In this episode of Tax Notes Talk, Jessica Millett of Hogan Lovells discusses the proposed changes to the Opportunity Zone program under the House version of the One Big Beautiful Bill Act and how the Senate might react.
Tax Notes Talk is a podcast produced by Tax Notes. This transcript has been edited for clarity.
David D. Stewart: Welcome to the podcast. I’m David Stewart, editor in chief of Tax Notes Today International. This week: open to new opportunities.
We’ve been covering the House’s One Big Beautiful Bill Act and its changes to tax administration. This week, we’re continuing our deep dive and exploring how the reconciliation package would affect the Opportunity Zone program.
Opportunity Zone legislation was originally enacted in the Tax Cuts and Jobs Act to provide incentives for investment in low-income areas. The new bill aims to improve the program, including making changes to reporting requirements and key definitions.
Here to talk more about this is Tax Notes contributing editor Marie Sapirie. Marie, welcome back to the podcast.
Marie Sapirie: Thanks. It’s good to be here.
David D. Stewart: Now, I understand you recently talked with someone about this. Who did you talk to?
Marie Sapirie: I did. I spoke with Jessica Millett, a partner at Hogan Lovells. Jessica has extensive experience in real estate transaction tax issues generally, and in the Opportunity Zone program specifically.
David D. Stewart: And what all did you talk about?
Marie Sapirie: We discussed many of the details of the changes to the Opportunity Zone program in the House’s version of the One Big Beautiful Bill Act. This is a highly timely conversation because we’re expecting the Senate version to be released soon, so having all of the background on how the House approached the extension and revision of Opportunity Zones in mind will be helpful in understanding any changes the Senate might make.
David D. Stewart: All right, let’s go to that interview.
Marie Sapirie: Thank you, Jessica, for joining us today to discuss the proposed changes to the Opportunity Zone program in the budget bill that Congress is currently working on.
Jessica Millett: Thank you, Marie. I’m really happy to be here with you all.
Marie Sapirie: The budget bill has passed the House with a renewal and extension of the Opportunity Zone program, and it is currently in the Senate, where further changes to the bill are anticipated.
Since our focus today are the changes to the Opportunity Zone program, it might be helpful to review the Opportunity Zone program to this point. So would you tell us a bit about the history of Opportunity Zones up to the recent proposal?
Jessica Millett: We’ll call it OZ 1.0, the initial version of the Opportunity Zones program that came to life with the Tax Cuts and Jobs Act. The first part of that program was the designation of the zones themselves. And obviously that’s important because it’s important to know where those zones are; that governs the whole rest of how the tax incentive works. But it was a relatively short-lived piece of the OZ program.
The designation process all took place in the first half of 2018, and the way that it worked is the governors of each state were able to designate a certain percentage of their low-income census tracts as Opportunity Zones. They were able to designate 25 percent of those low-income census tracts. And for this purpose, the definition of low income piggybacked off of the definition of low income for purposes of the new markets tax credit, and they looked there to factors such as poverty rates and median family income in the relevant census tracts.
The other wrinkle, I would say, in terms of the designation process the first time around is that certain contiguous census tracts could be nominated as Opportunity Zones. And what that means is that if a particular census tract itself did not meet the definition of low income but was contiguous to a census tract that did meet the definition of low income, then that contiguous tract could be nominated as long as it didn’t have median family income over a certain hurdle amount. So we’ll talk about that in a minute, when we get to the new program.
Those are the zones; they were designated in 2018. They have remained the zones throughout the entire program, even though we’ve had a new census since then. And so they are in effect now until, asterisks — they were supposed to be in effect until 2028. But again, we’ll talk about that.
Marie Sapirie: So the rules for deferring capital gains through investments in qualified opportunity funds are prescribed in section 1400Z-2. Since you’ve talked about the designation part, could you talk about how the statute generally works in its current form?
Jessica Millett: For sure. So, 1400Z-2 and the supporting regulations, which came out over the course of several years after 2017, they are really the bulk of the OZ qualification and compliance that everybody has been dealing with since then.
