You’ve got Opportunity Zone questions. We’ve got Opportunity Zone answers. This is the inaugural edition of Opportunity Zones Podcast Listener Questions. Today’s listener questions deal with options for existing Opportunity Zone property owners, incentives for Opportunity Zone businesses, and more.
If you’d like to submit your own question or comment, leave a voicemail on the Opportunity Zones Podcast hotline — call (682) 800-1505.
Click the play button below to listen to the episode.
- Leveraging Opportunity Zones to aid with prisoner reentry.
- How the substantial improvement test applies when a property is purchased with a mortgage.
- Pairing other tax credits (LIHTC, NMTC, and HTC) with Opportunity Zones.
- Options for existing property owners in Opportunity Zones.
- Incentives for new business owners in Opportunity Zones.
- How the Opportunity Zone tax incentive applies to a theoretical $1 million capital gain.
Featured on This Episode
- Lennox Jackson: Developing in Chicago’s Opportunity Zones (Episode #28)
- Rich Rogers: Twinning Historic Tax Credits with Opportunity Zones (Episode #9)
- Jessica Millett: QOF Formation Legal Considerations (Episode #37)
- Opportunity Zones Tax Savings Calculator
About the Opportunity Zones Podcast
Hosted by OpportunityDb.com founder Jimmy Atkinson, the Opportunity Zones Podcast features guest interviews from fund managers, advisors, policymakers, tax professionals, and other foremost experts in opportunity zones.
Jimmy: Welcome to the Opportunity Zones podcast. I’m your host Jimmy Atkinson, and today I’m fielding questions from listeners who have submitted voicemail messages to our opportunity zone podcast listener hotline. If you’d like to submit your own opportunity zones question or comment, you can do so by calling 682-800-1505.
Our first question today comes from Barry from Richmond, Virginia who has a question about how opportunity zones could possibly help prisoner reentry programs.
Barry from Richmond: Is there any opportunity zone investors around the country that’s working with re-entry with the first step that the Trump administration passed around criminal justice? Is there any opportunity zones that’s working maybe with nonprofits around the reentry of federal prisoners or prisoners coming back into low-income communities?
Jimmy: Barry, thanks for the question. I do not know of a lot of opportunity zones programs that are tackling prisoner reentry. The only one I know of anecdotally is the one that was conveyed to me by a former podcast guest of mine, Lennox Jackson from Chicago. He is working on a project that has some element of prisoner reentry and workforce housing on the Southside of Chicago. I’ll link to that podcast episode in the show notes for today’s episode. You can find those at opportunitydb.com/podcast.
If any listener out there knows of any other opportunity zones program that helps with prisoner reentry, let me know. Call the hotline at 682-800-1505 and leave a voicemail with the details and we’ll try to get that played during the next episode.
Our next question today comes from Vivian from long Island, New York and he has a question about the substantial improvement test.
Vivian from Long Island: I have a client of mine who has got an opportunity zone fund created. He has bought $490,000, which he wants to put in an opportunity zone. The question is, in case he buys a property for $1 million multifamily, eight units property and he puts in his $490,000 and gets the remaining mortgage from the bank, the question would be whether the money he has to spend, is it $1 million or just $490,000 for updating, renovating or whatever he wants to do with the property to get the benefit of the opportunity zone.
Jimmy: Well, Vivian, thanks for the question. This is actually a question I get pretty frequently or some variation of this question dealing with the substantial improvement provision of the opportunity zones legislation. So in this example, the investor invests $490,000 into an OZ property that is purchased for a million. So presumably he gets the remaining 510,000 in the form of a mortgage. The question is does he have to spend $1 million to meet the substantial improvement test or just the $490,000 in cash that he put in? And the answer is, neither actually. The answer is you have to put into the improvements a value above the adjusted basis in the property. And for the sake of this test, the value of the land is not included in that adjusted basis. So it all comes down to what the building value is worth. In this example, I’m gonna make up some numbers now, but we know the property was purchased for $1 million or it is to be purchased for $1 million.
Let’s say that the value of the building is 700,000 and the land is valued at 300,000. The investor or the qualified opportunity fund would then have to substantially improve the property by at least $700,000 or actually, I think it’s worded more than $700,000. So the amount that is invested in cash versus the amount that’s invested in the form of a loan or other financing a mortgage, that’s not the question here. It all comes down to what the adjusted basis in the property is minus the land value.
Our next question is from Ralph from Memphis, Tennessee who has a question about low-income housing tax credits.
Ralph from Memphis: I’m trying to get a question answered. Can you combine both low-income housing tax credits real opportunity zones tax credit into, use both of them for one project, for the same project.
