Real Estate 2019

Last Updated May 23, 2019


Law and Practice


King & Spalding LLP has a Real Estate team composed of 27 partners and 40 qualified lawyers with a national reputation for representing domestic and offshore investors in large-scale commercial real estate assets in the United States. The firm has represented clients in all major US markets (New York, San Francisco, Houston, Washington, D.C. and Chicago) on national marquee transactions over the past year. Its holistic, business-focused platform draws on the expertise of real estate partners, private equity partners, finance and restructuring partners, M&A partners and tax partners who constitute a team of dedicated, cross-disciplinary professionals with deep roots in the industry, regularly assisting clients with raising, structuring and deploying equity and debt capital in the public and private markets and completing real estate acquisitions, dispositions and developments with that capital. Particular areas of focus also include complex joint ventures, real estate funds, development and M&A, financial restructuring, public and private capitalisation strategies, domestic and cross-border tax structuring and Islamic finance.

Real property is governed by the laws of the jurisdiction where the real property is located, which includes US federal law, the law of the state where the property is located, and the local rules and regulations of the particular county and municipality.

Low interest rates and a large supply of capital allowed for growth to continue in 2018 in all major real estate sectors other than retail. E-commerce businesses continued to drive the industrial sector as industrial rents outpaced all other sectors. Investors in the multi-family housing sector moved to projects in suburban areas and second-tier cities, pulling back from downtown urban revitalisation projects due to concerns of over-supply. Alternative asset classes such as student and senior housing and data centres continued to attract new investors and capital. 

Notable US real estate transactions continued in the gateway markets, and included the sale of Chelsea Market by Jamestown Properties to Google’s parent company Alphabet Inc. for approximately USD2.4 billion, the second largest real estate deal in New York City’s history.

Other significant 2018 transactions showed the strength of alternative asset classes, including Greystar’s USD4.6 billion acquisition of EdR, the second-largest student housing company in the US, and the IPO of Americold Realty Trust, the world's largest cold-storage industrial REIT. 

One reform proposal is the repeal of The Foreign Investment in Real Property Tax Act (FIRPTA). The US enacted FIRPTA in 1980 in order to tax profits realised by non-US residents on income from the sale of US real property. FIRPTA acts as a significant obstacle to foreign investment in US real estate, and despite some reform in 2015, there remains an effort to repeal FIRPTA entirely.

A second reform that is being refined is the new federal 'qualified opportunity zones' programme. Opportunity zone legislation was enacted as part of the 2017 tax reform bill. Billions of dollars are expected to be freed up from unrealised investment positions and deployed quickly into capital-intensive rehabilitation, repurposing and ground-up projects in the more than 8,000 low-income census tracts in the designated zones. The government is working on regulations that will provide additional certainty for the programme.

Property rights may be acquired in a number of forms that include fee simple ownership, possessory interests such as leaseholds, and non-possessory interests such as easements. The owner of a fee simple interest generally enjoys all aspects of ownership without limitation (subject to any public or private restrictions that may govern the property). Possessory interests, such as space leases, ground leases, licences and life estates, are more limited and temporary forms of property rights. The tenant holds a leasehold interest in the property for a certain length of time while the owner continues to hold fee simple title. Easements are non-possessory interests in land that generally grant a non-owner the ability to enter property for a certain right of use, such as sidewalk usage within a retail project.

Laws governing the transfer of title to property vary by jurisdiction. In general, title to real property is conveyed by execution of a deed that is recorded and indexed in the real property records of the county in which the property is located. In transactions involving the transfer of title to commercial property, including office, retail, multifamily, hotels or industrial projects, certain personal property is typically also conveyed by a bill of sale from the seller to the buyer. Generally, the form of conveyance within each state is promulgated by statute and is the same regardless of the type of real estate, however, many states require additional disclosures for residential property.

Almost all local governments maintain title registration offices where owners and lenders record various claims to real estate. A lawful transfer of title to real estate is accomplished by executing a deed and recording it in the applicable county in which the property is located. Recording and deed requirements vary in each jurisdiction and must be followed precisely.

Buyers of commercial property routinely purchase owner’s title insurance. Title insurance generally insures the owner against any superior claims in the real estate based upon rights existing prior in time to the purchase.

Commercial real estate buyers typically perform physical, economic and legal inspections of the property. These inspections typically occur during a due diligence period which may vary substantially depending on the type of asset and circumstances of the transaction. Buyers will often engage third-party specialists to perform physical and environmental inspections of the property. Buyers generally also perform diligence related to the revenue stream of the property, the tenant leases, and a review of the zoning of the property. Buyers also conduct a title and survey review of the property.

Representations and warranties are some of the most heavily negotiated provisions in a real estate purchase contract, with few, if any, being provided by statute. In a sophisticated commercial transaction, sellers do not typically make representations and warranties with respect to items that the buyer can verify through diligence, such as the state of title or the physical condition of the asset. Most often, sellers will represent as to their authority to consummate the transaction, the existence and status of legal agreements affecting the property (such as leases and service contracts), the absence of defaults thereunder, the status of any litigation or claims affecting the property, and the absence of hazardous materials.

It is common practice to limit the buyer’s remedies against the seller for a breach of representations and warranties discovered after closing both by limiting the time in which the buyer may pursue the breach and by capping the amount of buyer recovery. Where a buyer discovers a material breach of a seller representation or warranty prior to closing, buyers can terminate the purchase contract and potentially recover damages for the buyer’s pursuit costs.

Contract law and land use law are critical for investors to evaluate potential purchases of real estate. Buyers should review and understand all of the documents that affect the property, including leases, service contracts and documents recorded in the local land records that impose obligations or restrictions on the property.

The Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA) is the primary federal legislation governing events related to the exposure of real estate to hazardous materials in the US. CERCLA imposes strict liability upon “owners and operators” of real property for penalties and costs related to hazardous waste contamination and clean up. Strict liability means absolute legal responsibility for an injury imposed on a party without proof of carelessness or fault.