So I’ll break it down into a couple different buckets. So first, from the perspective of the investors, there are certain — obviously, people do this for the tax incentives, and so 1400Z-2 runs through the various tax incentives that an investor can achieve by investing in the OZ program. They include deferral of paying tax on certain eligible capital gains. For a while there was a basis step-up, which was essentially complete elimination of some of those initially invested gains if you invested early enough. And then there was a complete elimination of gains on the new project, new development in the Opportunity Zone as long as an investor had stayed in for at least 10 years. So there were lots of rules and qualifications around all that.
You jump down a level to the qualified opportunity fund rules, and the QOF is a required piece of an OZ structure. An investor has to invest their eligible gain directly into the QOF to get the tax benefits, and QOFs have an asset test they need to meet. They can only be certain types of entities — corporations or partnerships for tax purposes. And the rules also cover the penalty if a qualified opportunity fund fails to meet its asset test.
So if you go down one more level, you get to the actual qualified Opportunity Zone business [QOZB] level, and most OZ structures are set up with a QOF investing in a QOZB. And the QOZB is really where the heart of the OZ development happens. So if it’s a real estate project, the QOZB is the entity that has to acquire the property, improve the property, develop the property, if you happen to be doing an operating business and the business itself is within the QOZB. So there’s a lot of rules there, including a tangible property test, which is very relevant, of course, for real estate projects. There are rules relating to the working capital safe harbor, which is a very important compliance piece. There’s rules — there’s an antiabuse rule also baked into 1400Z-2, so there’s a lot to parse through. It can be a tricky structure sometimes.
Marie Sapirie: So let’s turn to the proposed changes in the House bill. First, the bill provides for a new round of designations and revises the process. Would you tell us how the new round would work?
Jessica Millett: Sure. So the process itself appears to be largely the same as the first time around, meaning that the governor of each state would be able to designate, again, 25 percent of the low-income census tracks in his or her state to be Opportunity Zones. However, importantly, instead of by merely piggybacking off of the definition in the new markets tax credit rules, the bill introduces some changes to the criteria to be a low-income zone.
So the first time around, for example, a census tract qualified as a low-income zone if the median family income was no greater than 80 percent of the median family income in the relevant state or metropolitan area. They’ve now, in the House version of the bill, dropped that to 70 percent. So you’re in a situation where your pool of eligible zones is smaller.
There were some other nuances, too, including the fact that this time around they’ve eliminated the ability to nominate those contiguous tracks that we spoke about a moment ago. So I’ve seen some estimates floating around — I haven’t crunched all the numbers myself — that the pool of eligible zones is potentially decreased by something like 20 to 30 percent, but you can still only nominate 25 percent of them. So that’s something that a lot of people are disappointed in because you’re reducing the number of overall Opportunity Zones in OZ 2.0.
Marie Sapirie: There are also proposed changes to focus more tightly on rural areas. Would you explain how those rules would work?
Jessica Millett: Yeah, for sure. There was some proposed legislation that was introduced a couple of years ago to create a mirror rural Opportunity Zone program. And so a lot of the provisions in the House bill related to rural zones pull from that proposed legislation. But essentially, the requirement is that at least 33 percent of the designations in any one particular state have to be rural census tracks, and the definition of rural for this purpose is determined on the basis of the Consolidated Farm and Rural Development Act. And so they really want to make sure that there’s a focus on having these OZ investments be a little bit more geographically diverse than they’ve been in the first round.
One of the big criticisms that has been hurled at the Opportunity Zone program is that a lot of the developments and projects that have been done have been projects that would’ve been done otherwise, and they’re projects in gentrifying areas, metropolitan areas, etc. So this time around, they really wanted to make sure that more rural areas received the benefit of Opportunity Zone investment, as well.
Marie Sapirie: Also under the existing programs, only capital gains can be invested, but the House bill expands that. What are the parameters of that change?
Jessica Millett: Yeah, this is a change that a lot of people had been asking for, as well, in a way to democratize the program a bit. One of the other criticisms is that, well, if you need capital gain to invest, your pool of investors is fairly limited. And wouldn’t it be nice if you could give everybody the ability to invest in the OZ program?
