Lisa Knee

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One big unknown for Opportunity Zone investors is the definitionof substantial improvement. The regulations call for buildinginvestments to have substantial improvements made to them inkeeping with the spirit and intent of the regulation.

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But when you get down to the nitty gritty, a definition isnecessary. Lisa Knee, partner and co-leader of accounting firmEisnerAmper's Real Estate Practice Group, explains that there aredifferent ways to look at expenditures under the tax law, which iswhy a definition for substantial improvement is so crucial.

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“The statute provides that the substantial improvement testrequires additions to basis to exceed the adjusted basis of theproperty at the beginning of the 30 month period,” she tellsGlobeSt.com. “Expenses can either be deducted or capitalized underthe repair regulations. If they are capitalized the developer mayalso take bonus depreciation or a Section 179 deduction, whichcould allow some items to be written off,” she says.

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“What hasn't been addressed and needs to be is whether the IRSwill look at a strict definition of improvements in determining thenotion of additions to basis, or if it will look at the totalactual expenditures with respect to that building.”

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In the big picture, Knee describes it this way: the substantialimprovement definition could be one based on total costexpenditures or something based on the strict definition of whatmust be capitalized.

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There are related questions as well, such as with substantialimprovements to land. Do those qualify under the original use test,for instance.

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This is not the only uncertainty facing investors in OpportunityZones of course, but it is a significant one. For some investorsplanning improvements to an investment, this uncertainty is a causefor hesitation, Knee says.

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The US Treasury Department is holding a hearing tomorrow onOpportunity Zones but it is highly unlikely that substantialimprovement or other lingering issues will be addressed. Rather, itis expected that additional guidelines will be issued later thisyear that will include this and other areas of uncertainties. Themeeting on Feb. 14, is expected to hear comments on the regulationsthat the Treasury Dept. already released.

Some Remaining Questions

According to a White Paper that Knee and her team put together,there are several remaining areas where questions remain.

  • Related party leases. The law sensibly excludes owners fromselling to a related party (e.g. a spouse or trust controlled bythe seller) and then claiming the benefit for an existinginvestment. However, it doesn't specifically exclude LEASING to arelated party in the same manner.
  • Does residential real property count? While an existing IRScode (Sec. 1397C(d)(2)) specifically excludes residential realproperty from the business definition, the QOF provisions useresidential real property as an example of a business in one ofsections on how the law is intended to work.
  • Can you claim them for property you own with a triple net leasetenant? If the owner isn't paying any of the lease, existing rulessuggest it shouldn't count.
  • Do you need to substantially improve a vacant property for itto count? Revenue Ruling 2018-29 provides that QOF does not need toseparately substantially improve land upon which a building islocated but they don't address a vacant parcel of land or whetherimprovements to vacant parcels fall under the “original use”test.
  • If you borrow money and then pay it out as distributions on theinvestment in excess of the basis of investment, that normallytriggers a taxable gain. It isn't clear if doing that affects thedeferral and basis elections with respect to that portion of theQOF investment.
  • There is no hard-and-fast rule right now of how long you haveto reinvest gains from the sale of a QOF and preserve thetax-deferral.

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Erika Morphy

Erika Morphy has been writing about commercial real estate at GlobeSt.com 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.