23 Apr The Gray Area Around Opportunity Zones Tax Code
Opportunity Zones (OZ) are terrific real estate investments but the tax code governing them is confusing and contradictory. Over the coming weeks and months, we expect IRS clarification.
NOTE: New IRS regulations were released this week. We will dig into the fine print and update this post as soon as our tax team has a chance to dig in. Please check back for updates.
Meanwhile, developers and sponsors need to understand that there are outstanding concerns with the way the laws are currently written.
If you are considering an OZ investment, you should be especially aware of the following Opportunity Zone tax code questions that are yet to be resolved:
1. The biggest confusion around Opportunity Zone tax code: Can the fund refinance the investment and return the investors original equity?
With the way the law is written, SMARTCAP is taking the stance that we are unsure if we can actually refinance our OZ Fund investment and return our investors original equity. There are a number of unresolved issues that are quite complex and thus far, the IRS has provided conflicting guidance.One big issue in Opportunity Zone tax code we see is that this new investment class is considered a ‘zero basis’ investment as the investor has not paid tax on the gain they are deferring into the Opportunity Zone.
For the tax nerds out there like me, the 1400Z-2 code, says “basis is zero”. However, in regulation 1.1400Z-2€-1, the regulation discusses the basis increase that a partner in a partnership gets when they assume debt. So, the regulation contemplates a positive basis adjustment for guaranteeing debt and/or a partner’s pro-rata share of non-recourse debt. It is unclear which section has authority.
Specific tax code is generally a higher authority than general regulation.
The 1400Z-2 code is squarely at odds with the rules for general partnership. This brings up an issue in partnerships like SMARTCAP where only the principals or sponsors are guaranteeing debt, thus the limited investor does not benefit from this increased basis.
Clear as mud, right?
We are hopeful that at a minimum, after 12/31/2026 when the investor has recognized their originally deferred gain and now has a positive capital account, it will be reasonable to refinance the project and return equity. This would allow the investor to pay the taxes that are now due on the original gain and would also increase the total IRR of the project by returning principal earlier.
2. How do you sell an Opportunity Zone asset after the 10-year hold requirements and ensure the investors qualify for the correct tax code treatment?
Again, this is a tricky question that we hope to have guidance on in the coming months.
The issue with selling out of an Opportunity Zone investment is that technically, as we understand how the law is written as of this post, it appears that you have to sell the equity investment the investor made in order to get the 10-year tax benefit. This means selling the fund or security, not the underlying real property.
There is a lot of complexity caused by the way the law is written and the way that tax flows. Some legal teams and/or CPA’s believe that when you do sell the asset and distribute the money for sale, you will return a greater distribution than the investor’s capital account, thus triggering an IRS clause that treats the distribution as a sale of the equity. Some legal teams I have discussed this with do not agree with this stance.
So, this is yet another issue that will require additional clarity from the IRS to be fully resolved!
3. What happens in the event that distributions are made that would push the investor capital accounts below zero?
The initial investment is a zero-basis investment and while operating income should make the capital account go up, distributions will make the capital account go down. There is a very real possibility that a distribution could occur that is greater than an investor’s capital account.
According to one school of thought, such an event could trigger a deemed ‘sale’ of the security or investment which could potentially disqualify the investment from the 5-, 7- & 10-year tax benefits that accrue with an OZ investment; it could also accelerate tax on the deferred gain.
Based on how the laws are written today, and how capital accounting occurs, this is a risk that has not been fully detailed by the IRS or Treasury. There will be a burden on the sponsors to ensure that they do not distribute funds greater than investor capital accounts.
Good news: The IRS has announced that they will specifically address this issue in future regulations and formal guidance.
4. How does depreciation work on a capital gain investment that has zero-tax basis? Does the tax code allow us to utilize accelerated depreciation to offset income in an OZ?
Accelerated depreciation is a typical strategy that we utilize over a longer-term hold, such as in the case of OZs. The problem with taking accelerated depreciation is that if the investor’s capital account is zero, an investor cannot take any tax losses which would be created via depreciation.