However, the way that the House addressed this has been really panned almost universally from everybody that I’ve spoken with, because they give individuals a one-time $10,000 lifetime amount that you can invest into a qualified opportunity fund. But from a fund perspective, if you are really wanting to invest in a fund, $10,000 is far below the minimum required investment that I’ve seen in any fund, whether qualified opportunity fund or otherwise. And again, it’s not like it’s an annual investment amount; it’s a lifetime investment amount. So people seem pretty disappointed that this really isn’t going to move the needle.
Marie Sapirie: The proposed second round would result in new zones in 2027, but the current program sunsets at the end of 2026. Could you talk about the effect of that timing?
Jessica Millett: Yes. So as you mentioned, the new round runs from January 1, 2027, until December 31, 2033. So there’s no overlap of the two programs. I’ve got some thoughts on why that’s not the best idea. But in terms of the mechanics of the program, first and foremost, the zone designation process happens in the first part of 2027, and the inclusion date for any investments made in this new round is December 31, 2033.
One of the incentives that the OZ 1.0 offered, as I mentioned a few minutes ago, was this basis step-up concept. And so in the first round there was a 10 percent basis step-up for investments that were made by the end of 2021, and there was a 15 percent basis step-up if you invested by the end of 2019. So again, it really incentivized people to invest early in the program.
Here, there’s no 15 percent basis step-up, but there is a 10 percent basis step-up. So in order to be eligible there, you would need to invest by the end of 2028 to get that 10 percent basis step-up. And notably, in relation to the rural qualified opportunity program that they are introducing, that basis step-up would be 30 percent if you had invested in a rural qualified opportunity fund.
The other element of the program in terms of mechanics, focusing on the rural zones for just a second, is that in OZ 1.0 one of the ways that you could have qualifying property was by meeting the substantial improvement test. And so the scenario there is, if you buy an existing building that is in an Opportunity Zone, if you make significant capital improvements such that you double your initial cost basis of the building, you’ve substantially improved the building and its qualifying property. That’s still the test in the second round, except if you’re in a rural zone, then the substantial improvement threshold drops to 50 percent. So they’re making it a little bit easier to qualify for the substantial improvement tests in rural zones.
Marie Sapirie: And are there any other timing concerns with the new program?
Jessica Millett: Yeah, there’s a couple of things in particular that people are worried about. So first of all, as you mentioned, OZ 1.0 ends at the end of 2026, and this new program doesn’t start until 2027. And the zones themselves, that zone designation process, doesn’t even kick off until January 2027. So you’re not going to know the new zones until mid-2027 at the earliest.
That creates a little bit of a disincentive in terms of capital raising and investment in the Opportunity Zone program. You end up with this weird dead zone. So if you have gain — or I should say, if you are flexible in terms of when you can trigger your gain or when you want to invest it, etc., etc. — then there’s an incentive to wait and invest in 2027, because then you get the deferral until the end of 2033, as opposed to trying to invest now.
The corollary concern adjacent to that is, what happens with the first-round zones? In the legislation from the Tax Cuts and Jobs Act, the zones did not expire until the end of 2028. There’s always been some questions around, well, what happens after 2028? But at the very least, if you are a qualified opportunity fund and you are looking at acquiring a site to do a development in one of the OZ 1.0 qualified Opportunity Zones, at least you know that you have a few years until the end of 2028. Even if you don’t raise capital until 2026, you have some time to make a qualifying investment in property that’s in a qualified Opportunity Zone.
But in the House version of the bill, they accelerated the expiration date for the first-round zones until the end of 2026. And that’s given people a real heartache because now you’ve introduced even more uncertainty. And so, again, if you have a capital gain that you realize on December 31, 2026, then technically you have until mid-2027 to even go and invest that into a qualified opportunity fund. But if the zones are all expired at that point, there’s some real uncertainty in terms of whether you’ll even be able to make a qualifying investment if all the first-round zones have expired. So people are really hoping that the Senate will iron out some of those transition rules to make it clear that the first program does still have a few years to run, and it doesn’t really make sense to cut it off earlier than needed, artificially.
Marie Sapirie: One of the pieces of the original program that was removed from the original bill because of the Byrd rules for the budget process was the information reporting requirements, and this bill attempts to put them back in. Would you tell us about those rules?
Jessica Millett: Yeah, so there are different reporting requirements and different anticipated reports in a couple of different places. So first of all, at the QOF level, each QOF would have to file an annual return, including basic information and what’s your tax classification, etc., and then getting more granular in terms of what’s the value of your total assets, what’s the value of your qualified Opportunity Zone property that you hold?