Jimmy: Oh, Ralph, thanks for the question. The answer, the short answer at least is yes, you can do that. You can pair low-income housing tax credits with opportunity zones. In fact, you can pair a variety of other tax credits with the opportunity zones program, low-income housing tax credits being one of them, new markets tax credits and historic tax credits is another one that’s commonly used for reuse of historic buildings and historic building preservation. So I actually have a podcast episode on the topic of twinning historic tax credits with opportunity zones and I think it’ll come across as similar conceptually at least if you want to give that one a listen with my guest Rich Rogers from January of 2019 earlier this year. I’ll link to that episode in the show notes for today’s episode, which you can find at opportunitydb.com/podcast.
Now I should warn you that you know, doing so may comp complicate things a little bit. I would definitely get in touch with the CPA to see how to go about doing all that. But essentially what you’re doing is just creating different capital stacks that would kind of feed into the same project as I understand it.
Our next question comes from Betty in Miami, Florida and she has a question about options for existing property and business owners in opportunity zones.
Betty from Miami: Hello. Hi. This is Betty from Miami, Florida. I’m calling to find out of information because I’ve been running into problems. I have a small property, a residential property that I aim to develop in a very up and coming area but I have an existing LLC and an existing property and it appears that only new owners of a property and new establishers of a business are eligible to participate in the opportunity zone program, which seems to be a big, a big problem for those of us who want to invest in our communities.
Jimmy: Hi Betty, thanks for the great comment. I think you speak for a lot of existing property owners and a lot of existing business owners out there who feel like they’re getting the short end of the stick here when it comes to community investment in opportunity zones. A lot of existing property owners, existing business owners such as yourself, I hear from them all the time via email and phone. They want to participate in the program. They’ve been in these opportunity zones for a long time and they’re feeling like the benefit doesn’t apply to them and in a way they’re right and you know the intent of the policy for better or worse is to bring new capital into opportunity zones. So they’ve set up this program to make it pretty difficult for existing property owners and business owners to participate, unfortunately.
That said, there are a few options for existing property and business owners. And I had Jessica Millett on my podcast. She’s a tax attorney for Duval & Stachenfeld’s in New York city. Jessica was on the podcast with me back in June to discuss legal considerations for qualified opportunity fund formations. And part of our conversation didn’t actually make the final cut for that episode. One of the questions that I asked her about was this very one, some options for existing property owners. So I’m gonna let Jessica actually answer this question. She can do it better than I can. This is from our conversation back in June, recorded a few months ago now. The question I pose to her was, what are some options for existing property owners?
Jessica Millett: Yeah, sure. So, this is a tricky one and there’s some policy issues that creep in here that I think people need to be sensitive to as well because as you mentioned, one of the rules in order for property to be a good property in the hands of the QOF or in the hands of a Qualified Opportunity Zone Business, it does need to be acquired by purchase after December 31st, 2017.
So, I mean, the one thing that an existing property owner can do is just sell the property, right? Sell the property to a new qualified opportunity fund and take the cash and walk away and maybe you take your cash and you invest in a separate qualified opportunity. That’s where some of the policy issues get a little bit tricky because in a sense, you are displaced from the people who’ve sort of been in the zones and on the property for a long time. So I think that’s one that people are less comfortable with. But there are several options for existing property owners to hold onto the property or to keep at least a piece of the property while still allowing the property to be developed under the opportunity zone program.
The first thing that you can do is you can look at that the way that the related party rule works. And what the statute does is it has this related party requirement, and it defines relatedness for this purpose pretty low. It’s at a 20% ownership level. So one thing that you can do is you can, if you’re an existing owner, you could sell your property to a new QOF, and then you can try and come back into the equity structure for our 20% interest.
Now, of course, it doesn’t allow you to keep the majority stake in the property and I suppose if you think about the policy goals behind the program, you know, the policy as I understand it, is to really bring new money, new investment into these opportunity zones. So in a sense, the statute really backs that up by not really permitting these existing property owners to keep a huge ownership interest in the property.
There are a couple of other structures that people are using which the treasury has not explicitly blessed, but they also haven’t explicitly said that you can’t do it. So I think one thing that people are thinking of, you know, that first structure I mentioned where you sell a property outright and you come back in for 20%, that’s a way for an existing property to actually participate in the opportunity zone tax benefits, right? If they sell the property and they have an eligible gain, they can then come into the QOF and take advantage of the QOF tax benefits while also having an ownership interest in the property.
Another thing that people are thinking about, and this just gets a little bit technical, but if as I kind of talked them through the structure, it might be helpful for some people. So you know, the way that most of these deals are set up if you have a qualified opportunity fund owning an interest in a lower-tier entity, a qualified opportunity zone business. And so if you assume that that qualified opportunity zone business is going to be a partnership for tax purposes, then you can think about the QOZB having essentially two partners, right? One partner will be the QOF. The QOF will contribute all the money into the QOZB to develop the property. And then you can have the existing property owner actually contribute the property into the QOZB.
