Anticipation is growing about the promise of the so-called Opportunity Zone program created under The Tax Cuts and Jobs Act, signed into law Dec 22, 2017. The provisions of the Act that established the Opportunity Zone program were included in the massive tax code overhaul to help create a framework for investments in economically distressed areas. In short, the Opportunity Zone program allows qualified U.S. investors to defer and potentially avoid tax on unrealized capital gains if they reinvest their unrealized capital gains in a Qualified Opportunity Fund. If the program delivers on its promises, some of the billions of unrealized capital gains might be liberated to fund projects in economically depressed areas. 

The Opportunity Zone program creates opportunities and potential challenges for members of the construction industry. Contractors and design professionals are strongly advised to think about the impacts of the program if they participate in projects subject to the program’s rules. Among other things, the Act requires Opportunity Zone projects to be to be “substantially improved,” creating opportunities for builders to bid on and win projects in new areas. However, with some exceptions, the projects must be substantially improved in a specific period of time, creating potential for owners to shift the risk of not completing a project in the period of time to the general contractors.

In short, the Act allows a taxpayer to elect to defer taxes on the gains from property sold in 2018 and later by investing the gains in a Qualified Opportunity Fund. A fund is a private investment vehicle, which is treated as either a corporation or partnership for federal income tax purposes. A fund must be created solely for investing and holding its assets in Qualified Opportunity Zone Property. The fund must hold at least 90% of its assets in Zone Property, which includes Qualified Opportunity Zone Stock, Qualified Opportunity Zone Partnership Interests and Qualified Opportunity Zone Business Property.

Zone Property must be used in a Qualified Opportunity Zone Business, which is a trade or business meeting several tests.

First, substantially all of the tangible assets of the business must be used in a Qualified Opportunity Zone. Opportunity Zones are census tracts nominated by the individual states and approved by the federal government. The census tracts qualify because they meet the criteria specified in the Act, namely that they are low-income urban and rural communities. For example, there are more than 120 Opportunity Zones in Colorado, and the state deliberately attempted to diversify the zones that qualify. 

Second, at least 50% of gross income for the fund must come from the active conduct of a trade or business in the Qualified Opportunity Zone.

Third, the fund must hold a limited amount of investment property. Finally, the fund must not be engaged in owning or operating specific “sin” businesses. The deferral of gains is scheduled, and property must be held for five- and seven-year time periods to qualify for 10% and an additional 5%, respectively. Moreover, if the investment in the fund is held for at least 10 years, any additional gain is effectively reduced to zero. And, there lies the pot of gold that many developers in Opportunity Zones are eyeing. 

There are several potential opportunities for builders, including a promise of new construction in markets that have not benefited from the long run of prosperity. There are some clues that the Opportunity Zone Program may be particularly useful for investors and developers of multifamily housing by providing additional unconstrained incentives for investment, and builders who have specialized in those areas might find new opportunities to add projects. For example, the Act appears to provide some advantages over the New Markets Tax Credit (NMTC), which has been instrumental in driving multifamily investment in similar areas. The NMTC is subject to an annual allocation limit ($3.5 billion per allocation round), and the limits can freeze out investment in certain low-income communities in a given year. The Opportunity Zone Program does not have an allocation limit. Further, it does not presently appear that the program has restrictions on investment in rental real estate.

Finally, the Act might create an opportunity for contractors and design professionals to benefit from the Opportunity Zone Program—just like any other investor. If a contractor has capital gain tax liabilities that it might seek to defer and possibly reduce, they could approach their owner-clients with the possibility of investment in the project. The Act requires their investment to be in cash, so there will be constraints on how these co-investment deals might be structured. In addition, the Act provides tax incentives not just to developers of real property, but also to companies that invest in Opportunity Zones. A new construction firm that locates their business in an Opportunity Zone, for example, might be able to take advantage of capital gains tax deferral and possible reduction.

The Act has imposed a number of restrictions on investment. Among other things, the period in which “substantial improvement” is to be completed in just 30 months after acquisition. Even moderately complex development projects will tend to eat up a good chunk of that 30-month period in entitlements and permitting. Contractors should be wary of sharing risks with an Opportunity Zone developer and confirm that their obligation to complete will not result in damages related to the developer’s failure to take advantage of the tax savings. Although clauses limiting consequential and incidental damages may address this matter, it is a good practice to call out tax liabilities in a contract. The Treasury Department is eyeing regulations that might liberalize the 30-month requirement, but builders should still be wary.

However, regulations are yet to be issued, and there is still uncertainty about how the program will function. The U.S. Department of Treasury has been tasked with preparing implementing regulations but, as of this writing, none have been released.