HARP – On This. . .

Opportunity Zones are among the hottest of Hot Topics in real estate investment today.  With the December 22, 2017 enactment of the Tax Cuts and Jobs Act that added Section 1400Z to the Internal Revenue Code, Opportunity Zones were authorized as a potentially powerful tax deferral and tax exclusion incentive to develop predominantly low-income communities. The tax issues related to Opportunity Zone investment are multilayered and complex, but the essential tax benefits are reasonably straightforward and easy to understand. The potential tax benefits of investment in Opportunity Zones are serving as an exciting foundation for investment in community redevelopment. Opportunity Zones are not, however, the tax and investment panacea some imagine.

STATUTORY AUTHORIZATION

Authorization to create Qualified Opportunity Zones was set forth in new IRC Section 1400Z-1. Special rules for treatment of capital gains invested in Qualified Opportunity Zones are set forth in Section 1400Z-2.

DESIGNATION OF OPPORTUNITY ZONES

As of December 2018, all Qualified Opportunity Zones have been designated. Each Opportunity Zone corresponds to a Census Tract meeting certain low-income guidelines. There is currently no mechanism to create any additional Qualified Opportunity Zones or to expand or modify any existing Qualified Opportunity Zone.  Various mapping tools are available online to enable you to locate Qualified Opportunity Zones and to determine whether any specific property is located within a Qualified Opportunity Zone and therefore eligible for the special tax treatment authorized by IRC 1400Z-2. 

THREE KEY TAX BENEFITS OF OPPORTUNITY ZONE INVESTMENT

The three principal tax benefits of investment in a Qualified Opportunity Zone, assuming the technical rules required by IRC 1400Z-2 and the implementing regulations are satisfied, are as follows:

1. Tax Deferral. Tax on capital gain reinvested in a Qualified Opportunity Zone is deferred until December 31, 2026 (unless the investment is sold or exchanged prior to that time).  See: IRC §1400Z-2 (B). The capital gain subject to deferral is not limited to just capital gains from the sale of real estate, but also includes other capital gains, including those derived from the sale of stock and partnership interests as well.
2. Partial Exclusion of Deferred Gain; 5 Year and 7 Year Holding Periods. A portion of the deferred gain reinvested in a Qualified Opportunity Zone for five years or seven years is excluded from taxation by increasing the tax basis of the investment by a percentage of the reinvested gain. In the case of an investment held for at least five (5) years, the tax basis of the investment is increased by an amount equal to ten percent (10%) of the amount of the deferred gain. In the case of an investment held for at least seven (7) years, the tax basis of the investment is increased by an amount equal to an additional five percent (5%) of the amount of the deferred gain, with the result that after seven (7) years of gain deferral the basis of the property will have increased by an aggregate of fifteen percent (15%) of the deferred gain. Since the recognition date for deferred gain is December 31, 2026 pursuant to IRC §1400Z-2(B), as referred to above, in order to receive the maximum tax benefit the gain must be reinvested in a Qualified Opportunity Zone on or before December 31, 2019 (seven years before December 31, 2026). But still, the tax benefits for the five (5) year holding period remains available for investments made through December 31, 2021. See: IRC §1400Z-2(B).
3. Stepped-Up Basis For Post-Investment Gain; 10 Year Holding Period. Perhaps the most powerful incentive is the special rule for investments held for at least ten (10) years. Pursuant to IRC §1400Z-2(C), in the case of a qualifying investment in a Qualified Opportunity Zone held by the taxpayer for at least 10 years, upon election by the taxpayer the basis of the investment will be stepped-up to its fair market value as of the date the investment is sold or exchanged. The effect of this provision is to exclude all appreciation in the investment from taxation (although it should be noted that the taxpayer would have been obligated to recognize and pay tax on 85% of the initially deferred gain (7-year holding period) or 90% of the initially deferred gain (5-year holding period) as of December 31, 2026).  If there has been substantial appreciation during the holding period of ten or more years, no tax on that gain will be owed if the taxpayer elects to have the tax basis stepped-up to the fair market value of the investment as of the date it is sold or exchanged. See:  IRC §1400Z-2(C).