In many cases, the sponsors of the investment will sign a personal guarantee on the loan. This will turn the investment into a ‘recourse capital account’, which will increase the investors capital accounts based on the amount of debt they guarantee.
Generally, investors do not guarantee the debt and so there is no basis for those investors. This means, any depreciation in early years is likely to be allocated to those who provide guarantees on the debt.
The 25% recapture rate for straight-line depreciation and the ordinary income rate for accelerated depreciation is technically a capital gain tax, so it is possible that an OZ might be considered a tax-free recapture and could provide significant benefit to those who are able to capture the depreciation throughout the project.
After investors pay tax on 21/31/2026, they will have a positive account at that point and could then start taking advantage of the losses generated from depreciation.
5. Another Opportunity Zone tax code issue: future income is generally allocated first to those who were allocated losses in the previous years.
This means, if the sponsor were to take the losses associated with depreciation, they would then take future income (not the cash distribution, only the income being allocated on an investor K1 from the operations of the company). This could put the investor at risk of receiving distributions greater than their capital account and thus potentially trigger the sale of the security from the IRS standpoint, as discussed above.
6. Will a “NNN Leased Asset” rise to the Level of an “Active Trade or Business?”
This is a really interesting question raised by one of our astute investors recently.
The answer is: we cannot be 100% certain that an NNN Leased Asset will raise to meet the threshold of an Active Trade/Business.
However, the real question is “what is the definition of an NNN lease?” First, let’s talk about why this matters.
Qualified Opportunity Zone Businesses are required to earn 50% of their income from within a Qualified Opportunity Zone and must be an Active Trade or Business. If the activity of the Opportunity Zone Fund does not rise to the level of an Active Trade or Business, then the fund will be subject to stiff financial penalties.
There is significant case law that holds that a true ‘Net’ leased building is not an Active Trade or Business. A true ‘Net’ leased building is a building where the tenant is solely responsible for paying insurance, taxes, as well as the cost of maintaining the building directly. The landlord has no responsibilities and simple collects a check. This is arguably a very ‘passive’ investment.
There is, however, good news:
In the real estate world, most ‘NNN Leased’ properties refer to the entity who bears the cost for the work, not the entity who actually completes the work and is legally on the hook for taxes, insurance, and repairs.
(As an example, SMARTCAP operate numerous NNN Leased properties where we actively fix building issues. These issues include HVAC, Plumbing, Electrical, etc. We also are responsible for daily activities at the center such as day porter service, landscaping maintenance, HVAC servicing, pressure washing, snow removal, etc. That does not take into account the full-time office staff that facilities bill payment including taxes, insurance, vendors, utilities, etc.)
Collectively we spend hundreds of hours on every property we own every year. Though our specific fact pattern has not be tried in a court of law, there is significant judicial precedent that these types of rental properties and management activities rise to the level of an ‘Active Trade or Business’.
You can find a similar explanation to my logic by reading ‘section-199a-triple-net-leases-considered-a-trade-or-business’. Another good resource, written by Forbes, is in this insightful article: ‘why-is-the-irs-punishing-triple-net-landlords.
You can also review a case which clearly articulates that the acts of operating a property, including negotiating leases, maintaining assets, accounting, etc. are all taken into consideration.
In the case here, you will see that the owner spent less than 5 hours per year and did not qualify, so it is imperative that you are investing into an actively managed asset. Assets SMARTCAP manage take hundreds of man-hours every year including full time property management, asset management, accounting, lease negotiation, construction management and other time-consuming tasks. These activities would be very easy to prove as “highly active management”; thus, they should qualify us as an “active trade or business.”
For the record, the information outlined above represents SMARTCAP’s best opinion as we delved into the tax code, regulations and IRS guidelines. It also represents the analysis of our CPA partners, Brendan McAuliffe and John Launceford of Berntson Porter. We have partnered with Berntson Porter since 2017 and highly recommend the firm’s willingness to dig in with us to develop specific Opportunity Zone tax code expertise.