An owner that has not caused environmental contamination can limit its risk by following the US Environmental Protection Agency’s interim guidance regarding safe havens for bona fide prospective purchasers and innocent land owners. To qualify as a bona fide prospective purchaser, one must perform “all appropriate inquiry” into the contamination status of the property prior to purchasing the property. All appropriate inquiry requires investigation of the environmental condition of the property by a qualified professional documented in a written report; typically this is in the form of a Phase I Environmental Report.

A prospective buyer should confirm the permitted uses of a parcel of real estate under applicable zoning or planning law by researching the designation of such property by the local zoning or planning office. In addition to reviewing the zoning regulations promulgated by the local authority, a prospective buyer can obtain a zoning report that summarises the property’s compliance with the applicable zoning code.

If a proposed development is of significant value to a community, the applicable public authority may enter into development agreements with the developer, containing concessions and requirements with respect to the project.

Governments in the US have the power of eminent domain – ie, the right to take private property for public purposes. The Fifth Amendment of the US Constitution, which applies to the federal government as well as state and municipal governments, provides safeguards to protect property owners, including requiring compensation for any taking of property.

State and municipal governments typically impose some level of taxes and/or fees with respect to the transfer of real property, however, the scope and reach of such taxes and fees varies widely by jurisdiction. Many jurisdictions impose excise or stamp taxes (commonly called transfer taxes) at the state, county and/or municipal level that are determined based on the sale price of the property. 

Whether transfer tax applies may depend on both the type of transfer (fee title versus lease) and the structure of a transfer (a direct transfer or an indirect transfer through the transfer of the entity that owns the property). In some jurisdictions, the tax may only be imposed on the transfer of title to the property, while other jurisdictions may impose the tax on the transfer of a leasehold interest.

Certain jurisdictions only impose transfer tax on the direct transfer of real property, but not if the transfer is indirect, for example, where the entity holding title to the property does not change, but the ownership of that entity is transferred. In other jurisdictions, the tax is also imposed on indirect transfers of real property.

Foreign persons generally are permitted to acquire US real estate. However, the federal government imposes economic sanctions and restrictions that prohibit transactions with certain individuals, organisations and nations. The PATRIOT Act also requires certain disclosures related to the identity of foreign investors. Foreign investors should also be mindful of the requirements of the Bureau of Economic Analysis of the Department of Commerce, the Foreign Investment in Real Property Tax Act (FIRPTA), the Agriculture Foreign Investment Disclosure Act of 1978, and Department of Defense regulations, among others. Notably, in August 2018, the Foreign Investment Risk Review Modernization Act expressly expanded the applicability of the Committee on Foreign Investment in the US (CFIUS) to foreign investment in real property.

Commercial real estate acquisitions – whether of a single property or a portfolio – are typically financed with mortgage and/or mezzanine loans. The economic terms of a commercial mortgage loan vary depending on the type of property, the intended development plan, the reputation and financial strength of the sponsor, and the course of the financing. The financing may be structured with fixed or variable interest rates, may be fully drawn at closing or provide for additional advances over time, and is typically non-recourse to the borrower other than certain 'bad boy' carve-outs. As a non-recourse loan, the security for repayment of the loan is limited to the property and the borrower’s other property-related assets.

Under a traditional mortgage loan, the borrower must provide the lender with a first-priority lien on the property as security for repayment. The lien is evidenced by a mortgage or similar instrument filed in the local public land records. Upon a default by the borrower, the lender’s remedies include the ability to foreclose on the security instrument and either sell the property to a third party or obtain ownership and possession of the property directly.

The security provided in connection with a mezzanine loan is a pledge of the borrower’s ownership interest in the property owner so that upon foreclosure the mezzanine lender is able to control the property by holding 100% of the membership interests in the property owner.

As additional security for a mortgage loan, the borrower is generally required to assign all property-related assets held by the borrower such as all leases and rents and property-related contracts and agreements.

While there are no general restrictions or prohibitions on granting security in US real estate to foreign lenders, the receipt by a US person of loan proceeds from a foreign lender and repayment of the same is subject to US anti-terrorism and anti-money laundering regulations.

Foreign investment activity which could result in foreign control of a US business is also subject to oversight by the Committee on Foreign Investment in the US (CFIUS), a committee that has broad latitude to screen transactions with foreign investors for national security risks. Historically, the agency’s jurisdiction was focused on mergers, acquisitions and takeovers of US businesses engaged in commercial activity, but the Foreign Investment Risk Review Modernization Act of 2018 (FIRRMA) will further expand the reach of CFIUS to also cover the purchase, lease or concession of US public or private property that is “in close proximity to” a “U.S. military installation or other facility or property of the U.S. government that is sensitive for reasons relating to national security.”

CFIUS has not yet promulgated regulations defining “close proximity,” describing what qualifies as a sensitive facility, or delineating how properties in “urbanised areas” will be carved out of this provision. Because CFIUS has not signalled when it will implement these new real estate regulations, it is creating uncertainty for foreign real estate investors and their lenders and underwriters when evaluating investment risks.

In connection with the recording of any mortgage or other security instrument in the public records, the borrower will generally be required to pay various taxes and fees such as intangible taxes, documentary taxes and registration fees. The amounts of such taxes and fees are often based on the loan amount (or portion thereof being secured by the applicable instrument), but the calculation will vary depending on the jurisdiction.

Before an entity can deliver valid security over its real estate assets, the entity must be duly formed and validly existing in its jurisdiction of organisation and, if this jurisdiction is different to that within which the property is located, authorised to do business in the state in which the property is located.

The entity must also have insurable title to the property as evidenced by a title insurance policy insuring the priority of the lender’s lien.

Generally, the loan documents will govern enforcement of a lender’s security interest in real property, subject to requirements and limitations of state law, such as notice to a defaulting borrower and other interested parties, public notice requirements prior to a foreclosure sale, and rights of redemption following a foreclosure sale. Upon foreclosure, lenders generally take title to the property free and clear of any properly noticed junior liens, but subject to any superior liens (eg, taxes).

Existing secured debt may only become subordinated to newly created debt pursuant to an agreement among the parties, as the priority from recording the security instrument of the existing debt would have first priority over any newly created debt. Typically, in order to effect such a subordination, the debt holders would enter into a subordination agreement and/or an intercreditor agreement. 

