Funding Improvements to Existing Buildings in Opportunity Zones
(As it appeared in the February 2019 issue of Properties Magazine under”Vantage Point” – pages 71 & 72)
There is growing interest in the redevelopment of existing buildings located in Opportunity Zones as a result of the new tax incentive created as part of the Tax Cuts and Jobs Act of 2017. As discussed below, any redevelopment plan must be carefully considered to determine if it will meet the specific requirements of the opportunity zone program.
The tax incentive generally allows a taxpayer to sell an asset and defer the payment of capital gains tax on the sale by reinvesting cash equal to the gain amount in a so-called Qualified Opportunity Zone Fund (“QOZ fund”). The deferral of the capital gain extends to the earlier of the sale by the taxpayer of the QOZ investment or 2026, whichever is earlier. Additionally, if the taxpayer holds its QOZ investment for at least 10 years, the taxpayer may sell the QOZ investment without incurring further capital gain on the appreciation of the investment. Generally, it is relatively straight-forward to create a QOZ fund by private parties and a fund may be created simply to reinvest in one or more buildings located in an opportunity zone.
For these tax benefits to be realized by an investor, the QOZ fund must meet certain requirements, including that substantially all of the QOZ fund assets consist of “qualified opportunity zone property.” Real estate, as well as tangible personal property, located in an opportunity zone generally qualifies provided it is either new when purchased by the fund, or “substantially improved” by the fund. One of the challenges for a QOZ fund is the requirement that a purchased building be “substantially improved,” which requires that the fund make additional capital improvements to the building at least equal to the fund’s acquisition cost for the building. For example, if a QOZ fund purchases a building for $400,000, the QOZ fund would need to make further improvements of an additional $400,000 within 31 months of purchase, making its total investment $800,000. The amount of the additional improvements is computed only with regard to the fund’s cost in the building, exclusive of the land. Under Treasury Department proposed regulations, an existing building would have to be purchased through the QOF after 2017, be substantially improved within 31 months of purchase, and continue to be used by the QOZ fund in the opportunity zone throughout its ownership.
There may be several ways to fund the improvements, depending on the plan for redeveloping the property. Where the building is purchased by the QOZ fund, the fund may raise capital investment or borrow from a third party to fund the improvements. This would be the case for a multi-tenant building, whether commercial or residential, or for a single tenant building where there is no tenant participation in financing the improvements.
Alternatively, where the QOZ seeks a business tenant for the property, such as a manufacturer, the improvements may be a “build to suit” arrangement that takes into account the specific build-out plans of the tenant. The tenant improvements may be either landlord or tenant-financed, or some combination thereof. Landlord-financed improvements would typically qualify as additional investment by the landlord in the building and reflected on the landlord’s balance sheet as a depreciable real estate asset. If the improvements are tenant-financed, the tenant improvements would not qualify for the “substantial improvement” requirement for the landlord if the tenant is viewed as owning the improvements. For example, if the lease provides for the tenant to pay for some or all of the tenant improvements, the improvements might not be treated as owned by the landlord, because the landlord did not pay for the improvements and has no obligation to reimburse the tenant for the costs. If the goal is for the tenant improvements to be owned by the landlord to meet the substantial improvement requirement for the building but the tenant will fund the cost of the improvements, the parties may wish to structure the funding of the improvements as a loan from the tenant to the landlord that will be repaid by the landlord in accordance with a specific repayment schedule. Also, the lease should specify that the parties intend for the landlord to be the owner of, and entitled to depreciate, the tenant improvements.
Furthermore, there may be circumstances where making additional substantial improvements to an existing building located in an opportunity zone is uneconomical. For example, a building may be currently functional, or recently renovated, so that it does not need further substantial improvements. If this is the case, the building could not be qualified opportunity zone business property. However, the tenant, rather than the landlord, may seek to become a qualified opportunity zone business provided that substantially all of its assets are qualified opportunity zone business property that are used in the conduct of a business in the opportunity zone. Any tenant improvements and other new tangible personal property (such as equipment and office furniture) that are owned by the tenant and used in the business likely would qualify as opportunity zone property for the tenant.