designatedlaunchedRealEstate Roundtable President and CEO Jeffrey DeBoerRoundtable Senior Vice President and Counsel RyanMcCormick

What is the Opportunity Zone program and how does it relate toreal estate?

DeBoer: The point of the program is toencourage capital formation and patient, long-term investment inthese areas by reducing or eliminating capital gains taxes fortaxpayers investing in newly established Opportunity Funds. AnOpportunity Fund itself is created in the private sector, and itmay be organized as a partnership or corporation. Thus, a qualifiedfund may be owned by a single individual, by a small number ofpartners, or by a large pool of investors operating with aprofessional fund manager. Opportunity Funds can invest inincome-producing real estate located in an Opportunity Zone, suchas an apartment complex, shopping center, or officebuilding.Depending on how the Treasury Department drafts theimplementing rules, Opportunity Zones could be a powerful new toolfor mobilizing capital for real estate projects that create jobs,improve communities, and spur economic growth. In the real estateindustry, there is a tremendous amount of interest in OpportunityZones right now. But there are also many unanswered questions. TheReal Estate Roundtable is meeting regularly with lawmakers andAdministration officials to provide industry feedback and supportthe implementation process.

How do the Opportunity Zones' capital investment tax incentiveswork?

DeBoer: In short, capital gain fromprior investments -- proceeds from the sale of real estate, stocks,securities, etc. -- can be rolled into an Opportunity Fund and thetax that would otherwise be owed on the gain from the priorinvestment is deferred and not taxed until the end of 2026. Second,capital gains tax on this deferred gain is reduced by 10% if theinvestment is held for five years or 15% if the investment is heldfor seven years (through a tax basis “step-up”). Third, capitalgain generated from the investments made by the Opportunity Fundare exempt from capital gains tax altogether if the investment inthe Opportunity Fund is held for at least 10 years.Thus,Opportunity Zones incentivize capital investment in two criticalways:(1) the deferred and reduced tax owed on capital gain that isrolled into an Opportunity Fund, and(2) the elimination of capitalgains tax on the subsequent gain from long-term Opportunity Fundinvestments.However, there is an important and often overlookedlimitation. The exclusion of capital gain for investments inOpportunity Funds held for 10 years is only available to equityinvestments that are financed with rolled-over gain. Thus, if ataxpayer invests $10 in an Opportunity Fund, but only $7 representsgain from a prior investment, then only 70% of the taxpayer'sequity investment is eligible for the capital gains exclusion(assuming the investment is held for 10 years). At least currently,the capital gains exclusion does not extend to new capital thatcannot be traced to gain from a prior investment. In the future, ifCongress looks to build and expand on the existing Opportunity Zonelaw, we will urge policymakers to consider extending theOpportunity Zone benefits to new capital.

This is not the first time the federal government hasexperimented with tax incentives to spur private investment inlow-income communities. How do Opportunity Zones differ from priorefforts?

McCormick: Community-based taxincentives such as Enterprise Zones, Enterprise Communities,Renewal Communities, and the New Markets Tax Credit (NMTC) havebeen part of the federal tax system for 25 years. At best, theseprograms have met with mixed results. Various factors havecontributed to their underutilization. Excessive complexity hasdeterred potential beneficiaries. Generally, the tax benefits aretoo small to justify the compliance costs and cumbersome,bureaucratic hurdles. The programs have imposed restrictions on thesize of investments. Moreover, an emphasis on employment subsidieshas discouraged investment by capital-intensive businesses. Perhapsmost importantly, the programs have not incentivized taxpayers toexit existing investments and redirect their capital to thetargeted areas, nor have they facilitated the pooling of capitalfrom multiple sources.Opportunity Zones aim to avoid the mistakesof these earlier schemes and achieve a level of scale that,hopefully, will result in a virtuous cycle of investment leading toadditional investment. Unlike prior programs, Opportunity Zonesreward taxpayers for exiting from existing investments andredirecting their capital to low-income communities. Unlike theNMTC, investors do not have to compete with one another for alimited number of tax credits in a costly, centralized process.Opportunity Zones also promote the pooling of capital throughOpportunity Funds. It is this pooling feature that could betransformative in terms of mobilizing capital from disparatesources to support jobs and growth. Moreover, the fund structurethat underlies the program may result in a business model wherelocal entrepreneurs with knowledge and expertise partner withoutside investors, creating a new cadre of business leaders andlasting benefits for the community.

Where are the Opportunity Zones located?

McCormick: Congress delegated theOpportunity Zone selection process to the governors of the 50States, five US possessions, and District of Columbia. All ofPuerto Rico is an Opportunity Zone. States could designate up to25% of the low-income census tracts as Opportunity Zones (orminimum of 25 zones). States also had some flexibility to designatecontiguous census tracts that did not meet the full, low-incomecriteria. The low-income criteria is similar to the test used forthe New Markets Tax Credit. The process went very quickly. Stateshad about four months to make their designations, which will remainin effect for the next 10 years. The 8,700+designated census tracts are home to nearly 35 millionAmericans. In aggregate, they have an average poverty rate of32%.