Generally, a lender holding or enforcing security in real estate should not have liability under environmental laws; however, not all environmental legislation (eg, the Clean Water Act) contains protections for secured lenders, and secured lenders are generally not protected from third-party tort claims based on personal injury or property damage caused by environmental contamination. In addition, lenders who cause environmental issues or who exceed their role as a 'lender' and act more like a property owner by participating in the management of the property (whether pre- or post-foreclosure) can be held liable under certain environmental laws.

Generally, the onset of a borrower’s insolvency would not affect the validity of a security interest granted by the borrower in favour of a lender. However, the filing of any form of bankruptcy petition would automatically stay any proceedings initiated by creditors against the borrower, including any enforcement proceedings or real property foreclosure proceedings. 

With LIBOR anticipated to be phased out by the end of 2021, the key questions for borrowers are what future interest payments will look like and how interest rate products will be impacted by the new reference rate replacing LIBOR. Borrowers should review existing (and new) credit agreements to determine if their loan’s interest rate is tied to LIBOR and if there is a defined substitute. The borrower should discuss the substitute rate that the lender intends to use and when the interest rate will be calculated using the substitute rate.

Local governments are typically responsible for strategic planning and zoning in their respective jurisdictions, and the degree to which local governments control the process differs tremendously. A variety of tools are used by local governments to regulate development, including special zoning districts, comprehensive plans, subdivision, site plan and unified development ordinances.

Building codes are typically used to create regulations regarding the method of new construction or refurbishment of an existing building. Building codes are expansive and contain varying requirements for different types of asset classes and uses. Jurisdictions often go beyond standard building codes and enact regulations for the design and appearance of new and refurbished buildings.

Local governments are typically responsible for regulating the development and designated use of individual parcels of real estate.

The entitlement process varies by local jurisdiction. Generally, if the project or refurbishment is permitted under applicable use restrictions, the process would be administrative, with third parties not having the right to object to the proposed development. If the project or refurbishment is not permitted under the applicable use or zoning restrictions, then re-zonings, variances or amendments to the comprehensive plan are some of the typical processes required to be able to proceed with the desired development. This would usually require public notice and public hearings, during which third parties would have the right to object to (or support) the project.

A local government’s decision regarding an application for permission for development or the carrying on of a designated use is subject to appeal in most jurisdictions. The specific right of appeal and related process will be specific to the jurisdiction. Typically, the right to appeal a decision related to a project that is permitted under the applicable use restrictions is narrow relative to a decision regarding re-zoning or amendments to a comprehensive plan. While the timeline for an appeal will depend on the jurisdiction and the decision being appealed, an appeal must usually be filed within 30 to 60 days of the initial decision. In many jurisdictions, courts follow the 'fairly debatable' rule, whereby the court will not overturn a zoning decision which is supported by substantial evidence and was not made arbitrarily.

Applicants often enter into agreements with local governmental authorities or agencies in order facilitate a development project, whether required by statute or ordinance or merely as part of the approvals process for the development. In many cases, the local governmental authorities will condition approvals on the applicant agreeing to take (or refrain from taking) certain actions. These agreements will bind the project and development either for a specific period of time or in perpetuity. For example, they may restrict the use or require certain infrastructure improvements.

Local governments have many different tools to enforce restrictions on development and designated use. During construction of a project, the local government may impose a fine on the developer/owner of the development or, in the case of a more severe violation, the local government may issue a 'stop work' order halting any construction on the site. Additionally, to the extent that performance bonds have been required for the project, the local government could trigger rights under any performance bonds, which would allow the local government to complete any outstanding requirements covered by the bonds. After completion of the project, the local government may bring a suit for specific performance or otherwise enforce any regulations through the courts.

Real estate investments in the US may be held in any type of legally recognised entity, however, two types of entities are most frequently used: limited liability companies and limited partnerships.

Limited liability companies (LLCs) have the liability-limiting characteristics of a corporation, such that the owners are not personally liable for the debts and other obligations of the company, but they are taxed as partnerships, meaning the income of the LLC is passed through to its owners before it is taxed. Also, LLCs have very flexible governance structures granting the owner(s) (or member(s)) wide latitude under the applicable LLC statute, and unlike a limited partnership, an LLC may have only one owner (known as the sole member), making it a particularly popular choice for individual investors. 

A limited partnership is formed by one or more limited partners, who generally provide the source of capital for the partnership’s operations (in this context, the investment in real estate), and a general partner that is responsible for the management of the partnership. Limited partnerships have two key features that make them popular for real estate investments. First, a limited partner is not personally liable for the partnership’s debts and other obligations. Second, limited partnerships allow the income of the partnership to pass through to its beneficial owners before it is taxed. The main drawback of the limited partnership structure is that it requires at least two parties (the limited partner and the general partner), and the general partner is personally liable for the debts and other obligations partnership, though in practice the general partner itself is usually a type of entity, such as an LLC or corporation, that shields its beneficial owners from personal liability.

There are other ownership entity types under US law that can be used as well, such as S corporations, C corporations, general partnerships or limited liability limited partnerships, although they are less common than LLCs and limited partnerships.

A real estate investment trust (REIT) is any entity that elects REIT status, which allows it to pass income through to its owners. REITs are creatures of the tax code and are subject to complex tax rules which require the advice of experienced practitioners. For certain types of assets and for investors with certain tax postures (particularly non-US investors), a REIT may provide significant tax advantages over a conventional investment vehicle.

Limited liability companies are governed by an operating agreement. Where an LLC is owned by a sole member, the operating agreement is typically a simple document that sets forth certain basic formalities. Because there is only one owner, full control of the entity as well as all of the economic benefits and burdens are vested in that owner, so there is no need to allocate control and economic rights. Where an LLC has multiple members, the operating agreement will often grant day-to-day control of the company to one member (known as the managing member), to an entity that is not a member of the LLC but is controlled by a member (known as a non-member manager) or to a board of members, but the other member or members will have the right to approve certain decisions. The scope of these approval rights is negotiated between the members. In addition to governance, operating agreements establish the priorities of economic distributions, procedures for calling additional capital from the members and rights for a member to transfer or otherwise exit the LLC.

