The Opportunity Zone program (OZ), part of the 2017 Tax Cuts and Jobs Act, has generated great interest in and discussion about investment in blighted inner-city areas. The lion’s share of opportunity zone publications speak only to investment in multifamily and other types of commercial structures and operating businesses. Mostly overlooked, the tax deferral benefits of the program from the purchase of vacant land in an opportunity zone may be more advantageous than those of a 1031 exchange.
A major benefit of a Qualified Opportunity Zone Business (OZ business) investing in vacant land in an opportunity zone is that it need not meet either the “original use” test or the “substantial improvement” test required to satisfy the Qualified Opportunity Zone Business Property (OZ business property) criteria. The only condition for vacant land to qualify as an OZ business property is that it be used in operating a trade or business. This gives real estate investors a vehicle to achieve both long-term tax benefits and significant returns without the necessity of large capital improvements.
Structurally, investors with realized capital gains must invest those gains into a Qualified Opportunity Fund (QOF) within 180 days of the capital gains realization. For purposes of a vacant land investment, a closely held (QOF) could be established by the investor(s) in order to have greater control over the funds and the investment. To maximize the benefits from investing in vacant land through the OZ program, using the vacant parcel in a low-cost business operation could generate solid revenue while over the long term, the property appreciation could add significant returns with minimal capital expenditures.
Some examples of low-cost businesses that would satisfy the OZ business property requirements while the land continues to appreciate include:
In Urban Areas:
- Storage facilities for recreational vehicles and boats
- Surface parking lot
In Rural Areas:
- Production and sale of crops
- On-site food warehousing
- Food packaging/sorting facilities
These businesses require minimal capital improvements to the land and minimal management and oversight investment.
Leasing the OZ business operations to an unrelated business entity is another strategy that can further limit operating overhead costs to the OZ investor(s). To employ this strategy, the approved OZ business must first improve the vacant land for the specific approved business use. For example, if the approved OZ business use is a surface parking lot, the OZ business must first improve the land to the level required to operate a parking lot. After the parcel is improved, the OZ business can choose to lease the parking lot business operations to an unrelated business so long as the OZ business retains the responsibility of maintaining the parking lot.
The OZ program is another public-private partnership designed to encourage private investment in distressed areas around the country in return for tax incentives. The temporary and permanent tax deferrals on gains available through the OZ program may be more attractive than 1031-exchanges or other real estate gain-deferral practices. Making vacant land the qualified OZ business gives the investor(s) greater flexibility in determining a business use and the possibility of earning consistent revenue with limited capital expenditures. If an investment in the OZ program is being considered, real estate investors should include vacant land in those considerations.
Sources: Bloomberg Tax; Novogradac; CohnReznick; National Law Review; Proskauer Tax Blog.
Director of Research
Written by John Fioramonti
Kidder Mathews Research