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An investment in a Qualified Opportunity Fund that is in turn invested within a Qualified Opportunity Zone is entitled to certain tax deferral of capital gains, certain basis step-up and, if held long enough, the ability to not have to pay tax on the appreciation of investment within the fund beyond the initial deferred gain.
On December 22, 2017, as part of Congress’ House Resolution 1, the concept of a Qualified Opportunity Zone (QOZ) was added to the toolbox of potential community development tools. In this Alert, we explain what a QOZ is and offer strategies to help real estate developers take advantage of the benefits of QOZs. In short, an investment in a Qualified Opportunity Fund that is in turn invested within a QOZ is entitled to certain tax deferral of capital gains, certain basis step-up (which will lower tax on sale/disposition) and, if held long enough (10 years or more), the ability to not have to pay tax on the appreciation of investment within the fund beyond the initial deferred gain. As explained below, QOZs are in low-income areas; thereby, investment in these areas is incented by the creation of the ability to defer gain within them.
What is a Qualified Opportunity Zone?
A QOZ is a census tract that is located in a low-income community (LIC), i.e., an area designated as such due to it having a 20 percent poverty rate. The qualification process to designate QOZs will end on March 21, 2018:
• QOZs must be located within a LIC as shown on the census map.
• The governor of each state must nominate their desired LICs to the U.S. Treasury Department by
March 21, 2018. Each state may only nominate up to 25 percent of the eligible LICs within a given state, noting that up to five percent of the 25 percent may be non-LIC tracts that are contiguous to other applicable LICs.
What is the Benefit of a Qualified Investment in a Qualified Opportunity Zone?
If designated as a QOZ, the bill allows investors to defer short- and long-term capital gains realized on the sale of property if the capital gain portion of the sale or disposition is reinvested within 180 days in a Qualified Opportunity Fund (QO Fund).
Benefits of Investing Within a Qualified Opportunity Zone Fund
• Owners of low tax basis properties can sell these properties and defer the capital gains to the extent the gains are invested in a QOZ; and
• QOZs are likely to attract investor capital that is looking to defer capital gains, thereby making
the QOZs potentially more valuable than non-QOZ properties.
Recognition of Gain
• Gain is required to be recognized on the earlier of a disposal of the QO Fund investment or December 31, 2026.
• Gain is reduced over time in the following manner:
• The basis of the QOZ investment increases by 10 percent of the deferred gain if the investment is held for five years from the date of reinvestment; and
• The basis of the QOZ investment increases by 15 percent (i.e., an additional five percent) of the deferred gain if the investment is held for seven years from the date of reinvestment. In other words, the gain on which capital gains is paid is reduced to 85 percent of the original gain.
• Appreciation on investments within the QO Fund that are held for at least 10 years are excluded from gross income (i.e., if held for 10 years, the appreciation is not taxed).
What is a Qualified Opportunity Fund?
A QO Fund is an investment vehicle that is organized as a corporation or partnership for the purpose of investing in a QOZ property that holds at least 90 percent of its assets in QOZ property. Note, there are presently no limitations on the amount of the investment, and there are no overall limits on the total investment that the collective funds can make. Moreover, the QO Fund, if it so desires, could invest in Low Income Housing Tax Credit deals, historic tax credit deals and New Markets Tax Credit deals if it so desired within the QOZ.
Qualified Opportunity Zones Viewed as an Economic Tool
The permitted creation of a QO Fund that can: 1) receive appreciated property within 180 days of a sale or disposition; 2) appropriately shelter it with an applicable investment within a QOZ; and 3) enable up to 15 percent of the gain to be deferred until sale of the investment or December 31, 2026, enables a 15 percent increase in the basis of the asset that is subject to gain recognition, which results in a very powerful means to reduce applicable tax.
Moreover, if one does not sell or dispose of the property within the QO Fund in the QOZ for 10 years or more, the appreciation of such property (beyond the initial deferred gain, which is taxable), will be not be subject to tax. This potential to appropriately avoid capital gains on a future sale should encourage funds to be invested in QO Funds that will in turn invest in QOZs. These QOZs, as noted above, will be in LICs that might not otherwise have seen such an investment, which should thereby act as an economic driver within these more difficult investment areas.