Limited partnerships are governed by a limited partnership agreement, which allocates the management rights and responsibilities of the partners as well as their economic benefits and burdens. By definition, the general partner is tasked with the day-to-day management of the partnership. Consent rights and other rights of the limited partners to participate in the partnership are negotiated between the partners, as are their economic rights.

Corporations are formed by articles of incorporation and governed by their bylaws. These provide for, among other things, governance rights, capital raising, distributions and exit rights.

The costs of forming and organising an entity vary by state, but typically a few hundred dollars are required for filing fees, annual registration fees and taxes. Some states also require that minimum capital be invested in entities. Regardless of whether an entity is formed in a state that requires the entity to be minimally capitalised, failure to capitalise an entity with adequate funds to operate for its intended purpose may expose its owners to personal liability, since this is a factor courts frequently consider in claims to pursue limited partners or members for the debts of a limited liability entity.

Limited liability companies typically provide a lot of flexibility in allocating management responsibilities. Management of a limited liability company can be controlled by one member (member-managed) or by a non-member manager (manager-managed). Management may also be vested in more than one member. Additionally, the operating company may establish a board of managers to manage the entity. The limited liability company agreement provides for the procedures related to governance of the entity, including frequency of meetings, elections and voting.

In limited partnerships, limited partners are generally permitted to have limited voting and control rights over the affairs of the limited partnership. Limited partnerships may have one or more general partners, which are responsible for managing the limited partnership.

Shareholders of corporations elect directors to the board which manages the corporation; however, state laws may require shareholder votes to approve certain matters. Additionally, the board of directors may appoint officers to manage the day-to-day business of the corporation.

Entity maintenance and accounting compliance costs vary based on both the state of the entity’s organisation and the state in which the property is located. Typically, states require an annual report and a filing fee of a few hundred dollars. Since most real estate investment vehicles are pass-through entities for US federal income tax purposes, most state income taxes are similarly passed through to the entity’s owners. However, a few states impose franchise, income or similar taxes on pass-through entities. Corporations will pay state income tax in the states they are formed or operate if those states have an income tax. Accounting costs will vary based on the states in which an entity is formed and operates, as well as the nature of the entity and its assets and income.

Leases, ground leases, licences and easements are the most common agreements used to grant a right to occupy real property. Generally, leases differ from licences in two primary ways: first, the term of a licence is typically shorter than that of a lease; second, the grantor of a licence typically retains the right to revoke the licence, whereas early termination rights are less common in a lease. Ground leases typically grant the tenant the right to develop, construct and operate a building on the leased land during the term of the agreement, which is longer in duration than the term of a space lease.

An easement may also be used to grant a party use of a designated portion of another party’s property for a specific purpose. While some easements are granted with unlimited duration, easements can also be used for limited time periods, such as providing access to a construction site until development is completed.

Commercial leases can be broadly categorised based on the scope of economic and other responsibilities allocated to the tenant. This is typically based on the type of property being leased (multi v single tenant) and the duration of the lease. 

Tenants under absolute net leases agree to assume the most responsibility. Under these agreements, the tenant is obligated to pay a base rent as well as all other operating expenses including taxes, maintenance costs, insurance, utilities as well as any structural repairs that may be required during the lease term. Under a triple-net (NNN) lease, the tenant agrees to pay base rent as well as all or part of the property taxes, common area maintenance and insurance, while the landlord’s responsibilities are typically limited to structural repairs. A double-net (NN) lease commonly provides that a tenant pays base rent as well as its pro rata share of property taxes and insurance, while the landlord is responsible for common area maintenance and structural repairs. Under a single net (N) lease, the tenant pays base rent and its pro rata share of property taxes, and the other building expenses are the landlord’s responsibility. Finally, under a gross or full-service lease, the tenant pays one rental amount per month which amount includes the tenant’s share of taxes, insurance and common area maintenance costs.

Generally, with respect to commercial leases, lease terms, including rent, are freely negotiable. 

Lease terms for commercial space are typically for a term of years. In some instances, a landlord and tenant may also negotiate for renewal options. Ground leases have longer terms, which allow the tenant to finance and develop the property as if it were the owner.

All leases typically require the tenant to maintain the leased space, including in many instances responsibility for non-structural repairs in the leased premises. With respect to shared spaces, maintenance and repair obligations are typically placed on the landlord. Alternatively, a single tenant of a property (including a ground tenant) is typically responsible for handling maintenance and repair obligations directly at its own cost.

Rent is generally paid on a monthly basis throughout the term. The first payment is often made at the beginning of the lease term, and subsequent payments are made in advance of the next lease month.

Rent, including any rent escalations during the term, is negotiated prior to signing a lease. Rents typically escalate on a percentage basis at intervals during a lease term. Additionally, to the extent a tenant pays its pro rata share of taxes and other charges to the landlord, these charges may increase during the term as costs increase.

Commercial leases may contain a schedule setting forth the amount of the base rent for each year of the lease term, or a formula to calculate the year-to-year changes in rent payable based on the applicable factors.

Additionally, if the lease provides an extension option by which the tenant can extend the term, many leases will provide for a determination of the fair market rent (often subject to third-party arbitration in the event of disagreement over the amount) to govern the extension terms.

Jurisdictions differ in their approach to imposing VAT with respect to rent. However, most states do not impose a VAT on rent.

Many leases require tenants to post a security deposit with the landlord, which deposit may be gradually reduced or returned to the tenant over the term of the lease. Additionally, many landlords require the tenant to pay the first month’s rent at lease signing.

If renovations or a build-out of the leased premises is required prior to occupancy, then the tenant will be responsible for the costs of this work unless the tenant negotiates for the landlord to provide a sum to be applied to these renovations.

Common areas are usually maintained by the landlord, but at the cost and expense of the tenants. Depending on the lease structure, the tenants will either pay their pro rata share of the cost of common area maintenance in addition to base rent, or these costs and expenses will be included in an all-inclusive rent that accounts for these costs.

Most commercial leases require each tenant to contract and pay for the utilities and telecommunications serving that tenant’s space, but utility costs for common areas of the building are typically allocated to, and paid by, all tenants on a pro rata basis.

