Qualified Opportunity Zones (QOZs) were created to drive economic investment and job creation in distressed areas so as to spur economic growth. The tax incentives given to invest in QOZs include: (1) deferral and reduction of capital gains tax, and (2) a possible tax exemption on the growth of the QOZ investment–both of which constitute powerful tax benefits to the investor. Though QOZ investments must be located within a properly designated Opportunity Zone, the investments are not limited to real estate, which gives investors flexibility in structuring their specific QOZ deal.
However, there are very specific and complex rules that must be followed in order to qualify for the QOZ tax benefits.
Due to the potential deferral of tax on capital gains and because they are often tied to real estate, QOZ investments may be confused with §1031 Like-Kind Exchanges which allow a taxpayer to sell a piece of investment real property and defer tax on the capital gains if the sale proceeds are timely re-invested in “like-kind” real property. Like QOZs, §1031 transactions are subject to very precise rules. The §1031 tax deferral allows a real estate investor’s investment to grow from one property to the next without the investor immediately paying capital gain tax along the way. In a §1031 transaction, the investment must be in real estate but can be, and usually is, structured as a very low risk passive investment for the investor-landlord (e.g., via a triple-net lease under which the tenant pays all taxes, maintenance, and insurance on the property, in addition to rent).
Though there are similarities between QOZ deals and §1031 transactions, they are not the same. For example, a QOZ business investment must be an “active” trade or business. A §1031 transaction, on the other hand, can qualify for its intended tax benefits if the investor-landlord swaps one passive triple-net leased property for another. That type of passive real estate investment cannot qualify for QOZ benefits, though, because standard triple net leases, by themselves, do not qualify as an active trade or business. Afterall, the intent behind QOZs is to spur economic development and job growth, not to reward passive portfolio income with additional tax benefits.
Despite potential roadblocks, the tax benefits of QOZ investments have caused many real estate investors to try and fit a typical triple net real estate deal into the QOZ framework. Creative advisors are pushed to find ways to structure the deal to qualify as a QOZ investment that still achieves the investor’s desired economic outcome. The overarching idea to keep in mind is that the investment should be an active trade or business, not just a passive investment, and that the investor should have some risk.
The recently issued IRS regulations have indicated that triple net leases, in and of themselves, will not qualify as a QOZ investment. That is because in a triple net lease all the risk is pushed onto the tenant – obviously desirable from an economic standpoint for the landlord-investor, but not considered an active trade or business from the IRS’ perspective.
One way to try and capture the economic value of a triple net lease, but still leave some risk with the landlord, might be to gross-up the project’s rent but have the landlord pay for some or all of the typical triple net pass-through items. For example, rather than charging tenants $15 per square foot triple net, charge them $22 per square foot and have the landlord-investor pay for taxes, maintenance and insurance. That way the landlord-investor has the risk/reward if those triple net costs are higher or lower than the $7 increase in rent.
In addition, to further bolster the concept that the landlord investor is in an active trade or business, consider creating a consulting / strategic advisory role for the landlord in the tenant’s business. If these roles are legitimate and structured the right way, they may be sufficient to demonstrate the QOZ investment is not a typical passive real estate investment and is truly an active trade or business that is spurring economic growth and development within the QOZ.
Unfortunately, QOZs are still new and have yet to face significant IRS scrutiny such that reliable guidance is available to demonstrate the IRS’s position on these (and other) ideas. Investors weighing their options between a §1031 transaction and a QOZ project should consult with competent advisors to make sure they get the right deal with the proper economic structure that maximizes the associated tax benefits.
