The New York State Brownfield Cleanup Program (BCP) has demonstrated how tax incentives can stimulate the development of contaminated properties. Now that the federal Internal Revenue Service (IRS) has designated over 8,700 Qualified Opportunity Zones (QOZs), contaminated sites in low-income areas across the United States may be able to benefit from this new federal tax incentive program.
The QOZ program was created as part of The Tax Cuts and Jobs Act of 2017. It is designed to spur investment in low-income and rural communities by allowing taxpayers to defer and potentially reduce taxes on capital gains. According to some estimates, the QOZ program could unlock an estimated $6.1 trillion in private capital investment towards distressed communities across the country. Even if only a fraction of this amount is ultimately invested, the QOZ program has the potential of becoming one of the largest community development initiatives in history.
In 2018, the Treasury Department and the Internal Revenue Service (IRS) issued proposed proposed regulations and a Frequently Asked Questions page for the QOZ program, which were supplemented by a Revenue Ruling. 513 of the QOZs are located in New York State. New York City has 306 of the QOZs with 94 in the Bronx, 124 in Brooklyn, 61 in Queens and 35 in Manhattan.
Like any tax incentive, the QOZ program is extremely complex so potential taxpayers should consult tax professionals before participating in these investment vehicles. The proposed regulations generated over 149 comments and questions remain if QOZ program needs to be further tweaked to facilitate brownfield projects. Following is a big picture description of the QOZ program and questions about how it may interact with brownfield projects.
The centerpiece of the opportunity zone legislation is a new type of investment vehicle called a Qualified Opportunity Fund (“QOF”) which can be organized as a corporation or a partnership. A taxpayer can invest the proceeds from a capital gain from the sale of nearly any asset (business, real estate, stocks, bonds, etc.) in a QOF and receives either stock or an interest in the QOF.
There are three basic types of tax benefits that are available to QOF investors.
Deferral of Capital Gains Tax – a taxpayer who has an investment that has appreciated, can postpone or defer 100% of capital gains taxes by investing a gain realized from a sale or exchange into a QOF within 180 days of the sale or exchange of stocks, mutual funds, or other investments such as sale of real estate or a business. The capital gains tax will be deferred until the date QOF investment is sold or December 31, 2026, whichever is earlier.
Reduction of Capital Gains –a taxpayer who invests in a QOF by December 31, 2019 will be able to reduce the taxable portion of its capital gains depending on how long the funds are held in the QOF. For capital gains held in an QOF for at least five years, the taxpayer will only be required to pay tax on 90% of the capital gain (in tax parlance, the investors’ basis on the original investment is increased 10%). If the funds remain in the QOF for two more years (total of 7 years), the taxpayer will only have to pay tax on 85% of the capital gain.
No Tax on Capital Gains- A taxpayer holding the investment in the QOF for at least ten years will not have to recognize any gain (i.e., pay capital gains tax) on the post-acquisition economic appreciation in its QOF interest so long as the taxpayer disposes of the investment prior to January 1, 2048. However, the taxpayer will still have to pay the deferred reduced taxes on the initial gain.
Questions About Real Estate Investments and Brownfield Projects
The proposed QOZ regulations provide that a QOF may invest in real property provided the “original use” of the property must commence with the QOF or the QOF must “substantially improve” the property within 30 months of acquisition.
“Original Use” Test
The enabling legislation did not define the term “original use. Revenue Ruling 2018-29 addressed the application of “original use” to a scenario where a QOF purchased a property with an idled factory building that the QOF intended to convert to residential rental property. The IRS concluded that the “original use” test was not applicable to the factory building because its use did not commence with the QOF even where the QOF intended to materially change the building’s use. However, it was possible that the redevelopment project could still qualify for the QOZ if the QOF satisfied the substantial improvement test (see below).
In the comments to the proposed rule and the recent public hearing, stakeholders urged IRS to clarify its regulations that if a building is unused or vacant for a significant period of time, a new investment in the building should be considered an original use for purposes of qualifying as Opportunity Zone property.
The EPA Office of Brownfields and Land Revitalization (OBLR) submitted a comment requesting that “original use” be redefined so that it applies to properties that meet the CERCLA definition of brownfield sites, properties that contribute to blight or create barriers to economic vibrancy due to prolonged vacancy or underutilization, that are vacant for at least one year or that have been foreclosed and held by a local government or land bank. EPA further suggested that the underutilized test apply to the entire property or to “a portion thereof … which is used only at irregular periods or intermittently.” According to EPA, this would help facilitate redevelopment at partially shutdown facilities.
“Substantial Improvement” Test
The proposed regulations provide that a QOF will be deemed to have substantially improved the property if it invests an amount equal to at least 100% of the cost basis (i.e. purchase price) of the property over a 30-month period. The Proposed Regulations and the QOZ Revenue Ruling clarify that the substantial improvement calculation only considers the cost basis attributable to the building(s) on the property (e.g. portion of the purchase price allocated to the building) and excludes the cost basis attributable to land.
At the recent public hearing, stakeholders asked IRS to extend the 30-month period for substantially improving a property because of the time it takes to obtain entitlement and regulatory approvals. Some commenters suggested the IRS create separate pre-development and construction periods. Without such an extension, stakeholders expressed concern that investors would be forced to invest in existing projects that are already entitled and that owners of those projects would likely charge a premium that may offset much of the tax benefit, thereby discouraging the very investments the QOZ program was designed to attract.
In written comments, EPA asked the IRS to extend the 30-month period for completing improvements because of the time it takes to complete demolition of existing buildings, excavation, cleanup and grading and other site preparation work.
EPA also suggested that funds applied to environmental assessment and remediation should be included when calculating if the developer complied with “substantial improved” test.
In addition, EPA requested IRS to allow gains realized from the sale of remediated property to be carried over into another QOZBP. EPA said this would allow an investor to sell a property it remediated to a vertical developer and allow the investor to reinvest the proceeds in another QOZBP
It is unclear how the “substantial improvement” test applies to the purchase of raw or vacant land. The proposed regulations had reasoned that that excluding the cost basis of land from the substantially improved calculation would facilitate repurposing vacant buildings in qualified opportunity zones. However, the IRS requested comments on whether vacant real property that is productively utilized after some period of abandonment could qualify as QOZBP. Specifically, the IRS asked:
- Should some period of abandonment or under-utilization of tangible property erase the property’s history of prior use in the opportunity zone?
- If so, should such a fallow period enable subsequent productive utilization of the tangible property to qualify as “original use”?
- Should the rules appropriate for abandonment and underutilization of personal tangible property also apply to vacant real property that is productively utilized after some period?
- If so, what period of abandonment, underutilization, or vacancy would be consistent with the statute?
It is anticipated IRS will address or clarify these issue when it issues revised proposed regulations in the upcoming months