How soon until we start to see real estate-focused OpportunityFunds in the marketplace?

DeBoer: Investors and real estate fundmanagers are actively in the process of evaluating options, settingup funds, and conducting due diligence. We expect the first fundsmay be closely held partnerships. In those cases, decisions can bemade relatively quickly and decisively, and the investors may bewilling to bear some of the regulatory risk associated with a newprogram that has not yet been fully implemented. As time passes andthe regulatory regimes takes shape, the pool of Opportunity Fundinvestors may grow.McCormick: There is somepressure to move quickly, because gain that is rolled into anOpportunity Fund is only deferred until the end of 2026. As aresult, the equity investment must be made by the end of 2019 inorder to get the full 15% tax basis “step-up” that comes frominvesting in an Opportunity Fund for seven years.In addition, inorder for an Opportunity Fund investment to qualify for the taxincentives, the underlying property must be acquired by the fundafter Dec. 31, 2017. That said, the law delegated many ofthe key implementation issues to the Treasury Department toresolve. These include: (1) how an Opportunity Fund is certified(2)how quickly must an Opportunity Fund deploy new capital, and(3)when has an existing real estate asset qualified as an eligibleinvestment?

Let's explore those issues in greater detail. What are theissues with respect to Opportunity Fund certification?

McCormick: A qualified OpportunityFund is an investment vehicle, structured as a corporation or apartnership, organized for the purpose of investing in OpportunityZone property. The IRS has indicated that taxpayers canself-certify as Opportunity Funds by completing anas-yet-unreleased form. No formal approval or action by the IRS isrequired. Some commentators have suggested that regulators shouldcreate a vetting process in which Opportunity Funds are “screened”by the federal government for specific social purposes orobjectives before investments are made and placed. We believeTreasury review would create an unnecessary bottleneck that woulddelay economic investment in low-income communities. In astreamlined federal process built around self-certification ofOpportunity Funds and market-driven investment decisions, privatecapital should be better able to flow to its best use while localauthorities will continue to have ultimate authority over newprojects and developments.

What rules govern the timing of Opportunity Fundinvestments?

McCormick: An Opportunity Fund may besubject to penalty unless 90% of its assets consist of OpportunityZone property. The 90% asset test is measured biannually. The testhas been interpreted by some commentators as a strict requirementthat an Opportunity Fund must deploy new capital within six months.We believe this would be an overly restrictive interpretation ofthe statute, and we have asked Treasury to clarify the law toreflect typical real estate fundraising and investment timelines.The construction or rehabilitation of real estate may take muchlonger than six months to complete. During the construction orrehabilitation process, cash and cash equivalents may be a largeportion of the assets held by the fund. We believe OpportunityFunds should have a longer runway to invest their capital andcomply with the 90% test—this would be consistent with the mannerin which real estate investment actually occurs and the extendedtimelines that Congress has provided for otherpurposes.

When does real estate qualify for Opportunity Zone taxbenefits?

McCormick: Under the Opportunity Zonelaw, the original use of qualifying real estate must commence withthe Opportunity Fund, or the property must be substantiallyimproved by the Opportunity Fund. This requirement may not beoverly burdensome for new construction and development. However, inlow-income, urban communities, the substantial improvement test maybe a significant hurdle for real estate projects, notwithstandingthe capital-intensive nature of rehabilitating, renovating, orrepositioning real estate. The property improvements must exceedthe tax basis of the property at the time of acquisition. This is ahigher standard than the test used for private activity bonds andthe Low-Income Housing Tax Credit.In order to maximize capitalformation and job growth, we are asking Treasury to use itsregulatory authority to implement the substantial improvement testas flexibly as possible. Additionally, we are recommending thatpolicymakers consider legislative enhancements to the OpportunityZone program that would extend eligibility to significant propertyrenovation and value-add projects, which are otherwise unlikely tomeet the statutory substantial improvement test. A modified testcould greatly expand the impact of the program in low-income, urbancommunities where existing, dilapidated and underutilized buildings-- rather than open land -- comprise the majority of real estate inneed of investment and revitalization.

What are the next steps in the process?

DeBoer: We anticipate Treasury willsoon issue guidance, hopefully within the next 30 days. We expectthe guidance will address some of the most immediate issues, suchas how investors roll over gain from existing investments intoOpportunity Funds. However, it may leave some other questionsunanswered, such as how Treasury will interpret the substantialimprovement test for existing real estate assets. Going forward, itwill be critical for interested elements of our industry to remainactively involved in the rulemaking process. The Roundtable hasbenefited immensely from the insight and wisdom of members of ourTax Policy Advisory Committee, which helped developed our recentcomment letter. We plan to continue to meet with Treasurystaff, key lawmakers, and others to provide insight into how theindustry can truly help the Opportunity Zone program fulfill itsambitious objective of stimulating economic development and jobcreation.

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Erika Morphy

Erika Morphy has been writing about commercial real estate at for more than ten years, covering the capital markets, the Mid-Atlantic region and national topics. She's a nerd so favorite examples of the former include accounting standards, Basel III and what Congress is brewing.