Brownfield Redevelopment Becomes Big Opportunity Zone Winner in Final Treasury Regulations
Treasury convinced by EPA’s case that Opportunity Zones need to cater to brownfield redevelopment to be successful. Final regulatory release develops clear and detailed pathways and preferences for real estate redevelopment.
Two years and one month since the creation of Opportunity Zones in the Tax Cuts and Jobs Act, and less than two weeks before its first benefit—a step down in the maximum allowable step-up in basis (worth 5%)—is set to expire, the Treasury Department has released its final set of Opportunity Zone (OZ) regulations. Treasury took in substantial expert comments on the enormous tax mechanism that is designed to encourage private sector capital gains to flow through reinvestment into undercapitalized communities across the country, which necessitated substantial consideration across multiple industries given its vast potential impact to every land and business existing within and OZ. The goal of these final guidelines is to add working clarity to the OZ regulations and respond to the many significant issues seen by experts to be unclear, unworkable or holding the law back from its full potential.
Prior to the release of the final 544 pages of OZ regulation, market participants generally lacked the confidence as to how certain types of real estate transactions, particularly redevelopments, would work in OZs. And there was wide confusion as to how to handle multiple assets or businesses in a single qualified OZ fund, the consequences of asset sales in certain scenarios, especially the consequences of early sales, and many other practical considerations.
These new and final OZ regulations go a long way towards ameliorating the bulk of these concerns. Better yet, they establish a clear path and preferential treatment for real estate redevelopment, particularly toward brownfields (potentially polluted properties) and real estate requiring environmental remediation.
“These regulations provide clarity and certainty for investors, which will enhance the flow of capital to new and expanding businesses, and create sustained economic growth in communities that have been left behind,” Treasury Secretary Steven Mnuchin said in a statement.
Smoothing the Wrinkles for Real Estate Redevelopment
The final OZ regulations come one year and a day since U.S. EPA’s Office of Brownfields and Land Revitalization (OBLR) wrote a letter, dated December 18, 2018, asking the IRS for clarification, particularly as to two threshold tests: the "substantial improvement” test and the "original use" test. As originally written, for example, "substantial improvements" did not consider land costs. As such, any cost for the environmental remediation of land seemingly would not qualify for preferential capital treatment under the new OZ regime, even though remediation is required in the redevelopment of many real estate parcels.
But attempting to catalyze real estate redevelopment in chronically underinvested communities, where many vacant, blighted, abandoned and brownfield properties exist (and often cluster), without including the costs to address land improvement, environmental remediation and legacy reuse issues simply will not produce the intended effects of the OZ law. It would make a patchwork of investment potential out of the map of parcels in every OZ. As OBLR wrote, OZs have:
And, throughout the 544-page release, Treasury clearly subscribes to OBLR’s encouragement by beefing up OZ regulations on brownfield redevelopment and environmental remediation in substantial detail.
Brownfields are “in” Opportunity Zones
“Cleaning up and reinvesting in these properties increases local tax bases, facilitates job growth, utilizes existing infrastructure, takes development pressures off of undeveloped, open land, and both improves and protects the environment,” Treasury writes in its final OZ release. The final regulations make clear that “all real property composing a brownfield site, including land and structures located thereon,” will be treated by the IRS as satisfying the “original use” test.
As for the “substantial improvement” test, Treasury writes that “remediation of contaminated land is taken into account for determining if the land has been more than minimally improved, and that the QOF or qualified OZ business must make investments into the brownfield site to improve its safety and environmental standards.” Each of the following costs are specifically, but not exclusively, mentioned as being included as “substantial improvements” to real property: (i) equipment installed in a building and used in a trade or business, (ii) demolition costs, (iii) reasonable capitalized fees for development, (iv) required permits, (v) necessary infrastructure, (vi) brownfield site assessment and remediation, (vii) professional fees, and (viii) necessary site preparation costs (including remediation and utility upgrades).
This pivot towards pre-development costs is substantial because it matches the reality of real estate redevelopment on the ground. It is also incredibly helpful and healthy for brownfield and legacy site redevelopment in particular because these types of projects require additional pre-development activity, which often makes the difference between success and continued stagnation. The potential to put capital to work in the critical pre-development phase could prove very constructive for OZ activity.
To alleviate concerns that the property purchased in OZs will not actually get remediated, Treasury’s final regulations also make clear that to qualify an eligible entity “must make investments in the brownfield site to ensure that the site meets basic safety standards for human health and the environment.” But if such remediation of contaminated land does occur, then these “betterments to land… may be added to the basis of the purchased land and included… if the betterments are paid for by the eligible entity.”
Against Bad Land Banking
Sensitive to the potential for unproductive land speculation whereby land is acquired but development is purposely postponed, the regulations also carve out an exception for “insubstantially improved land.” If OZ land is unimproved or minimally improved and the eligible entity purchases the land with an expectation or an intention to not improve the land by more than an insubstantial amount within 30 months after the date of purchase, then such de minimis improvements in the land will not be considered as substantially improving the property for purposes of qualifying for preferential OZ treatment.
“In determining whether an eligible entity had an expectation or an intention to improve the land by more than an insubstantial amount,” Treasury writes in the final regulations, “improvements to the land by the eligible entity including grading, clearing of the land, remediation of contaminated land, or acquisition of related qualified opportunity zone business property that facilitates the use of the land in a trade or business of the eligible entity, will be taken into account."
Tolling the 31-month Working Capital Safe Harbor
After the potential for tolling the 31-month working capital safe harbor was introduced in the last release of OZ guidance, Treasury also received several comments and requests for additional guidance regarding delays resulting from governmental action, as well as delays arising from natural disasters and other intervening events. The former guidance seemed quite generous and implied that waiting for governmental action at any time “stops the clock” on the 31-month working window for OZs, but Treasury notes this is not the case. Real estate developers deal with all manner of permitting in the ordinary course of business, thus “applicants can obtain governmental permits through a routine process of predictable duration.”
“The Treasury Department and the IRS continue to expect a qualified Opportunity Zone business, to the maximum extent practicable, to take any actions during the governmental permitting period that are necessary for the improvement of tangible property subject to the 31-month working capital safe harbor,” Treasury’s release states. “Therefore, with regard to instances in which governmental delay does not pose a substantial obstacle for improving such tangible property, a tolling of the 31-month period would not be appropriate.” This rather limited tolling makes sense as a bulkhead against uncommon development delay.
On the other hand, Treasury has also expanded the scope of tolling the OZ 31-month working capital safe harbor in certain instances. The final regulations make clear that “if a governmental permitting delay has caused the delay of a project covered by the 31-month working capital safe harbor, and no other action could be taken to improve the tangible property or complete the project during the permitting process, then the 31-month working capital safe harbor will be tolled for a duration equal to the permitting delay.”
This could prove a critical and very constructive development in the OZ framework that clicks it into sync with the reality faced by the many redevelopment projects working their way through brownfield programs, RCRA permits and the Superfund program. This type of operational flexibility will allow OZ projects to take life in these critical locations where prior land use requires additional public oversight, often involving the community through direct engagement and mandatory public meetings.
Taken together, the substantial operational and definitional adjustments made towards real estate redevelopment, pre-development activities and environmental remediation in the final OZ regulations have the potential to clear the path towards additional capital investment into some of the most distressed, most pivotal assets in America’s chronically underinvested communities lying within OZs. Indeed, few other legal mechanisms so overtly encourage investmentment into our legacy sites and brownfields through means so effective as environmental remediation, which is exactly the kind of pre-development action necessary to unlock the potential of sites held back by their prior use.