Those interested in leveraging Qualified Opportunity Funds (QOF) to further invest in Opportunity Zone Business (QOZB) investments should watch carefully. Like with the rest of the business world, the COVID-19 pandemic may impact the ability to close on Opportunity Zone Business investments within their required deadline. In response, the IRS announced earlier this month that the 180 day period may be extended as late as July 15, if their 180-day deadline falls between April 1 and that date. As with most actions in response to COVID-19 we anticipate additional guidance to follow.
Plus, while the number of abandoned, foreclosed and government tax sales may not be today’s headline news, that might not be the case soon. The vacant property/original use carve out defined by the IRS in December could potentially save a QOF millions in development fees, and more importantly, time. Here’s what you need to know.
How it Works
The 180-day deadline for a Qualified Opportunity Fund (“QOF”) to invest in a Qualified Opportunity Zone Business (“QOZB”) is one of the requirements under the Tax Cuts and Jobs Act of 2017. So long as the QOF satisfies this obligation, the investment in the QOZB will defer the capital gains tax owed on the funds invested in the QOF until December 31, 2026, reduce the total amount subject to capital gains by 10%, and allow the entire investment in the QOF to grow capital gains tax free so long as the investment is held in the QOF for no less than 10 years.
Take a Closer Look at the IRS’ December Guidance
The third round of guidance, released by the IRS in December, is worth a second look due to its changes to the definition of Original Use. There is now a special carve-out for vacant property, which avoids the substantially improved requirement if it meets one of the following criteria:
- Building was vacant in April 2018, was vacant for at least one year immediately before or immediately after, and is still vacant;
- Building has been vacant for at least three years ; or
- Building was acquired directly from local government, which must have received title through abandonment, bankruptcy, foreclosure, or some other involuntary transfer.
Each of these tests requires 80% of the property as measured by square feet to be “unused” in order to qualify as vacant. Depending on the length of the COVID-19 shutdowns and the effects on various real estate markets, we could see an increase in the number of abandoned, foreclosed, and government tax sales properties on the market. Established QOFs and individuals looking to take advantage of opportunity zones should continue to monitor these as the situation develops in their future plans.
Offering Specific Vacant Property Insight
For example, if a 100 unit apartment building located within an opportunity zone is sold to a QOF through its QOZB, the QOZB would need to substantially improve the property by an amount equal to the adjusted basis of the building. However, if that same property was in a tax sale to a QOF, the apartment building would not need to be substantially improved. The QOZB could lease the property the same day it is acquired and the QOZB will have satisfied the “original use” requirement. All of the revenue generated by the apartment building would be subject to tax, but the QOF would pay no capital gains on the property so long as the QOZB is held for no less than 10 years.
What Investors Can Do Now
QOF investors should be mindful of the ever changing economic environment and the government’s responsive programs. The CARES Act extended this particular deadline, but we do anticipate further guidance. Opinions vary, but there is the potential for significant devaluation of real estate in the coming months or years. There is significant risk to those that rely on recent data showing real estate prices not yet dropping as predictor of where the market will go. Valuations may not drop; they may well drop significantly and then go through a very difficult recovery. Either way, opportunity zone investments will help the recovery of some of the hardest hit areas.