeing renewed excitement about the OZ program across the board and much more of it. And I think there's a number of reasons for that, right? I think that the possible capital gain increase is actually getting people talking about this and talking about, “OK does that make it more or less attractive?” And I think in most cases it makes it more attractive.
One other tax change I didn't get a chance to talk about is that Biden might eliminate like-kind exchanges, which now are limited to real estate, but if that goes away completely, this becomes one of the only ways to defer capital gain, taxation, and becomes even more important. So, we have those tax changes that are driving a little bit of excitement and renewed interest. We have the fact that the program will be less politicized under Biden. And I think it will go back to being seen as a true economic development tool with bipartisan support, and I think that's going to drive excitement. We've seen unprecedented gains in the bull market we've had over the last few years. There is a lot of money on paper out there. There are huge gains that could be utilized in this program. We've been in this global pandemic for a year as a result of which we have significant economic fallout across our United States, right? If there was ever a need for economic development tools, it is now. States, cities, towns, they're going to have to use every tool at their disposal to incentivize recovery and growth. All of these things I think are working together to reinvigorate the OZ program, which really leads to my last point.
The OZ program is not a panacea that is going to, on its own, bring relief and development to low-income communities. That's not what it is. That's not what it ever was intended to be. It doesn't make bad investments, good investments. It doesn't. But it is one tool, right? It is a tool. It can be part of the capital stack in a transaction. It could be that one more thing that makes the project feasible. Its greatest and most impactful use is when it's used as part of a package that state and local governments have put together alongside job training programs, small business loans, streamlined regulatory processes, tax increment financing. The more cooperation and collaboration that exists between investors and funds and your local and state municipalities and economic development authorities, the more likely it is that this program is going to be used in a way that meets its original objectives.
Lafe Metz: Well, Lisa, it was a privilege to talk to you. I learn more about Opportunity Zones every time we have a chance to interact, and your knowledge of the statute and also your practical experience are evident. And so, we're lucky to have you here at Buchanan. Thank you again for joining us. I also want to thank all of our listeners for tuning in. We hope you'll join us for future episodes of Tax Facts, and you can do that by subscribing to the podcast on Apple or Google or Spotify or wherever you like to listen. If you'd like to learn more about Buchanan and our experience in tax law and in real estate. Please visit our website at www.bipc.com and you can also learn more about opportunity zones at www.bipc.com\opportunity-zones. Until next time I'm Lafe Metz, and I'm here with Lisa Starczewski. And thank you very much for tuning into Tax Facts.