6 Key Takeaways from the New Opportunity Zone Regulations
In April, the Treasury released the highly anticipated guidance pertaining to the Opportunity Zones (“OZ”) program. Surveying the commentary that quickly followed, a common refrain is that Treasury’s general tenor remains constructive. Many expect this set of regulations will provide an added layer of comfort that will accelerate OZ capital flows. We agree that these regulations solidify several critical points and also create additional flexibility to implement an OZ program. With respect to further clarifications, the IRS does not necessarily expect to issue a new set of regulations, but will be accepting comments on the “New Proposed Regulations.”
Given the density of the most recent set of regulations (169-pages of technically intricate reading material that made us thankful for our lawyers) we expect ongoing legal and business commentary to trickle out over the next few weeks. That said, six key points immediately stood out:
1. Refinancing distributions
One of the most frequent and insightful questions we have received from investors relates to whether refinancing proceeds can be distributed to investors and what the tax treatment of those distributions would be. The answer to this question is important for two main reasons: (1) the refinancing event could function as a critical liquidity mechanism for investors who will need to pay their deferred tax bill in 2027 and (2) refinancings are pursued in most real estate projects, especially ground-up developments that we expect will comprise most of the OZ transactions.
To put numbers behind this question, imagine an OZ asset is developed for $100 using $65 of debt and $35 of equity. After stabilization in year 4, the asset is appraised at $150 and a lender is now willing to lend $100 against the asset. After paying down the original $65 loan, Cadre has $35 of distributable proceeds from the $100 loan. Given the OZ tax benefits are tied to an investor remaining in the Qualified Opportunity Fund (“QOF”) for 5, 7 and 10 years, are investors allowed to receive that $35 distribution while still accruing tax benefits? Treasury has now stated that the answer is yes in the majority of cases (e.g., the refinancing needs to be after two years).
However, and importantly, not every QOF structure will share in this positive outcome. Specifically, QOFs that are structured as corporations or REITs that distribute refinancing proceeds would indeed trigger all or a portion of the investor’s deferred gain and be treated as a sale of the investor’s QOZ investment.
2. Secondary liquidity
Another positive update from the New Proposed Regulations is that investors can acquire an interest in a QOF from another QOF investor. In other words, investors can purchase QOF interests on the secondary market as opposed to acquiring the interest from the QOF itself in the initial fund offering. For example, an investor with eligible capital gains could purchase an interest in a Cadre OZ deal after the asset is fully stabilized. One important consideration is that each investor is governed by their own investment clock, so an interest purchased year 3 would need to be held through year 13 to receive the capital gains exclusion. Despite some of these limitations, this provision could significantly expand interim liquidity options for investors within well-structured QOFs.
Given our mission to increase the liquidity of private real estate through the Cadre Secondary Market, we are particularly excited to see this new clarification.
3. Original use
As discussed in the Cadre Opportunity Zones 101 Guide, in order to count as a qualified asset, a real estate project must meet either an “Original Use” or a “Substantial Improvement” test. Substantial Improvement was defined in previous regulations to incorporate a “doubling” of an investment’s basis within a 30-month time period. The majority of OZ real estate projects to date have relied on this prong. The New Proposed Regulations provided additional clarification on Original Use, stipulating that buildings that have been vacant for at least five years prior to being purchased will satisfy the original use requirement. Additionally, it seems that fully constructed buildings which have not yet received their Certificate of Occupancy would also satisfy Original Use. In certain circumstances, this could allow investors to take less development risk while still meeting the OZ regulations.
4. Depreciation recapture
Another frequently asked question is how income from a qualifying property will be taxed. At a high level, the tax benefits for Opportunity Zones relate to capital gains taxes, not taxes on ordinary income generated by the property. However, the latest set of regulations clarify that investors may also be able to use a common income tax saving technique related to ordinary income within QOFs.
Specifically, one of the benefits of owning private real estate is that investors can often use non-cash depreciation expense to offset taxable income. Treasury has now clarified that this dynamic applies to OZ deals as well. The added benefit for OZs relates to a concept known as depreciation recapture. While depreciation can sometimes allow for tax-free distributions during the hold period, investors are typically subject to “depreciation recapture” upon sale whereby the previously sheltered taxes are recouped.
As it stands, the current regulations seem to allow investors the ability to avoid depreciation recapture within QOFs. This benefit could meaningfully increase the tax-equivalent IRR earned by investors. Cadre’s partnerships will be set up to benefit from this potentially favorable outcome.
5. Opportunity Zone businesses
The vast majority of OZ deals executed to date have been real estate transactions due to the relative simplicity of adhering to OZ regulations compared to start-up businesses. While Cadre will remain focused on real estate transactions, it is worth noting the New Proposed Regulations offered important and constructive clarifications for operating businesses. While not a direct benefit for managers pursuing real estate strategies, we view this first and foremost as a critical step forward for the overall success of the OZ program. The economic growth of OZ census tracts will be best supported by the complementary growth of businesses and real estate. Further, the potential proliferation of businesses located within OZs can also be creatively explored for landlords seeking tenant demand at their real estate projects.
6. Anti-abuse rules
Looking ahead, Treasury also highlighted in the New Proposed Regulations that anti-abuse rules and regulations will be the subject of future clarification. From our perspective, anti-abuse rules will provide important guideposts that should increase the intentionality and longevity of the Opportunity Zones program. We do not anticipate these rules impacting Cadre’s approach, but we will continue to monitor potential developments.
Taken together, the New Proposed Regulations have increased our level of conviction and assessment of actionability related to Opportunity Zones. Importantly, we understand that we are not the only manager who will arrive at that conclusion. We therefore plan to remain at the forefront of understanding as this exciting program evolves, and will continue to select high-quality opportunities for our clients with an unwavering commitment to discipline and rigor.