EXAMPLE:   Suppose QOZ investor sells an asset and realizes a capital gain of $500,000 on October 1, 2019, and then decides to invest that $500,000 in gain in a Qualified Opportunity Zone investment on or before November 1, 2019.   The tax on that gain is deferred until December 31, 2026 or until the investment is sold, whichever first occurs.  If the investment is held at least five years, as of November 1, 2024, the basis in the investment will be increased by 10%, meaning $50,000 of the originally invested $500,000 gain is excluded from taxation. If the investment is held at least another two years (for a total of seven years), as of November 1, 2026 the basis in the investment will be increased by another 5%, meaning an additional $25,000 of the originally invested $500,000 is excluded from taxation.  As of December 31, 2026, the remaining deferred gain of $425,000 ($500,000 minus $50,000 (the 5-year exclusion) and minus $25,000 (the 7-year exclusion) will be realized, with the result that taxes shall be due on $425,000 of the originally deferred gain as of the investor’s tax filing date in 2027.  

Suppose also that in the ten or more years following the initial investment of gain on October 1, 2019 the Qualified Opportunity Zone property in which the investment was made appreciated substantially, with the result that the post-investment gain attributable to the initial $500,000 investment (i.e. the gain after October 1, 2019) is $2,000,000.  Under IRC §1400Z-2(C), at the election of the taxpayer to step-up the basis of the property to fair market value, the $2,000,000 post-investment gain is excluded from taxation.

OPPORTUNITY ZONES AS SOCIAL-IMPACT LEGISLATION

The challenge for Opportunity Zone investing is that it is not enough to simply “invest” and hold in an Opportunity Zone. Instead, either (i) the original use of qualified opportunity zone business property must commence with the investment of qualified opportunity funds, or (ii) if the property is already in use, it must be substantially improved within thirty (30) months.  Generally speaking, “substantial improvement” means improving the property by an amount equal to the cost basis of the property upon acquisition by purchase after December 31, 2017, less any amounts reasonably allocated to land. See: IRC §1400Z-2(d)(2)(D).

Opportunity Zones were designed to inspire social-impact projects. Investment projects in Opportunity Zones are supposed to make a positive difference for the low-income community in which it is situated. The investor seeking the tax advantages of investing in a Qualified Opportunity Zone must put its funds to work to create economic opportunity in the community. Merely investing in an existing property or business is not enough.

SECTION 1031 TAX BENEFIT vs. OPPORTUNITY ZONE TAX BENEFIT

A question I am often asked is whether an Opportunity Zone Investment is better than a tax-deferred exchange pursuant to IRC Section 1031? The short answer is that one is not inherently better than the other, they are just different. It’s like asking whether penicillin is better than a sandwich. Clearly, if you are merely starving a sandwich is better. If you have a bacterial infection, you might be better off using penicillin.  The tax benefits of investing in a Qualified Opportunity Zone are different from the tax benefits offered by a tax deferred exchange of like-kind property pursuant to IRC Section 1031, and the circumstances under which each may be beneficial are different. Each has its place. I will be posting an updated article on IRC Section 1031 tax-deferred exchanges shortly.

OPPORTUNITY ZONES AS ECONOMIC DEVELOPMENT INCENTIVE

Qualified Opportunity Zone investments in real property require significant capital improvements and the acceptance of a substantial degree of investment risk. The investment risk is that the property must yield acceptable investor returns to sustain the project over a holding period of at least 5 years, but ideally 10 years, and that during the 10-year holding period the property will substantially appreciate in value, making the promised exclusion of gain taxation meaningful.  Because of the substantial investment required to substantially improve property (i.e. double the basis of the existing improvements) and the uncertainty that the primary tax benefit to be derived from appreciation in value over 10 or more years will be achieved, today’s value of property is not automatically enhanced merely because it is located within an Opportunity Zone as some existing owners seem to believe. The project itself must make substantial economic sense on its own – just as if it were not in an Opportunity Zone. The tax benefits available through a Qualified Opportunity Zone investment will not make a poor investment or a marginal investment good. They will only make a good investment better. 

