H2C SELLER STRATEGIES SERIES PART 3:
OPPORTUNITY ZONE INVESTING

How Opportunity Zone Investing
Can Offset the Impact of Tax Reform

August 29, 2019

 

Tax law changes have created potential challenges as well as opportunities for sellers of healthcare real estate. In this three-part series from Hammond Hanlon Camp LLC (“H2C”), H2C presents key information as well as transactional strategies that may offer sellers the ability to mitigate potential tax consequences.

 

In part two of our Seller Strategies Series, Hammond Hanlon Camp LLC (“H2C”) shared information on several existing tax strategies under the new tax law, including Section 1031 and 721 Exchanges and Delaware Statutory Trust investing. This third and final installment outlines Opportunity Zone Investing, a new and exciting tax deferral strategy introduced under the new tax law.

 

One new strategy healthcare real estate investors can consider to offset the impact of tax reform is Opportunity Zone investing. It’s an approach that healthcare organizations and investors across the country are using to strengthen community health—and for some organizations, it presents the opportunity to defer capital gains taxes.

 

An Opportunity Zone is an economically distressed community in which new investments, under certain conditions, may be eligible for preferential tax treatment that enables deferment of capital gains on the sale of an appreciated asset. This applies to real estate investors who sell assets after Jan. 1, 2018.

 

Examples of recent Opportunity Zone investments include:

 

• Kaiser Permanente’s investment in a fund designed to improve housing stability and reduce homelessness in eight states

• Johns Hopkins’ partnership with Walgreens to create a “Well Experience” store that brings new healthcare services to one community

• Pro Medica’s partnership with Local Initiatives Support Corporation to fund $45 million in community revitalization efforts

 

Here’s how it works. After the sale of an asset, an investor must invest the gain portion of the sale proceeds into a Qualified Opportunity Fund (“QOF”) within 180 days. A QOF is an investment vehicle for the purpose of investing in an eligible property that is located in an Opportunity Zone. The entire amount of the gain that is reinvested into the QOF will be tax-deferred.

 

It’s important to note that the deferred gain is taxable upon the investor’s sale of its interest in the QOF or as of Dec. 31, 2026. Capital gains are deferred based on the holding period of the QOF interest.

 

The QOF holding period requirement is as follows:

 

• 5 years: 10 percent of the deferred gain is forgiven

• 7 years: 15 percent of the deferred gain is forgiven (Note: An investor must invest in a QCF no later than Dec. 31, 2019 to qualify for this deferment.)

 

If the investment is held in the QOF for at least 10 years, 100 percent of the deferred gain will be forgiven upon the sale of the eligible property.

 

What can be invested in QOFs? Short- and long-term capital gains are eligible for investment in QOFs. including captain gains from an actual or deemed sale or exchange (also known as a 1231 gain). Ordinary income, including depreciation recapture, is not eligible for reinvestment into a QOF.

 

Understanding Section 1231 gains. When depreciable property is sold at a gain, all or part of the gain may be recognized as ordinary income under the depreciation recapture rules, according to the IRS. Any remaining gain is considered a Section 1231 gain, which is the net gain less recaptured depreciation. (Note: This applies only to assets sold at a gain).

 

Both the selling partnership and up-tier partners are eligible to invest in an Opportunity Zone, subject to certain timing requirements. If a partnership wishes to reinvest the capital gain from a sale into a QOF, the 180-day period for doing so begins on the date that the partnership sells or exchanges the asset and realizes the gain.

 

If the partnership chooses not to reinvest the capital gain into a QOF, any of the partners may invest their share of the capital gain into a QOF to defer the tax on that gain. In this instance, the partner’s 180-day period will not begin until the last day of the taxable year in which the realization event occurred. Alternatively, if the partner knows that the capital gain was realized by the partnership and also knows that the partnership is not going to invest that gain into a QOF, the partner may elect to view its own 180-day period as beginning on the date the realization event occurs.

