Qualified Opportunity Zones have been a much-discussed topic since they were created by the Tax Cuts and Jobs Act of 2017. Two PICPA members from Drucker & Scaccetti in Philadelphia – Chris Catarino, CPA, MT, and Steven Rossman, CPA, MST – discuss the regulations and how CPAs can advise clients on these new investment incentives.

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By: Jim DeLuccia, PICPA Communications Manager

Podcast Transcript

Qualified Opportunity Zones, or QOZ, is a hot topic both inside and outside the CPA community. It's been that way since they were created by the Tax Cuts and Jobs Act of 2017 as a community investment incentive. I'm at the offices of Drucker & Scaccetti today to talk to two experts on this topic on what these QOZs mean for CPAs and their clients. I'm joined by Stephen Rossman, CPA, MST, who is a shareholder, and Chris Catarino, CPA, MST, who is a principal. First, gentleman, thank you both for allowing me to come to your offices to conduct this interview today. You guys are just a couple blocks down from the PICPA headquarters.

[Catarino] Totally our pleasure.

[Rossman] Yep. Thanks for coming down.

I know this topic, I've been hearing a lot about it personally, but there is no way that I can speak on it to any intelligent level like you both can, but I guess for the context and for purposes of the discussion, can you define Opportunity Zones for me, please?

[Rossman] Jim, I'd be happy to do that. As you mentioned, as part of the Tax Cuts and Jobs Act, there were two code sections that were added. 1400Z-1, which basically kind of defined the zones, and 1400Z-2, which defined the funding mechanism, which are called Qualified Opportunity Funds. For the Qualified Opportunity Zones they are lower economic income areas that were basically as part of the 2010 census. These lower economic areas were designated and incorporated into the selection process for the Opportunity Zones as part of the Tax Cuts and Jobs Act.

[Catarino] Yeah, and part of that selection process involved each state being designated a certain amount of those low income census tracks that they could choose to be qualified Opportunity zones. Each state had “x” amount that they can designate. And it was the governor's decision as to which zones that qualified would become Qualified Opportunity Zones. So as of, I believe it was June of 2018, each state had made their Qualified Opportunity Zone designations. At this point we have all of the Opportunity Zones have been designated so far. They don't appear at this point like they'll change over the next 10 years. What we have right now is what we'll have for the foreseeable future.

Great, I should identify for the audience there. That was Steve Rossman who spoke first and then we got Chris Catarino speak second there. What kind of opportunities and – pardon the pun here –challenges do these present to CPAs?

[Catarino] They carry a lot of opportunities for investors that are investing in the zones. There's three major tax benefits that are associated. The first being gain deferral. If an investor has a capital gain and then they make an investment into an opportunity fund, they can defer that capital gain until 2026, or until they sell their investment. The second tax benefit is as they hold their interest in the fund, if they hold their interest for five years, 10% of their original deferred gain gets forgiven. If they hold their interest another two years or seven years in total, another 5% gets forgiven.

They have the deferral, they can have a portion up to 15% forgiven as they hold it. And then in 2026 they would recognize that that remaining gain that was deferred or 85% of that remaining gain. And the third tax benefit is the real home run, which is if an investor holds their investment in a fund for 10 years or more and then sells their interest in the fund, they don't pay any tax on the appreciation in the fund. That's a real benefit there. The deferral is great, the forgiveness is a nice benefit as well, but the real incentive is to make a long-term investment in the area so that upon sale after 10 years, the full amount of appreciation is non-taxable.

Steve, did you have anything to add to that?

[Rossman] Chris pretty much hit it on the head. But yeah, the, the, right now what we see as those benefits. There's also some challenges as well, specifically that 10-year hold that Chris mentioned, there is some ambiguity as to how you can exit the investment after the 10 years to make sure you get that tax free appreciation. While it's 10 years out from now, there really needs to be some planning done now to make sure that you accomplish that and you achieve that goal specifically.

In addition, there's some timing challenges relative to the investment in the qualified opportunity funds. When an individual has a capital gain, they need to get that, not the proceeds, but the actual gain. If the investor sold there Apple stock for $3 million and the gain is $2 million, they have to invest the $2 million gain into a qualified opportunity fund within 180 days of the gain. There's some timing issues there.

[Catarino] Yeah. I think to piggyback on that. Some of the challenges, or one of the biggest challenges we're seeing is the timing that's required to meet all of the Opportunity Zone requirements. Steve mentioned the timing on recognizing the gain and then getting that investment into an opportunity fund. Once that point is reached there's another timeline that starts for that opportunity fund to now deploy the capital and buy property in a zone or start to use it for operating a business in the zone.