What makes a Qualified Opportunity Zone investment similar to a IRC Section 1031 Exchange is that they both provide for tax deferral. Tax deferral for a Section 1031 investment is potentially without end. Tax deferral for a Qualified Opportunity Zone investment is temporary, but carries with it the additional benefit of potential exclusion of gain from taxation.  Section 1031 exchanges have been part of the Internal Revenue Code for nearly 100 years and are well understood as a tax deferral tool. Qualified Opportunity Zone investments are a brand-new tax mitigation tool authorized in December 2017, with the rules for their use still being written.

The potentially powerful tax incentives offered by Qualified Opportunity Zone investment, coupled with their focus on revitalizing economically distressed communities, is what has made investing in Opportunity Zones one of the hottest topics in real estate.

END*

*NOTE: The foregoing article is for educational purposes and is not intended as tax advice. Taxation of Opportunity Zone investments is highly technical and fact sensitive. Consult with your own tax advisor when applying the subject matter of this article to any specific tax scenario.

Employment Restrictive Covenants

The issue of enforceability of employment restrictive covenants comes up often in business, including the business of commercial real estate.

A common scenario is as follows:  A person goes to work for a company and is required to sign a Noncompetition and Nonsolicitation Agreement. Typically, it will say something like “during the term of employment, and for a period of one year after termination of employment, the employee will not compete with or solicit any customer or vendor of the employer.”  Sometimes the Noncompetition/Nonsolicitation Agreement is required to be signed as a condition of being hired. Other times the employer will tell an employee who is already employed that signing the Noncompetition/Nonsolicitation Agreement is a condition to continued employment.

Are Employment Noncompetition/Nonsolicitation Agreements enforceable in Illinois?

As a general proposition, Noncompetition/Nonsolicitation Agreements are enforceable in Illinois, as long as they satisfy a three-pronged test:  They: (1) must be no greater in scope and duration than is required for the protection of a legitimate business interest  of the employer-promisee; (2) must not impose undue hardship on the employee-promisor, and (3) must not be injurious to the public.

In a decision filed December 1, 2011, the Illinois Supreme Court shook up the Illinois employment bar by overruling an extensive line of cases that had narrowed the three-pronged test described above to a two-pronged test created by Appellate Court decision in 1973. In a case referred to as the Kolar decision, (Nationwide Advertising Service, Inc. v. Kolar, 14 Ill. Ap. 3d 522 (1973), the Kolar court held that an employment restrictive covenant was valid if there were (i) a near permanent customer relationship with the employer, and (ii) the employee had gained confidential information through its employment. The Illinois Supreme Court emphasized in its December 2011 opinion that the Kolar test is not valid. (Reliable Fire Equipment Company vs. Arredondo 2011 IL 111871). The Illinois Supreme Court, instead, reaffirmed the legitimate business interest test, and clarified that “whether a legitimate business interest exists is based on the totality of the facts and circumstances of the individual case. Factors to be considered in the analysis include, but are not limited to, the near-permanence of customer relationships, the employee’s acquisition of confidential information through his employment, and time and place restrictions. No factor carries any more weight than any other, but rather its importance will depend on the specific facts and circumstances of the individual case.”

For the most part, the Illinois employer’s bar hailed the Arrendondo decision as a victory, believing it gave employers a broader basis for enforcing employment restrictive covenants.  Ironically, many attorney’s representing primarily employees were encouraged by the Arrendondo decision as well, believing it gives employees more room to challenge enforceability by challenging, factually, whether a “legitimate business interest” is at stake.

“Little Known” Two-Year Rule for Employment Restrictive Covenants – Illinois

While the foregoing is all well and good, a fundamental concept of law is that employment