Now, if the only thing that they’re contributing is raw land, if we try and make it simple, we say, well, wait a minute. If you’ve contributed that property into the QOZB, then the QOZB has not acquired the property by purchase. It’s been contributed in. And that’s absolutely true. But the way that they defined some of the rules that apply at the QOZB level in the regs, they said that substantially all of the tangible property of the QOZB has to be this property that’s been acquired by purchase. And they defined substantially all for this purpose at 70%. So if you think about it, you kind of have a bucket of 30% that you can do whatever you want with and the 30% of the tangible property in the QOZB does not have to be acquired by purchase.
So if you have an existing property owner contribute land into and the QOZB and the QOF comes in and throws in a bunch of money and use that money just to go off the property. If the value of that land, which were we would concede in that influence as sort of a bad asset, that tangible property not meeting 70% test. But if it’s less than 30% of the value of all the tangible property, then technically under the rules that should work. You should be able to meet the 70% test that way. So that’s another thing that people are thinking about, which allows existing property owners to stay in the deal without triggering an upfront tax and still get the property developed.
Jimmy: Well, thanks Jessica for the thorough answer. So just to summarize there what Jessica said, you know, three options that she brought up. One is the property owner or the business owner could just sell outright to a qualified opportunity fund and walk away. Two, the existing property or business owner could sell the property or business to a qualified opportunity fund and then reinvest back in as long as the investment is less than 20% of the total equity in the fund. That would skirt around the related party rules just fine and then that existing property owner would be eligible for the tax benefits albeit at a much lower equity ratio drawing down from 100% theoretically to under 20%.
And then the third one was pretty technical in nature. I don’t know if I can summarize that one very eloquently, but essentially, you know, taking advantage of the 70/30 test and basically just having that property be a “Bad asset” within the QOZB.
We’ve got time for one more question today and it comes from Eric in Playa Del Rey and his question deals with business incentives for business owners in opportunity zones.
Eric from Playa Del Rey: Hi, my name is Eric from Playa Del Rey and I just have a question about businesses that are filling into the opportunity zone. Maybe you’ve covered it before but I haven’t heard it. What are the benefits to a business that moves into an opportunity zone as far as red, gray, etc. I have some people that I meet that own business and when I mention that you open an opportunity zone, I wish I knew exactly what they would be benefited by.
Also, if you can break down exactly what a million dollar capital gain savings would be or deferment would be over the five years, seven years and the 10 years or what happens if you leave it in longer. And then I remember you mentioning something about 47 years and how that all plays out in simple math for capital gains. Thanks so much.
Jimmy: Eric, thanks for the question. Or actually it looks like you snuck in two questions on me here. So to answer your first question, what incentives apply to business owners who open up shop in an opportunity zone or move into an opportunity zone? Are they eligible for benefits such as rent breaks, etc? Rent breaks, no. Really the benefits surround capital, so they should theoretically have a somewhat easier time raising capital if they’re looking to raise capital from outside investors, they can tout their business as a qualified opportunity zone business, which would be eligible for the main opportunity zone investing, tax breaks.
If they want to self capitalize, if they want to start up a new business in an opportunity zone and maybe they’re not seeking outside funding, but they just want to capitalize it themselves. Let’s say a client of yours wants to establish a business insight in an opportunity zone and he has a capital gain in the stock market that he wants to realize, he can sell his Facebook stock or his Amazon stock or his ETFs or mutual funds or whatever it may be.
Maybe he’s got a million dollar capital gain. He can use that to fund his new qualified opportunity zone business, and then defer the gain, reduce the gain liability and then exclude all capital gains appreciation on the back end. So and that kind of dovetails nicely into answering your second question, which was what would a $1 million capital gain savings be over those 5, 7 and 10 year periods?
And the answer is, and this may surprise you, nobody knows for sure. And the reason for that, there’s two reasons for that. One, we don’t know what the tax rate is gonna be in 2026, which is when the deferred capital gains come home to roost is they are recognized at the end of 2026 and the 2026 capital gains tax rate will apply. We don’t know what that rate’s gonna be. And two, the biggest benefit to the program is what happens on the backend.
It’s what happens to that in suing capital gain that is generated the opportunity zone investment. And well, how much did your $1 million grow to within that opportunity zone investment that’s going to determine how much you’re actually saving. But we can use a couple of assumptions here and well, first before I do that, I’d like to point my listeners to a calculator that I have on my site that kind of tackles this very problem. The opportunity fund tax calculator. It can be used to estimate the tax savings of an opportunity fund investment or an investment in a qualified opportunity zone business. You want to find that and play with some of the numbers and make some assumptions and plug some of your own variables in. You can do so at opportunitydb.com/calculator.
