New Opportunity Zones Could be Used to Finance Rental Housing
As noted in a recent client alert, opportunity zones (OZs), the new community development tool authorized in the tax law enacted in December, represent the first new tax incentive for private capital in low-income communities since the creation of the new markets tax credit (NMTC) in 2000.
The OZ program is similar to the NMTC program in that both are designed to incentivize investment of private capital in low-income community businesses and both are sorely needed to address unmet needs for capital in those communities. It is also anticipated that both incentives will be able to assist similar types of developments, albeit at different levels of subsidy per dollar invested.
However, the OZ and NMTC programs also differ in several important ways. Perhaps the most significant difference is that business investments under the NMTC program are almost always debt, while OZ investments must be in the form of equity.
The NMTC is subject to an annual allocation limit, which in recent years has been $3.5 billion per allocation round, and that limit means that many low-income communities won’t see an NMTC investment in a particular year. OZs don’t have an allocation limit; volume will be set only by investor appetite. With $2.3 trillion in unrealized capital gains for U.S. investors, even a fraction of this potential demand would still be significant for community development capital.
The mix of investors for each incentive is also expected to be different. The NMTC tends to draw major banks, due at least in part to the Community Reinvestment Act, and not individual investors, principally because of individual alternative minimum tax limitations. OZs will likely attract major corporations, including major banks, as well as more high-net-worth individuals, as there is no equivalent alternative minimum tax limitations.
Another key – and often overlooked – difference from the NMTC is that the OZ program does not have restrictions on investing in affordable rental housing.
How Rental Housing Qualifies
All rental real estate, including residential real estate, located in OZs appears to be eligible to be a Qualified Opportunity Zone (QOZ) property as long as the real estate is newly constructed, or acquired after Dec. 31, 2017 and substantially improved, and meets the active conduct standard provided in the statute.
QOZ businesses must meet the following requirements:
- Substantially all of their tangible property owned or leased must be QOZ business property which is defined as:
- Property acquired by purchase (not exchanged) after Dec. 31, 2017;
- Property in which its original use in the OZ commences with the QOZ business, or such property is substantially improved over a 30-month period; and
- Property which is substantially used (e.g. available to be leased) during substantially all of the QOZ business’ holding period in the opportunity zone.
- Fifty percent of their income must be derived from active conduct, a substantial portion of their intangible property be used in such active conduct,
- Less than 5 percent of their unadjusted basis of property is nonqualified financial property, and
- They are not “sin” businesses as defined by the private activity bond (and NMTC) statute.
Real estate that has been previously used in an OZ can still qualify as QOZ business property as long is purchased after Dec. 31, 2017 by the OZ business and as long as the OZ business substantially improves the property. Real estate is substantially improved for OZ purposes if during any 30-month period following acquisition of such property there are additions to basis that exceed the adjusted basis as of the beginning of the 30-month period. This is generally a much higher standard than the substantial improvement standard under the low-income housing tax credit (LIHTC) which requires a taxpayer to spend $6,800 per unit or 20 percent of adjusted basis over a 24-month period.
“Active conduct” is not defined in the OZ statute. But, under a similar “active conduct” standard (relating to Gulf Opportunity or GO Zone property), Treasury defines active conduct by a taxpayer in a trade or business based on meaningful participation in the management or operations of the trade or business, and specifically cites an example of managing and operating a new apartment building in the GO Zone as active conduct.
That requirement would likely preclude the use of “triple net leases,” where the tenant or lessee agrees to manage the property and pay all real estate taxes, building insurance, and maintenance on the property in addition to any normal property fees, such as rent, utilities, etc. Most affordable rental housing properties don’t involve triple net leases.
Alternatively, Treasury could adopt a standard for OZ similar to the “active conduct” standard in the NMTC program whereby a qualified business is considered active if a community development entity (CDE) reasonably expects that the entity will generate revenues (or, in the case of a nonprofit corporation, engage in an activity that furthers its purpose as a nonprofit corporation) within three years after the date the investment or loan is made. Under this standard, even real estate under “triple net leases” is likely to qualify.
Nonqualified Financial Property
Nonqualified financial property is defined as debt, stock, partnership interests, options, futures contracts, forward contracts, warrants, notional principal contracts, annuities and other similar property, but does not include reasonable amounts of working capital.
Because the definition of nonqualified financial property includes debt with terms more than 18 months, most financial institutions or investment holding companies will generally be excluded from qualifying as a QOZ business. However, given that most rental housing management and operating businesses are not financial institutions or investment holding companies, this provision should not be an impediment to participation.
As defined under Internal Revenue Code (IRC) section 144(c)(6)(B), a trade or business will not qualify as an QOZ business if it is engaged in owning operating any private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises (i.e., liquor store). Again, this should not block participation for affordable rental housing.
Benefits of Twinning with LIHTC
The Opportunity Zone statute does not forbid OZ investments from being combined with other community development tax incentives, such as the LIHTC. Moreover, the 15-year LIHTC compliance period lines up well with the long-term incentives of OZ. While appreciation of LIHTC developments are by nature limited and therefore taxable gains are less likely, any gain commonly realized from excess losses deducted in highly leveraged LIHTC developments, especially bond-financed ones, could be forgiven. Depending on the development, twinning the OZ incentive with LIHTC will likely increase equity pricing.
There are two very important next steps for OZ implementation. First, governors must identify the low-income areas in their states designated as Opportunity Zones. Governors must submit those nominations or request a 30-day extension by March 21. Second, the Treasury Department must develop the rules that determine how Qualified Opportunity Funds are certified, and then certify those funds meeting the criteria. Once these two steps are taken, capital can begin to flow.