When a single tenant occupies an entire building and is directly responsible for operating costs at the leased premises, it typically maintains insurance for the full replacement value of the building. In most other instances, the landlord will carry property insurance covering the full replacement value of the building. Whether the cost of the insurance is ultimately borne by the tenant will depend on the type of lease (ie, whether the lease is a double- or triple-net lease). Property insurance will typically cover all perils that damage a property, subject to certain exclusions and/or excluding specific perils (eg, earthquake or flood) which may be covered under separate policies. 

Landlords frequently restrict the uses of the leased premises. Restrictions may be imposed to induce tenants to lease space by guaranteeing competitors or incompatible users will not be operating in the building.

Land use and zoning rules and regulations may also impose use restrictions on a property.

Most leases require the tenant to obtain the landlord’s consent prior to making any alterations or improvements to the premises. For substantial alterations, many leases will require the tenant to submit the plans and proposed contractor to the landlord for approval.

Residential leases are the most-regulated type of leases. Laws and regulations vary by jurisdiction, but residential leases may be subject to rent control or regulation, health and safety requirements and laws that prohibit discrimination against individuals that are members of a protected class, such as sex, race, religion or national origin. While commercial leases are generally not as heavily regulated as residential leases, they are subject to common law (including nuisance-related law) and zoning ordinances, among other rules and regulations that may vary by jurisdiction.

Generally, a tenant’s inability to pay rent will trigger a termination right on the part of the landlord. If the tenant files a petition for bankruptcy, it must typically assume or reject a commercial lease within 120 days of its bankruptcy filing, which timeline is subject to extension by the bankruptcy court. If the lease is rejected, the tenant will be forced to move out, but the landlord’s claim against the tenant will be subject to bankruptcy protections, including an automatic stay on any lease payments. The bankruptcy process commonly lasts for multiple years.

Many landlords require tenants to post a security deposit (either in the form of cash or a letter of credit) in order to enter into the lease. Additionally, the landlord may request that a creditworthy guarantor enter into a separate agreement to guarantee the tenant’s obligations under the lease.

A tenant generally does not have a continuing right to occupy the premises once the term of its lease has expired, but it is important for landlords not to acquiesce in a hold-over to ensure no new rights inure to the tenant. To deter tenants from remaining in a premises after the term, landlords typically impose significant rent on tenants who hold over as well as make the tenant responsible for all damages incurred by the landlord.

Many leases provide that a material casualty, or the taking by eminent domain of a significant portion of the premises, will trigger a termination right for the landlord and tenant. Additionally, landlords may generally terminate the lease in connection with an uncured event of default by the tenant.

A court may force a defaulting tenant to leave by judicial action after the landlord brings a claim against the tenant. The timeline for a judicial action varies by jurisdiction, but eviction in many jurisdictions can take place in less than a month. Additionally, some jurisdictions allow the landlord to take 'self-help' remedies to immediately evict the tenant, such as changing the locks.

Where the government or municipal authority is not a party to a lease agreement, such authorities are not able to terminate a lease which was privately negotiated by other parties. However, a governmental authority could perform a taking of the real estate which is subject to the lease, thereby making the existence of the lease moot. The timeline governing the government authority’s taking of the real estate would depend greatly on the government authority and real estate at issue.

The most common pricing structures used on construction projects are

  • fixed price;
  • reimbursable (cost-plus or time and materials); and
  • unit pricing. 

Under a fixed price structure, the parties agree to a fixed price for the completion of the work, with the contractor generally bearing the risk of project costs exceeding the fixed price.

In a reimbursable arrangement, the owner pays for the costs of construction on a reimbursable basis and bears the risk of extra costs. Traditional reimbursable pricing structures can be coupled with a cap or guaranteed maximum price in a hybrid approach.

Unit pricing is an arrangement where payment is based on actual quantities at fixed unit prices.

Responsibility for design and construction of a project is typically assigned through two primary delivery methods: 'design-bid-build' and 'design-build'. 

Under a 'design-bid-build' arrangement, the engineer or architect is responsible for the design of the project. Once the design is completed, the owner will separately engage a contractor to assume responsibility for constructing the project as designed. 

Under a 'design-build' arrangement, the contractor also acts as the engineer and assumes responsibility for both design and construction. 

Construction risks should ideally be borne by the party in the best position to control and mitigate such risks. Once identified, the risks can be managed or allocated among the project participants through risk transfer (eg, through indemnities) or risk assumption and reduction (eg, through a limit of liability).

These risk devices are not without limitation. Most states have enacted some form of 'anti-indemnification' legislation which prohibits or limits the rights of parties to shift certain risks (eg, the sole negligence of a party). Similarly, a court will not enforce a limitation of liability in the event of wilful misconduct or fraud. 

Schedule-related risks can be managed through a combination of schedule milestones, robust schedule and reporting requirements, recovery obligations, liquidated damages, early completion incentives, and clear contractual provisions addressing when extensions of time are allowed.

Damages due to a delay in construction are often difficult to estimate, so construction contracts frequently contain a liquidated damages clause that applies if a contractor fails to achieve certain milestones or completion dates. An owner should carefully estimate its anticipated damages in the event of delay and ensure that the amount of liquidated damages both covers its anticipated damages and is enforceable against the contractor. Such anticipated damages may include lost profits, additional financing costs, and extra owner costs including additional overhead, rent, and personnel costs. Courts will not enforce liquidated damages provisions that are deemed to constitute penalties.

It is common for owners to require performance security from contractors including payment and performance bonds, letters of credit, retainage and parent guarantees.

Bonds, such as payment and performance bonds, are typical in the construction industry. A performance bond protects an owner against contractor default by ensuring that the contractual obligations of the contractor will be fulfilled. Under a performance bond, the surety can either step in and perform the work if there is a contractor default, or it can pay the damages arising out of the contractor default. It is important to note that unless the default is clearly the fault of the contractor, an owner should not anticipate that the surety will promptly perform or pay damages. In many cases an owner will be required to sue the surety to recover damages, which may take years to collect.

A payment bond ensures that a contractor will pay its subcontractors for the work and materials provided. Similarly, if there is an issue, the surety will step in and pay the subcontractors. 