And then with respect to each QOZB that QOF is invested in, you then have to include — again, according to the proposed legislation — information about the underlying QOZB, the different industry in which the QOZB has its trade or business, the relevant zone where the property is located, the amount of investments. Also, they’re asking for relevant employment information, in terms of the average number of employees of the QOZB or other indicators of employment impact. So they’re asking for a good amount of information from the QOFs.
For the QOZBs, interestingly, they didn’t get into too much detail in the proposed legislation. They punted it to regulations. But I suspect that the information that the QOZBs would have to provide is going to be similar to the information that the QOF needs to provide with respect to those QOZBs. So I think we have a good sense about what to expect there. There are some penalties for failing to comply with the reporting requirements.
And then I think the most important one is that the legislation would require Treasury to issue a public report starting in year 6, and then year 11. And in both of those years — years 6 and 11 — after the legislation has passed, Treasury would have to include a five-year comparison showing different factors with respect to each of the zones. They would have to show the unemployment rate, the number of workers in each particular zone, the poverty rate, median family income, other demographic information.
And I think that’s what a lot of people have been asking for. How do we know if this program is working? And without that data, it’s easy for people to attack the program, and it’s hard for defenders of the program to defend the program. So that would be great if we had it.
Marie Sapirie: What other items were investors and opportunity funds and businesses looking for that weren’t included in the House proposal?
Jessica Millett: So a lot of people had been asking for permanence in the OZ program, or if not permanence, at least some sort of — maybe like a rolling deferral period. Because, again, the way that the OZ programs — OZ 1.0, and now proposed OZ 2.0 — are set up, you have a hard cliff date at the end, and so that’s your inclusion date no matter what. And it means that the value of the tax incentive decreases the closer you get to that date because you no longer get the deferral benefits. So a lot of people have been hoping that there would be a rolling deferral mechanism.
A lot of the OZ investments have been made in real estate. I have seen some operating business QOZBs, but the rules really don’t always work so well. One of the big reasons why the rules don’t work so well is the 10-year hold. So if you go and you start this brand-new great company in an incubator, if somebody comes and offers to buy your company because they think it’s great and has a lot of potential, are you really going to say, “Oh, come back in eight-and-a-half years?”
So a lot of people have been hoping for a situation like that that they would allow an interim gain reinvestment type concept, so that you could roll over your proceeds into a new business. We didn’t get that. The fund of funds proposal has been out there for a while, and that would allow QOFs to consolidate for purposes of investing. There’d also been a request for allowing investments in CFDIs [community development financial institutions] to help dovetail with the new markets program, as well as perhaps some more leniency when it comes to affordable workforce housing, given that much of the country is in a housing crisis at the moment. So those are all a bunch of the things that I know had been asked for.
Again, we’ll see if the Senate picks up any of this, but I think at this point, having seen OZ 2.0, a lot of people are really focused in particular on transition rules and just making sure that OZ 1.0 and OZ 2.0 really dovetail with each other and OZ 2.0 doesn’t cause an immediate freeze in terms of current fundraising or current Opportunity Zone development.
Marie Sapirie: There is still a lot of work to be done before this bill gets over the finish line. Would you tell us what the next steps are and what we should be looking for in the Senate in particular?
Jessica Millett: Yep. So the Senate is going to have their crack at this bill. Among the OZ community, there’s a fair amount of optimism that some of these issues will get worked out. The first time around with the Tax Cuts and Jobs Act, there was no Opportunity Zone language at all in the House version of the bill; it was only introduced once the Senate got ahold of it.
And Sen. Tim Scott, this has been his baby for quite a while. I know that there’s been a lot of lobbying and congressional letter-writing trying to make sure that some of these key priorities are raised by the Senate. The one thing that I think everybody is also anticipating or keeping their eye on is whether the reporting requirements are going to get stripped out again. They don’t strictly have a budget impact, which is why they had to come out the first time. So we’re eagerly hoping that some of them make it through this time.
Marie Sapirie: Well, thank you so much for joining us on the podcast today.
Jessica Millett: Happy to be here.
Read the full article here