The Opportunity Zone

By Richard Rubin | Updated Oct. 19, 2018 4:52 p.m. ET

WASHINGTON The Trump administration, trying to accelerate tax-advantaged investment in low-income areas, offered generous definitions and rules Friday in a long-awaited package of regulations.

The Treasury Department designed the rules for the Opportunity Zone program to give businesses enough flexibility and certainty to start making major investments, senior department officials said.

The program was a small piece of last year's tax law and has been attracting intense attention from real-estate developers and fund managers who have been soliciting wealthy investors holding unrealized capital gains.

"This will be a turning point," said Michael Novogradac, a San Francisco accountant who advises fund managers and investors on tax incentives. "This will free up a lot of capital that's been waiting. And it provides sufficient clarity for many more investments to go forward."

Earlier this year, after getting recommendations from governors, the Treasury designated nearly 9,000 census tracts as opportunity zones, spread across urban and rural areas and including almost all of Puerto Rico.

Nearly 35 million Americans live in the zones, which have higher poverty and unemployment rates than the rest of the country, according to the Treasury. Developers have been planning projects that would qualify for the incentive, including a Marriott hotel in Arizona, affordable housing in Los Angeles and a 22-story office building and hotel in New York's Washington Heights neighborhood.

Investors in the zones get two benefits. First, they can roll capital gains from an unrelated investment into a zone and defer those capital-gains taxes until the end of 2026. Those taxes can be reduced by as much as 15% if investors hold on to their zone investments long enough.

Second, taxes on capital gains from investments in zones can be avoided if the investments are held for at least 10 years.

All told, the program is projected to reduce federal revenue by $9.4 billion between 2018 and 2022, according to the Joint Committee on Taxation, though the long-run cost could be smaller as deferred taxes are paid. Treasury Secretary Steven Mnuchin has said the zones could attract $100 billion in investment.

In the regulations released Friday, the Treasury created a 70-30 rule that measures whether a given business counts as having "substantially all" of its assets in an opportunity zone. Under that rule, as long as 70% of a business's tangible property is in a zone, the business doesn't lose its ability to qualify for the tax break.

For example, a restaurant chain with four locations inside zones and one outside could get the break. A senior Treasury official described that rule as a "pretty favorable standard." The Treasury had considered and rejected a 90-10 rule.

"They gave us a bright line and they drew the line in a place that's workable day to day," said David Levy, a tax partner at Skadden, Arps, Slate, Meagher & Flom LLP.

Because 10% of an opportunity fund's assets can already be invested outside a zone, according to the tax law, applying a

70-30 rule to the remaining 90% means that as little as 63% of a fund could be invested inside a zone, according to the regulations.

The rules also provided relief to real-estate developers, who had been concerned about the law's requirement that capital gains generally must be reinvested into the zones within six months after the prior investment is sold. That was a potential problem for projects that take time to develop.

The Treasury's proposed rules give businesses an additional 30 months to hold that working capital, as long as they have a plan for a qualifying project in a zone, the Treasury officials said. Those plans don't have to be filed with the government but must be available for an Internal Revenue Service audit, the officials said.

The Treasury also created a rule that defined how much improvement must be made to a building before it can qualify as a new investment. By excluding land value from that calculation, the rules enable more projects in high-cost urban areas, said Steve Glickman, founder of Develop LLC, who advises opportunity zone fund managers.

"The rules seem to provide the most favorable interpretation of the law and seem especially to be targeted to making the program more attractive to real-estate investors," said Adam Looney, a senior fellow at the Brookings Institution who was a Treasury Department official in the Obama administration

The program has bipartisan roots, and Congress deliberately created an open-ended program with few restrictions, with the idea of relying on market forces and the new tax incentive to guide development. It's easily used for real estate, but operating businesses can also take advantage, and private-equity firms are eyeing the incentive.

That openness is also a potential pitfall. The law doesn't require detailed tracking of investments, hiring of area residents or sharp limits on what types of projects qualify, raising the prospect that the program could benefit wealthy investors and raise rents without helping the low-income people it's supposed to assist.

"It has the potential to transform the neighborhoods that have been targeted. I think it's a little uncertain whether that's going to be good for the people who live in those neighborhoods," Mr. Looney said. "We're about to embark upon a tremendous social experiment."

Mayors in cities like Louisville, Ky., and Newark, N.J., and foundations across the country have been trying to use incentives and local regulations to shape projects to ensure that residents of the zones benefit, as money flows into their neighborhoods.