A letter of credit is an instrument issued by a commercial bank that an owner may collect on upon demand of payment. It is not uncommon for owners to require that a contractor supplement a letter of credit with a parent guarantee or retainage.

Retainage is a common form of security that allows an owner to retain an agreed percentage of each invoice. It provides an owner immediate access to a pool of funds that grows over the course of the project and is released once the contractor satisfies its contractual obligations.

Lien rights for contractors and/or designers are typically available, are statutory in nature and require strict compliance with statutory requirements (such as timely notice and filing requirements) in order for a claimant to attach a lien to real property. Property encumbered with a perfected lien is subject to foreclosure to satisfy amounts owed. 

An owner can remove a lien by successfully challenging the validity of the lien, paying the debt or obtaining a lien release from the claimant.

All states have requirements that must be met before a building can be inhabited or used for its intended purpose. The procedure and requirements for certificates of occupancy vary widely from jurisdiction to jurisdiction. Generally, a certificate of occupancy describes the type of permitted occupancy, legal occupancy limits, layout, and allowable use of a building. A certificate of occupancy confirms that necessary paperwork has been completed, fees have been paid, violations (if any) have been resolved, and that the building complies with all applicable laws and the plans and specifications approved by the local authorities.

Value-added tax (VAT) and sales tax are generally not imposed on the purchase or sale of real estate.

A common technique to mitigate a real estate transfer tax is to sell equity interests of an entity that owns real estate, rather than transferring the real estate itself. Some jurisdictions, however, combat this technique by also imposing a transfer tax on the sale of a controlling interest in an entity with significant real estate holdings. Mortgage recording tax may be mitigated in some jurisdictions by assumption of existing debt.

Some jurisdictions impose special tax on business rentals. For example, New York City imposes a 'commercial rent tax' equal to 3.9% of the gross rent paid for commercial premises located in certain parts of the city.

Income of foreign taxpayers is generally subject to one of two different taxation regimes. Income that is effectively connected with the conduct of a US trade or business ('effectively connected income' or ECI) is subject to taxation on a net basis at the same tax rates that apply to US taxpayers. Taxpayers who earn ECI or are engaged in a US trade or business, either directly or through a partnership or an LLC taxed as a partnership, are required to file a US tax return.

Foreign corporations are taxed at 21% on all ECI, while non-corporate taxpayers are taxed at up to 37% on ECI other than ECI that is treated as long-term capital gain, which is taxed at up to 20%. Under the 2017 tax reform legislation, certain “qualified business income” of non-corporate taxpayers qualifies for a special deduction of up to 20% of the amount of income, reducing the maximum effective rate to 29.6%. Rental real estate income generally constitutes qualified business income, provided that the level of activity associated with the rental income is substantial enough to constitute a trade or business and certain anti-abuse rules do not apply. The tax on ECI from real estate investment is generally not reduced by tax treaties.

Foreign corporations that have ECI may be subject to a second level of tax, called the 'branch profits tax'. The branch profits tax is generally equal to 30% of the after-tax earnings from a US trade or business, reduced by earnings that are reinvested in US business property (but increased by earnings that are withdrawn from US investments). The branch profits tax may be reduced or eliminated by treaty.

Certain types of non-ECI investment income, including dividends, interest and rent, are subject to a flat, gross-basis tax of 30%, which is generally collected by withholding at source. This tax can be reduced by treaty, but existing treaties generally do not limit taxation of income from real estate. Capital gain that is not ECI is generally free from US tax (subject to the provisions of FIRPTA described below).

Taxpayers whose real estate investments do not rise to the level of a trade or business may elect to treat the income from those investments as ECI, thereby escaping the 30% withholding tax in favour of the graduated tax on ECI. This election is frequently favourable for taxpayers, as it allows taxpayer to use deductions for interest, taxes and depreciation.

The Foreign Investment in Real Property Tax Act (FIRPTA) provides that gain or loss from the sale of an interest in US real property, or a corporation whose assets primarily consist of US real property, is deemed to be ECI, even if the gain would otherwise be capital gain not subject to US tax. Certain 'qualified foreign pension funds' (QFPs) are exempt from FIRPTA.

The tax on ECI is enforced through three significant withholding taxes. First, any US partnership (including an LLC taxed as a partnership) that is engaged in a US trade or business must pay a withholding tax on any ECI allocated to a foreign partner, which is generally calculated at the highest tax rate applicable to that type of partner (ie, 21% for a corporation, or 37% for a non-corporate taxpayer). Second, a special FIRPTA withholding tax equal to 15% of the gross purchase price must be collected by a transferee of a US real property interest from a foreign transferor. Finally, a new withholding tax created by the 2017 tax reform legislation requires the transferee of an interest in a partnership that is engaged in a US trade or business to withhold 10% of the purchase paid to a foreign transferor. In certain circumstances where the required withholding is not made, the partnership may be required to pay the tax.

Many foreign investors in US real estate choose to invest through 'blocker' corporations. Blocker corporations are separate taxpayers from their shareholders, and a shareholder is not considered to be engaged in a US trade or business solely as a result of owning stock in a corporation that is so engaged. As a result, shareholders of a blocker corporation may not be required to file a US tax return or pay tax on their ECI. Capitalising a blocker in part with shareholder loans may improve the tax efficiency of a blocker structure. 

A real estate investment trust (REIT) is a special type of blocker corporation. REITs must comply with numerous requirements for their organisation and operation, including restrictions on the nature of their assets and gross income. In return, REITs are subject to a special tax regime. Most notably, REITs can deduct dividends paid to shareholders from taxable income, which effectively eliminates the corporate-level tax on income that is distributed to shareholders. REIT dividends that are paid to foreign shareholders are subject to the 30% withholding tax, which may be reduced or eliminated by treaty. 

Under FIRPTA, REIT distributions that are attributable to gain from the REIT’s sale of a US real property interest are treated as ECI, and the shareholder must file a US tax return and pay the tax on ECI (including, for foreign corporations, the branch profits tax). QFPs are exempt from FIRPTA and are generally not subject to US tax on a REIT’s distribution of sale gains. Gain from the sale of shares of a REIT that is majority owned by US investors is not subject to FIRPTA. Thus, it may be possible to avoid the FIRPTA tax on a REIT’s distribution of proceeds from asset sales by selling the REIT’s stock to a buyer.