Now, getting back to your $1 million example, first of all, you get to defer that tax gain or that capital gain tax liability until 2026.
So essentially you’re receiving a seven-year interest-free loan from the federal government. And what amount are you receiving? Well, there’s a few different capital gains tax rates depending on what type of asset it is that is sold and whether or not you’re eligible to be taxed under the net investment income tax rate of 3.8%. But let’s assume that just to keep the math simple, I’m glossing over a lot of stuff here, but just keep the math simple that your capital gains tax rate on whatever it is that you are recognizing capital gain is 20%. So in your million dollar example, you have a $200,000 tax liability, but instead of paying that $200,000 in April of 2020, you’re now getting to defer recognition of that gain until the end of 2026 so now you owe $200,000 in 2027 or do you?
So two things are gonna affect that. One is your holding period. If you achieve a five year holding period before the end of 2026, you get to reduce your tax liability by 10%. So now you’re paying $180,000 instead of $200,000. And then the second thing is, if you achieve a seven-year holding period before the end of 2026 and if you are able to roll over your original gain into an opportunity zone investment by the end of this year, by the end of 2019, you will achieve that holding period of seven years before the end of 2026 assuming everything doesn’t blow up, you get to reduce your tax liability by 15%. So now instead of paying $200,000 in 2020, you’re paying $170,000 in 2027. So you get that seven year interest-free loan from the federal government and they’re essentially paying you to take it because now you’re saving $30,000 on your tax bill that eventually comes home to roost.
So two things there. One, $30,000 in tax savings, but two, a kind of a hidden amount is the additional amount of capital that you’re putting to work for you over that seven-year period. Instead of being able to invest just $800,000 after paying a $200,000 tax liability, you’re able to invest $1 million. So now you have just that much more capital compounding for you for that much longer. For an additional seven years, you’ve got an additional $200,000 compounding for you that you otherwise may not have. So it’s really, you’re saving more than just the $30,000 a year. You’re also earning more within your investment.
Now, big asterisks here, we don’t know what the capital gains tax rate is gonna be in 2026 so if it stays at 20% you know that’s how much you’re saving. But nobody knows what the future holds, right? We don’t know who’s gonna be in the white house.
We don’t know what type of administration we’re going to have. We don’t know what they’re going to do or not do with the capital gains tax rate.
So then third, this is the biggest one, is you get to exclude all capital gains, tax liability from within the appreciation of your opportunity zone investment. So well, what does that $1 million gain that you roll over into an opportunity zone investment, what does it do for you? And by that I mean how does that asset appreciate over time? And when you go to sell it in 10, 20, 30 years, depending, assuming that you are able to achieve a holding period of at least 10 years, whenever you go to sell that asset, you owe no tax on the a capital gain from within that asset. So in our example, we’ve got $1 million that we roll over into an opportunity zone investment.
Let’s say you put it to work in your own new qualified opportunity zone business. And then 20 years later you sell that business for $11 million. Well, you have a $10 million capital gain. And normally under today’s tax rates, assuming that they are 20%, you would owe $2 million to the federal government the following April. Well, in the opportunity zone investment example, that $2 million capital gain tax liability goes away forever. You never pay that $2 million.
So that’s a long-winded answer to your question. And again, the real answer is the short answer is I don’t know and nobody knows because it depends on a variety of factors. Depends on the tax rate in 2026 and depends on how much your investment grows over the holding period. Now you also mentioned a 47 year period that you thought I had brought up at one point, I think you may be referring to the year 2047 which is when this program officially ends.
According to current IRS regulations on qualified opportunity funds, the fund has to sell off the assets at some point in the treasury department and the IRS, somewhat arbitrarily picked the end of 2047 as the deadline to sell these assets to achieve the gains that you are then able to wipe out. So I think that’s what you meant by that a 47-year mark is actually the year 2047.
Thanks again to Eric for submitting that thoughtful two-part question. I hope I answered it satisfactorily for you.
And thanks to everybody who submitted a question these last two weeks since I opened up this new podcast listener hotline. If you’d like to submit your own question to be answered on-air or if you just have a general comment for me or for the website or for the opportunity zone program, you can leave a voicemail at the opportunity zones podcast listener hotline. Call 682-800-1505. I hope to do more of these episodes in the future where I collect a few of the best voicemail questions that are left and I can answer them on air.
So keep the questions coming out there for everyone, and I hope to hear from you soon. Thank you.