The Round 2 Regs
The much anticipated second round of OZ regulations (Round 2 Regs) arrived on April 17, 2019 and provided a number of important clarifications, most of which are favorable to taxpayers, especially for operating businesses that are started in, or move into, an OZ. But of utmost interest to NYREJ readers are those aspects of the Round 2 Regs that boosted the prospects for real estate development and operation.
Must the investment be “locked up” for a full ten years? Or can an OZ Fund mortgage the property and distribute loan proceeds to the investors without the investors losing their OZ benefits? Prior to the issuance of the Round 2 Regs, the most optimistic speculation was that investors would be allowed to extract no more than the appreciation in value of the property from the date of their investment. But the Round 2 Regs came down even more favorably for taxpayers.
The investor begins with no basis from the capital gain proceeds constituting the tax-privileged OZ investment. If and when the investor has remained in the OZ investment for five years before December 31, 2026, the investor receives basis equal to 10% of the OZ-privileged investment of capital gain proceeds and an additional 5% if in the investment for seven years prior to December 31, 2026. On December 31, 2026, the investor must recognize and pay tax on the full OZ-privileged investment amount minus any basis then existing. At that point, in most circumstances, the basis will be equal to the amount of the investment.
Thus, prior to January 1, 2027, the investor will have a very small basis if any—from equity. However, the investor could gain basis from the investor’s proportionate share of properly structured OZ Fund debt and thus be allowed to extract debt-supplied funds to the extent of basis (as juiced by the debt). For example, assume that in year 4 of the investment (i.e. before either the 10% or extra 5% basis addition has triggered) an investor becomes entitled to allocation of $100,000 of mortgage debt incurred by the fund for the purpose of making a cash distribution to the investors. The investor could receive a $100,000 distribution from financing proceeds without an immediate tax hit1.
Investors must be careful about the timing of the financing/distribution transaction. If it occurs too soon after the investment, it might be regarded as a sham investment. Many consider a two-year waiting period to be adequate. However, waiting for however long it takes to achieve true stabilization is the best course to take.
Existing Owners/Projects Under Construction/Leasing
We thought it likely that projects under construction and sold to an OZ buyer prior to issuance of a TCO would qualify as “original use” for the OZ buyer but were hoping to receive clarifying comfort on that very important issue. The Round 2 Regs delivered that comfort.
The OZ statute requires that a property must be purchased after December 31, 2017 by an unrelated party (the existing owner having no more than 20% ownership in the buyer) to be eligible for OZ benefits. This just does not work for the existing landowner in many situations—for example, where the existing landowner wants to continue to control the development of the property or just does not want to sell. However, the Round 2 Regs clarified that a property could be leased by the existing owner to a related party tenant. This is by no means a perfect solution but does give the existing landowner more room to maneuver.
But Some Sour Notes
Not a surprise but less than optimists hoped for—the Round 2 Regs state that “merely entering into a triple-net-lease” does not constitute an active trade or business eligible for OZ benefits. We will need to figure out exactly how to get beyond the “merely.”
And in a real surprise the Round 2 Regs state that gains from the sale of “1231 property” (real or depreciable property used in a trade or business, the source of most of the gains from the sale of real estate) can only be invested in the 180 days starting on the last day of the tax year of sale (i.e. the first 180 days of the following tax year), and not in the 180 days immediately after the sale. Most taxpayers are on calendar years. This could significantly reduce OZ investments from July thru December of each year, and, if applied retroactively, disqualify some investments already made.
Treasury has indicated that there may not be another round. That sound you heard is the train leaving the station…
1 Note, however, that the distribution would reduce the investor’s basis again to zero, which would affect the investor’s ability to deduct losses including depreciation deductions until the investor’s basis increased (either as of December 31, 2026, as a result of Fund income being allocated to the investor, or by sale of the property following the 10-year holding period).
Dan Flanigan is managing partner of the New York office of POLSINELLI.
Flanigan and POLSINELLI have provided the above material for informational purposes only. The material provided is general and not intended to be legal advice. Nothing in the material should be relied upon or used without consulting a lawyer to consider your specific circumstances, possible changes to applicable laws, rules and regulations and other legal issues. Receipt of this material does not establish an attorney-client relationship.