Real Estate & Construction
With the release of proposed regulations and a revenue ruling in late October 2018, the IRS has provided enough information for most individuals involved in real estate to be able to move forward to establish the QOF (and possibly the first-tier entity that will own and operate the QOZ Businesses) to invest in real estate or to select a QOF in which to invest. This is particularly true for real estate developers who plan to invest their capital gains in specific real estate projects. To benefit from the maximum 15% reduction in capital gains tax due on funds placed in a QOF, it is necessary that the fund be set up by December 31, 2019, which may cause the best properties to be tied up quickly. Potential investors should begin to consider the timing of possible sales and investment through a QOF, so capital gains may be devoted to new real estate investments under the QOZ program.
Investing in QOFs is a long-term strategy, deferring gain and relying on increased appreciation of the asset in 10 or more years to provide an improved return. Our QOZ team can help establish a QOF, advise on strategy related to amounts to be placed in various assets to diversify risk, and review structure and compliance issues at the QOF and QOZ Business levels. We also collaborate with other Thompson Hine attorneys and Project Management Consultants professionals to determine if other incentives could be applied to the project to reduce risk and increase short-term returns. While we have tried to simplify the QOZ program throughout our website to introduce this unique tax treatment to our many new and existing clients, the mechanics of the process can be quite complicated when you consider compliance, depreciation, debt and collateral, just to name a few factors.
We can also assist should there be a need to sell a QOZ Property prior to the end of the 10-year holding period. We can help with compliance issues and tax issues, and work with tax advisers/preparers to develop a the most beneficial strategy.
The proposed regulations and revenue ruling include clarity on some important issues for real estate investments including:
Substantial improvement. The cost of the improvements paid by the QOF must equal/exceed the tax basis of the building (but not also the cost of the land). The QOF can use its funds to purchase the land, but one favorable aspect of the proposed IRS regulations is that only the cost of the building is taken into account to determine if the substantial improvement standard is met. The allocation of purchase price between land and building will be important in determining whether the building is “substantially improved."
Safe harbor provisions. The proposed regulations apply to a QOF’s investments in QOZ Businesses that acquire, construct or rehabilitate real property in a QOZ. As long as the QOZ Business has a written plan and schedule for the deployment of the investments, and it complies with them, the committed cash will be considered reasonable working capital for up to 31 months.
Related party. There was a modification of the related party provision from the 50% prohibited common ownership to 20% prohibited common ownership for QOZ purposes.
Selling the asset. The tax legislation provides that the asset has to be sold at the expiration of the designation of the zone (December 31, 2028), which would prevent assets purchased in 2019 and later from receiving the full exclusion of appreciated value. The IRS has clarified in the proposed regulations that assets sold prior to January 1, 2048 would qualify for the exclusion with respect to all appreciation from the investment in the QOF through the sale date (as late as December 31, 2047).
Ground leases. With respect to structuring projects to utilize the QOZ program in conjunction with a project site consisting of land held before December 31, 2017, we are closely following regulatory developments concerning use of a ground lease structure. It appears that it is possible for a ground lease with improvements to qualify, but further guidance is needed regarding the value to be placed on the ground lease for purposes of making sure that the QOZ Business Property is at least 70% of all the tangible property (which includes leased tangible property). A to-be-constructed building may qualify as QOZ Business Property although the underlying land does not. There is no guidance shedding light on a ground lease situation, but the statute nonetheless would seem to permit this arrangement.
There are also planning factors due to related party rules if an owner leases land and building(s) to an entity in which the owner holds an equity interest.
- Assume that the land is owned by a related party and leased to the related operating entity that constructs the building. If the building is viewed as the stand-alone QOZ Business Property, that would seem sufficient. If, instead, the related party leases an existing building to the related operating entity and such long-term lease is treated as if the related entity acquired the property for federal income tax purposes, then it would seem that the acquired building (and the substantial improvements) would not qualify as QOZ Business Property.