Investments in US real estate benefit from certain tax advantages. For example, under the 'like-kind exchange' rules, one real property investment can be exchanged for another on a tax-deferred basis, provided certain requirements are met. Investments in buildings (but not land) can be depreciated over time, and real estate depreciation is generally not subject to the same 'recapture' provisions (which treat certain sale gain as ordinary income) as personal property depreciation.

The 2017 tax reform legislation, commonly known as the Tax Cuts and Jobs Act (TCJA), made many changes to US tax law, several of which may be particularly significant to foreign investors in US real estate:

  • The TCJA permanently lowered the US corporate tax rate from 35% to 21% and lowered the maximum tax rate for non-corporate taxpayers from 39.6% to 37% through 2025. In addition, as noted above, TCJA created a 20% deduction for individuals receiving certain pass-through business income through 2025, subject to a cap based on the wages paid to employees and the original investment in tangible property used by the business. 
  • The TCJA replaced the prior limitations on related-party interest payments with a provision that will limit net interest expense deductions by a US business to 30% of adjusted taxable income (generally, taxable income before interest, net operating losses, the new pass-through deduction, and, until 2022, depreciation and amortisation). Any disallowed interest can be carried forward indefinitely. The limitation does not apply to certain real property trades or businesses that elect to be excluded from the provision. 
  • The TCJA limits the ability of a taxpayer to use post-2017 net operating losses. In particular, taxpayers cannot carry back such net operating losses to earlier tax years but can carry them forward indefinitely. The amount deductible in any year is limited to 80% of taxable income. Carry-forwards are not indexed for inflation.
  • The new carried-interest provision under TCJA will treat net capital gain with respect to carried interests as short-term capital gain taxed at the higher ordinary income rates to the extent that such gains relate to investments held for three years or less. This new provision could increase the taxes on carried interest allocations made to a joint venture partner who earns a carried interest.
King & Spalding LLP

300 S Tryon Street Suite 1700

+1 704 503 2565

Author Business Card

Trends and Developments

Opportunity Zones

Opportunity Zones are a new economic development tool established by Congress in the Tax Cuts and Jobs Act of 2017. Sections 1400Z-1 and 1400Z-2 of the Internal Revenue Code set out the Opportunity Zone (OZ) programme’s benefits and requirements. The programme’s intent is to encourage investment in designated economically distressed communities by providing federal income tax benefits to taxpayers who invest in these communities. Taxpayers can take advantage of the new programme by reinvesting short and long-term capital gains into qualified opportunity funds (OZ funds). OZ funds provide capital gains deferral and forgiveness benefits to their investors by either operating a qualified opportunity zone business in an OZ or investing in one or more subsidiaries that are operating a qualified opportunity zone business in an OZ. Qualifying businesses include real estate ownership, leasing and operation, and most types of operating businesses.

Tax reform legislation established certain criteria for the designation of a census tract as an OZ and granted the governor or other chief executive office in each state or US territory the authority to make the designations. More than 8,700 census tracts across the country have now been designated as OZs, including tracts in the District of Columbia and five US territories. OZ designations will expire on 31 December 2028; however, the proposed regulations create a safe harbour for investments made before an OZ designation expiration so that investors can continue to receive certain tax benefits even after the OZ designation has expired.

Proposed and Forthcoming Regulations

In October 2018 and April 2019, the United States Department of the Treasury and the Internal Revenue Service (IRS) published proposed regulations for the OZ programme. Final Treasury regulations are not expected to be issued until later this year, but taxpayers may rely on the proposed regulations while final regulations are pending. While the proposed regulations have provided significant guidance on the programme, certain key issues remain to be addressed in the final regulations. 

In addition to the IRS and Treasury oversight, the White House Opportunity and Revitalization Council (the Council) was established by executive order in December 2018 and is comprised of representatives from 13 federal agencies. The Council published an Implementation Plan in April 2019 identifying actions each agency can take to focus existing federal programmes and resources on OZs and recommending changes to federal statutes, regulations, policies and programmes that would encourage public and private investment in economically distressed communities, including OZs.

Investing in OZ Funds

There are currently several trillion dollars-worth of unrealised capital gains, held by households and businesses across the USA, that are potentially available for deployment in OZs. The Opportunity Zone programme is designed to spur economic development by attracting investors to OZs through three distinct tax benefits that either delay or reduce the tax liability on profits treated as capital gains for federal income tax purposes. The key tax benefits, described in more detail below, include the following: (i) capital gains tax deferral on the original gain until the sale of the investment or 31 December 2026, whichever is earlier; (ii) a step-up in the investor’s tax basis on the eligible OZ investment by 10% if the investment is held for five years, and 15% if the investment is held for seven years; and (iii) forgiveness of capital gains tax on any new gain from the appreciation of the OZ investment if the investment is held for at least ten years. 

Any taxpayer, including individuals and entities such as partnerships, C corporations, S corporations, trusts and estates, may invest eligible capital gains under the OZ programme. Taxpayers may claim tax benefits for investing in an OZ even if they do not live, work or own property in that OZ. Entities investing in an OZ are not required to be domiciled or qualified to do business in the OZ, to own property in the OZ, to operate in the OZ or otherwise to have any nexus to the OZ other than the OZ investment. In the case of a partnership with OZ-eligible capital gains, the partnership may invest some or all of the gain in an OZ fund or, if the partnership does not elect to do so, any partner that was allocated all or a portion of the gain may invest its allocatable share into an OZ fund. The proposed regulations provide that analogous rules will apply to other pass-through entities (including S corporations, estates and trusts) and to their shareholders and beneficiaries.

Potential for Additional State Benefits

In addition to the incentives available at the federal level, taxpayers located in states that conform with the federal tax provisions may be able to defer and reduce state taxation on capital gains invested in OZ funds. States are also considering offering additional incentives for projects located in OZs. Examples include Missouri, the first state to pass OZ-specific legislation, which set aside a pool of USD30 million from its historic preservation tax credit programme for projects located in OZs, and Nebraska, which recently introduced legislation to give priority to OZs in the allocation of its Affordable Housing Trust Fund, Job Training Cash Fund, Site and Building Development Fund and Business Innovation Act assistance. 