Owners of properties within LICs should be considering whether to reach out to the applicable governing authorities within their state to have their properties tendered by their governor for inclusion within the QOZ designation. If a property is not proposed as a QOZ by March 21, 2018, the opportunity to be designated as a QO Z is likely to be lost forever (absent a future reopener, which is unc ertain).
Attorneys in the Real Estate Practice Group and the Corporate Practice Group at Duane Morris will continue to monitor and provide updates on any related developments once applicable regulations from the Treasury Department are issued.
If you have any questions about this alert, please contact Brad A. Molotsky, Arthur J. Momjian, any of the attorneys in the Real Estate Practice Group, attorneys in the Corporate Practice Group or the attorney in the firm with whom you are regularly in contact.
Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm’s full disclaimer.
There have been some proposed modifications to the Philadelphia Mixed Income Housing Bill. On June 22, 2017, City Councilmember Maria Quiñones-Sanchez introduced a bill proposing to provide for new affordable housing requirements in Philadelphia in the commercial real estate context. The bill, as originally drafted, would amend the Housing Code to require residential developers to include affordable housing units in their new and redeveloped residential projects. In return, developers would be rewarded with height and floor-area ratio bonuses. Since its initial introduction in June, the bill has been recently modified by its sponsor as part of the Planning Commission review process, resulting in certain substantive changes to its original form. A November 27 public hearing revealed dissension against the bill from neighborhood groups, housing advocates and developers, resulting in Councilmember Quiñones-Sánchez putting a hold on the bill. Further amendments to rectify the differing viewpoints are to be expected, and another hearing as well as a vote has been scheduled for December 5, 2017.
Background of the proposed modifications to the Philadelphia Mixed Income Housing Bill
Legislating affordable housing requirements in the commercial/residential real estate context is not a new trend in major cities nationwide. San Francisco and New York City, for example, have long had robust mixed income housing programs. Given Philadelphia’s high poverty rate, city officials view this bill as a way to provide increased affordable housing to its residents while still recognizing and meeting the needs of private developers.
Philadelphia Mixed Income Housing Bill NO. 170678
The bill directs private developers of new residential projects or substantially rehabilitated projects containing more than 10 units to set aside 10 percent of the units for affordable housing. The amended bill specifies, however, that its affordable housing requirements do not apply to student or subsidized housing. Under the original bill, the affordable units would have been available to prospective renters whose incomes were between 30 percent and 50 percent of the area median income (AMI) and to purchasers between 50 percent and 80 percent of the AMI, depending on the location of the units. Now, under the amended bill, the units would be available to prospective “low income” renters at or below 50 percent of the AMI and “moderate income” renters at or below 60 percent of the AMI. The amended bill would also make the units available to prospective “low income” purchasers at or below 70 percent of the AMI and “moderate income” purchasers at or below 80 percent of the AMI.
Originally, the bill applied to the entire city; as amended, however, the bill would only affect high-density zoning districts of RM-4, RMX-3, CMX-3, CMX-4 and CMX-5. These modifications result in both the affordable housing requirements and the incentives offered being inapplicable in zoning districts other than those listed above. The bill defines an affordable unit as one whose cost—whether rental or purchase—is 30 percent or less of the applicable maximum qualifying income level. These units were initially proposed to them should they opt to build affordable units. The amended bill grants substantial height and floor-area bonuses to developers who incorporate the affordable housing proposals, although the specifics of these bonuses may change in the next version of the bill. These developers will have enhanced development opportunities as a result of their assistance in providing homes to a wide range of Philadelphians.
The bill, if passed into law, would go into effect on July 1, 2018. Should it pass, the bill will not apply to construction pursuant to valid zoning permit applications that were filed prior to the effective date. Currently, a Rules Committee public meeting and the vote on the bill have been set for Tuesday, December 5, 2017.
Want More Information about the proposed modifications to the Philadelphia Mixed Income Housing Bill?
This Alert has been authored by Aaron R. Feinblatt, an associate in Duane Morris’ Real Estate Practice Group. If you have any questions about this Alert or otherwise, please contact Brad A. Molotsky at 856-874-4243.