 

QOFs vs. 1031 Exchanges. In instances where partners want different outcomes from the sale of assets, QOFs hold an inherent benefit over 1031s. Under 1031 Exchanges, the rules require all partners to invest their share of the gain into the exchange. However, a QOF allows each partner to individually determine whether to invest its share of the gain into a QOF.

 

Setting up a QOF. The Opportunity Zone Program requires investors to invest in a QOF, not in a specific property within the QOF. None of the tax benefits are available if the investor chooses to invest directly in property within an Opportunity Zone.

 

Limited liability corporations (LLCs) are permitted for use as a QOF as well as lower-tier partnerships or corporations if the LLC qualifies for the required elections.

 

QOF self-certification through IRS Form 8996. If an entity self-certifies as a QOF, there is no initial approval process required by the IRS. The entity can select the month during its initial taxable year that the entity wishes to be considered a QOF. This does not have to be the first month in which the entity was created.

 

An entity may form and begin certain tasks before self-certifying as a QOF. This enables the entity to delay the start of the first six-month testing period—required for investment in the Opportunity Zone—until it has investors. Form 8996 doubles as a reporting tool that must be filed with the IRS every year to report compliance with the 90 percent asset test, as detailed below.

 

QOF structures. The code for QOFs allows for two types of structures: a single-tier structure and a two-tier structure:

 

• Under a single-tier structure, the QOF holds the property directly. Ninety percent of the single-tier QOF’s tangible property must be held in a qualifying property.

• Under a two-tier structure, the QOF holds an interest in a lower-tier partnership or corporation (a joint-venture entity), and the joint-venture entity holds the property. The joint venture must own the property, as a QOF cannot own another QOF. Seventy percent of the joint venture entity’s property must be qualifying property. The joint venture entity is permitted to own intangible property if a substantial portion is used in the entity’s trade or business. The joint venture is also permitted to possess a reasonable amount of working capital.

 

Permitted investment strategies for QOFs. Ground-up development project requirements have not been clearly defined and must be evaluated individually for compliance with the original use test.

 

Substantial improvement to a property (“substantial improvement test”). The joint venture or single-tier structure must double its basis in the building within a 30-month period. There is no requirement for the basis in land to be doubled nor separately improved. The acquisition cost basis of the property must be allocated between the building and the land on an arm’s length basis to avoid any abuse of regulations. As such, QOF transactions typically have a development or redevelopment component to them and are not generally geared toward more stabilized real estate investments.

 

Working capital requirements for joint ventures. There must be a written plan that designates funds for acquisition, construction, or substantial improvement of the tangible property. A written schedule is required for the planned use of funds, in a commercially reasonable manner, within 31 months of receipt by the joint venture. The joint venture must use the funds in a manner that is substantially consistent with the schedule.

 

The Working Capital Safe Harbor states that the property that is being constructed or improved with the working capital will be considered to meet certain qualifying tests while the construction or improvements are in progress. Additional clarity on these requirements is likely to come from the Treasury Department as more clarifications are requested by investors.

 

Exit requirements. As previously noted, exit conditions are as follows:

 

• 5 years: 10 percent of the deferred gain is forgiven

• 7 years: 15 percent of the deferred gain is forgiven (An investor must invest in a QCF no later than Dec. 31, 2019.)

• 10 years: 100 percent of the deferred gain is forgiven
   

The 10-year hold is the minimum holding period to receive the full capital-gain benefit. At present, the latest possible year to exit the Opportunity Zone investment is 2047; however, this date could be subject to change, according to Duval & Stachenfeld.

 

Provided the QCF structure is set up according to the current guidelines, an investor should be protected even if future regulations change.

 

 

 

 

 

 

 

 

 

 

 

Navigating the New Tax Landscape

 

The changes that result from tax reform likely will impact a significant number of healthcare real estate owners that implement investment strategies based on previous rules around deductions. They also will have implications for real estate owners seeking to sell property and avoid capital gains taxes. View other articles in this series for essential information on these changes and action steps to consider.
 

For more information on the information presented in this article, contact us.

Disclaimer

 

This article has been prepared for informational purposes only. H2C does not provide tax or legal advice. All decisions regarding the tax implications of investments should be made in consultation with your tax advisor.