And there's also strict measurement dates that go along with this. Generally, everybody's familiar with year-end tax planning and cleaning up a 1231 balance sheet. For opportunity funds there's going to be midyear testing that happens as well, which is unusual. There's going to be, if you're representing a fund, there's a significant focus on June 30 financials and planning for that balance sheet because that's when a fund has a testing date. Also, in there initially, or sometimes that initial date isn't always June 30, it can be a different date. But planning for those timelines and those measurement dates is critical in handling an opportunity fund.

How many of these zones are located in Pennsylvania?

[Rossman] There's about 300 zones in the state of Pennsylvania and in the city of Philadelphia there's I think a little bit over 80, 82 zones designated in the city of Philadelphia. As well, there's zones in Allentown, Scranton, Pittsburgh, a lot of that major metropolitan areas.

Thanks, Steve. I just wanted to try to give an overall perspective to our listeners that could be from all corners of the state. What kind of impact do you expect for these Opportunity Zones to have in Pennsylvania? Chris, I see you have some comments on that.

[Catarino] Yeah, I mean we've already started to see a lot of opportunities on deals happening. What we're really seeing the potential is that they could be a serious catalyst for real estate development because of the tax benefits and capital coming in. Real estate is a really good asset that works for an opportunity fund because it's pretty easy to determine whether it's located inside a zone or outside a zone. Operating businesses are a little bit more challenging to determine where they're based, especially under the rules that they've laid out.

While we see a lot of opportunity for improvement in these neighborhoods, there is a concern about gentrification happening with the flood of capital and with this being such a market driven tax incentive where the bigger the profit on a project, the bigger the tax savings are. There may be deals happening that aren't necessarily the best for the residents in those neighborhoods, even though they may be the best returns for investors.

And at this point there's really no guardrails included in the program. Anything that really requires a measurement of impact, or job creation, or anything like that. So I think the communities, the local governments, the federal government, while this is a great, powerful incentive with a lot of opportunity, there's not a lot of levers the communities can pull to kind of reign it in if they feel like it's going sideways.

[Rossman] One other item to touch on, not only is it going on in Pennsylvania, it's all across the country in the six zones, Guam, et cetera. There's some type of fight for the dollars as well. And the thing is, as an investor, you don't have to invest in the state in which you live. You can invest in anywhere. There's several big industrial funds that are invested in different areas in the country. Chris mentioned briefly, there's local organizations such as the PIDC that is really into getting business to come into Philadelphia. They have their own Qualified Opportunity Zone initiative to try and get Qualified Opportunity Zone businesses to locate in Philadelphia.

[Catarino] Yeah. And there's a drive there to get the capital, right? If there's national capital that's looking at deals all over the country, right? It's the states are competing for those dollars, and PIDC is trying to promote the Philadelphia based projects and drive the dollars into the area and you're seeing a lot of other localities try to compete that way as well.

This is a pretty big deal here from what I'm hearing, but it's obviously still new. I guess there's a lot of to be seen, would you say, Steve?

[Rossman] Well yeah, initially there was projections that there might be upwards of $7 trillion of investible capital gains, but there's not likely $7 trillion of projects in these zones across the country. There's kind of a balancing act, if you will. But relative to the guidance that's been released so far, there's been two sets of proposed regs. One were issued in October of 2018, and then most recently in April of 2019 right after the end of tax season, they released the second set of regs.

[Catarino] There's also some more informal guidance that's out there. The IRS has done questions and answers on their website. They've also released the Form 8996 with instructions, which is required opportunity funds must self-certify that their opportunity funds and file that form initially and then every year going forward. There's a little bit more clarity in the instructions. And the IRS also released a revenue ruling to talk about a specific issue related to one of the requirements in the law for substantial improvement.

[Rossman] But still there's a lot of ambiguity, there's a lot of unanswered questions. A lot of the State Bar Associations and the National Bar Association, they responded to the proposed regs and asked to get certain things implemented in the final regulations. There's a lot of buzz, a lot of movement, and hopefully when the final regs are issued they'll have everything in a nice tight order.

CPAs like yourselves, they're still kind of dealing with a lot of this ambiguity, and is there any idea as to when it will be less ambiguous?

