In April 2019, the United States Treasury Department released the long-awaited second round of proposed regulations related to the “Opportunity Zone” initiative which was enacted as part of the Tax Cuts & Jobs Act of 2017. The initiative provides tax incentives to investors that invest in business or properties within designated “Opportunity Zones.” These areas, which were proposed by each state and approved by the federal government, are known as “Qualified Opportunity Zones.”
In order for an investment to qualify for the beneficial tax treatment, capital gains must be used to fund the investment and the investor needs to “substantially improve” the invested property, unless the property is original use property, meaning it has not been depreciated. To “substantially improve” the investment, the investor needs to double their initial tax basis in the property within thirty months after purchase.
So, what are the benefits of the Opportunity Zone program?
First, a taxpayer can defer the tax on their capital gains for up to seven years (until 12/31/2026). Second, a taxpayer can reduce the capital gains tax paid (the same gain that is deferred) by up to 15% if the Opportunity Zone investment is held for five or seven years. Third, and frankly, the biggest advantage, is that the appreciation in the investment is tax-free, as long as the investment is held for at least ten years and the investment meets the improvement qualifications.
Clarifications in Regulations Proposed in April 2019
The April proposed regulations clarified a number of OZ related issues, including clarity around buying or starting businesses through the Opportunity Zone program, the use of net Section 1231 Capital Gains to fund the investment, and guidance related to Opportunity Zone fund organization. In addition to property purchases and development projects, there is now a taxpayer-favorable three-part “Safe Harbor” that would allow for the acquisition or founding of a qualified business to be eligible for tax-free appreciation through the Opportunity Zone program.
Revenue Ruling 2018-29
Another piece of tax guidance recently issued was Revenue Ruling 2018-29 which concluded that a taxpayer only has to “substantially improve” their investment in a building rather than substantially improving the building and the land that makes up their investment. In the Revenue Ruling, a taxpayer purchased property with 60% of the total purchase price allocated to the land and the remaining 40% of the purchase price allocated to the value of the building. The IRS concluded that the taxpayer only had to “substantially improve” the 40% of their investment that related to the actual building.
If you’re following this fact pattern closely, it would appear that the IRS opened a window to purchase land and not have to improve it but still qualify for the tax benefits. However, Treasury has repeatedly stated in the proposed regulations that “Land Banking” is disallowed. However, certain land investments focused on agriculture where an investor does in fact substantially improve the land (improving irrigation, infrastructure, planting crops, etc) could potentially qualify for the Opportunity Zone program. The types of improvements and relative value of improvements needed to qualify are currently unknown. Additional guidance on the applicability of the Opportunity Zone program to Agricultural and Land investments is expected to be released in the Fall of 2019.
About Tyler Davis
Tyler Davis is an Accountant working with the property management division at SVN | Saunders Ralston Dantzler Real Estate. Tyler recently joined the brokerage after spending five years in the tax practice as a manager at PricewaterhouseCoopers in Birmingham, Alabama. Tyler graduated summa cum laude with his Bachelor’s in Accounting from Samford University in 2013 and received his Masters in Taxation degree from the University of Alabama in 2014. After passing the CPA exam, he began his career with PwC in 2014 where he gained valuable experience working with both life and property and casualty insurance companies across the country.