[Catarino] That's a great question. We know the next steps are for the proposed regs to be finalized. We're hoping we see some more of the questions that are out there answered there, or changes that everybody's hoping the IRS makes and Treasury makes that those are implemented. It's unclear, it doesn't seem likely, they're going to issue additional regulations on this. They've said that they're going to issue more informal guidance, potentially revenue procedures and revenue rulings.

But, really, we're still in the early innings here, right? The IRS, there's very few funds that have filed tax returns at this point and self-certified. Audit or examinations probably won't happen until another two years, three years. In that interim, I think people are really going to have to live with some of the uncertainty and some of the risk. And we think that's why it's important to work with a good team of Opportunity Zone advisers that really know the ins and outs of the law and the regulations that have already been written as well as a lot of the comments and the theories and the thoughts that are out in the community because we think that will help shape essentially what the IRS will ultimately enforce.

[Rossman] And to touch on Chris's point, this is brand new. They didn't designate the zones until mid-2018. I think a lot of investors were waiting on the sidelines, (A) to see where the zones were going to be, (B) to find out if there was some more guidance as to how everything happens. The first set of regulations really dealt with forming the fund and what happens at the beginning. The second set of regulations were more about the operations going through. We would hope that there might be a third set of regulations, but I think there's indications that there will not be.

But the big unanswered question we kind of think is the exit strategy. I mean, you want to get the tax free appreciation after the 10-year hold, but you just want to make sure that you're doing it appropriately and you're not going to have a foot fault and find out that, "Oh, this $2 million of gain is really going to be taxable after the 10 years."

What specifically do CPAs need to know about these QOZs?

[Rossman] To start out, the CPAs need to be able to advise their clients how best to do it and make sure that they're well within the boundaries of the timing. They got to make sure that the investor gets their gains into the funds within 180 days. They have to make sure that the dollars from the funds are deployed into Qualified Opportunity Zone business property within the testing periods that are delineated. The CPA who's involved in this kind of thing for their clients, they need to know all of the guidelines. You don't want to have a foot fault and have all of these great tax benefits be a non-factor because they miss something, or because something wasn't done within a specific time period.

[Catarino] Yeah. And I think in what we've been doing, we've kind of seen two sides of this. One is investors that have capital gains that are just looking to make good investments, that have the tax benefits and then be purely passive investors. On that front, it's advising the clients on the timing of the gains and when they need to make their investments is critical. And then also working with your clients so that they understand these are going to be highly illiquid investments. They're going to have a long-term hold. They're going to be inherently more risky than other private equity investments, just based on the locations that they're going to be operating in. And what we say is the Opportunity Zones can make a good investment great. But it can't make a bad investment good.

Essentially, to have to reap any real benefits, the project needs to be profitable, right? For that 10-year appreciation to count for anything, you need to have appreciation. If the project isn't profitable and it's not a good deal, the tax benefits don't really make up for it. On the other side, when you're representing potentially a real estate developer or somebody that's going to be setting up and sponsoring the fund, there's a lot of structuring considerations that need to be taken into account. One of the biggest things, one of the biggest conversations we're having is a one tier structure where an opportunity fund invests directly in property, or a two tier structure where an opportunity fund invests in another partnership or corporation, which is a Qualified Opportunity Zone business. And then that entity invests in the actual property.

And surprisingly there's a very big difference in the law and how those, two one tier versus two tier structures are tested. And in some cases it's better to be a one tier, and in other cases it's better to be a two tier and again to go back to the timing. There's a lot of timelines and reporting that needs to be managed for an opportunity fund so it's to be diligent and be forward looking and know when the testing dates are, what the plan is for the business and be able to proactively manage that balance sheet to make sure all the reporting and the testing dates are met and passed.

Well, I really appreciate you both covering this topic. I know how involved you are with it. Now, the one thing before we conclude here, I wanted to see if since you guys both are so heavily involved in it. For our listeners out there, where would you recommend they could go to get some resources on this?

[Rossman] First of all they can start out with our website, https://www.taxwarriors.com/opportunity-zone-resource-center. I know it's a long URL, but once you get to our website you can kind of tool around and find our Opportunity Zone Resource Center. In addition, we mentioned earlier PIDC, which is a quasi governmental organization here in Philadelphia. They have a website called www.philadelphiadelivers.com/opportunity-zones. Oh, and their website, they're trying to match investors with property owners and vice versa too.

Again, their whole mission is to get businesses into the city of Philadelphia. There's kind of a matchmaking site at that philadelphiadelivers.com, so check that out. Also, one other item on our resource center and it's also available directly on, I'm not sure which website, but through our resource center you can find an interactive map that has all of the designated zones throughout the country.