Temporary Deferral of Capital Gains Reinvested in OZs

The new law permits investors to temporarily defer tax on capital gains from the sale or disposition of any type of asset (including, but not limited to, equity interests, securities and real estate assets) if the gain is reinvested in an OZ fund within 180 days. The capital gains must be gain that would otherwise have been recognised as income before 2027 and must not arise from a sale or exchange to a related person or from certain hedging transactions. Depreciation recapture is not an eligible gain for an OZ investment. Investors are not required to reinvest 100% of the sale proceeds or the amount of the gain from the asset sale in order to claim a tax benefit; investors may choose to invest as much of or as little of the proceeds of an asset sale into an OZ fund as they wish. Taxes on the reinvested gain may be deferred until the earlier of the date on which the investment in an OZ fund is sold or exchanged, or 31 December 2026. There is no limit on the amount of gain eligible for this deferral. 

The 180-day period generally commences on the date of the disposition; however, in the case of a partner in a partnership that has eligible capital gains but elects not to make an OZ fund investment at the partnership level, an investing partner may elect to start the 180-day clock either (i) on the date the partnership sold the asset or (ii) on the last day of the partnership’s taxable year in which the partner would be required to recognise its allocatable share of the gain. Analogous rules apply to other pass-through entities and their shareholders and beneficiaries.

The tax deferral for reinvested capital gains remains available to an investor that subsequently disposes of its entire original interest in an OZ fund, as long as it reinvests the proceeds into another OZ fund within 180 days, which provides flexibility for investors to exit an OZ fund without forfeiting the tax benefits.

Investors will use Form 8949 to make the election to defer capital gains in an OZ fund investment. This deferral election may only be made for investments in an OZ fund; therefore, an investor may not make a deferral election for an otherwise qualifying investment that is made before an eligible entity is an OZ fund.

Step-up in Basis for Qualifying Investments Held Over Time

Although a majority of the original qualifying OZ investment will eventually have to be included in the taxpayer’s income, the OZ programme provides a step-up in basis for OZ fund investments that results in the permanent exclusion from income of a portion of the original amount of invested capital gain, depending on the length of time the OZ fund investments are held by the taxpayer. The investor’s initial basis in the gain invested in the OZ fund is zero. If the OZ fund investment is held for longer than five years, the investor may claim a step-up in basis equal to 10% of the deferred gain that was initially invested, resulting in 10% of the deferred gain being permanently excluded from income for the investor. If the OZ fund investment is held for more than seven years, the step-up in basis is increased to 15%. The step-up in basis may only be claimed with respect to the eligible capital gains initially invested; any amounts invested that did not constitute qualifying investment of capital gains when initially invested in the OZ fund are not eligible for the basis step-up.

Tax-free Growth on Long-term Investments

If an investor holds an investment in an OZ fund for longer than ten years, the investor’s basis in the investment upon disposition will equal the investment’s fair market value on the date it is sold or exchanged. As long as all programme requirements are satisfied, all post-acquisition gain on the sale or exchange of an OZ fund investment that was funded by reinvested eligible capital gains will be permanently excluded from income. Under the proposed regulations, an investor may make an OZ fund investment as late as June 2027 and may claim the ten-year forgiveness on new capital gains at any time between the expiration of the ten-year holding period and 31 December 2047. 

Consider an investor who sells a business to an unrelated party for USD8 million. If the investor’s basis in the business is USD3 million, the gain from the sale is equal to USD5 million. The investor may defer 100% of the tax liability on the gain by reinvesting USD5 million into an OZ fund within 180 days of the sale. If the investor holds the OZ fund investment for longer than five years, the investor may claim a 10% step-up in basis so that only USD4.5 million, or 90%, of the originally invested gain will be subject to taxation. If the investor holds the OZ fund investment for longer than seven years, the investor is entitled to claim a step-up in basis equal to 15% so that only USD4.25 million or 85%, of the originally invested gain will be taxed. Assume that the OZ investment has an appreciated value of USD10 million. If the OZ fund investment is held for more than ten years, the investor can sell the interest in the OZ fund at any time before the end of 2047 and will pay no tax on any appreciation in the value of the OZ fund investment that was purchased with the eligible capital gains. For the investor in our example, that is up to USD5 million of capital gain that will not be subject to capital gains tax. 

OZ Fund Investments Made with a Combination of Eligible Capital Gains and Other Funds

Investors are not limited to investing only eligible capital gains into an OZ fund; however, only those capital gains will receive the temporary deferral and the partial exclusion from income after five or seven years, and only the portion of the OZ fund investment held for at least ten years that was funded with the eligible capital gains will be eligible for the exclusion from income of all post-acquisition gain on that OZ fund interest. The permanent exclusion of post-acquisition gain on the portion of the OZ fund interest that was purchased with other funds is not eligible for the tax benefit. In other words, an investor can invest both qualifying funds and non-qualifying funds into an OZ fund, but the funds will be treated as if they are two separate investments for purposes of the OZ tax benefits.   

In the previous example, if the investor had invested USD10 million into an OZ fund, and only USD5 million of the investment was funded with an eligible capital gain, the investor would be entitled to claim a step-up in basis after five and seven years on the originally invested USD5 million gain but not with respect to the other funds invested in the OZ fund. If the investor held the OZ fund interest for longer than ten years, the investor would pay no tax on any appreciation in the value of the portion of the OZ fund investment that was purchased with the USD5 million gain, but the post-acquisition gain on the portion of the OZ fund investment that was purchased with other funds would not be eligible to be excluded from income.

Qualified Opportunity Funds

An OZ fund may be a partnership, limited liability company or corporation that was organised in one of the 50 US states, the District of Columbia or a US possession, and was formed for the purpose of investing in qualified OZ property. The OZ fund must have acquired such property after 31 December 2017, from an unrelated party, and must undergo semiannual tests to determine whether its assets consist on average of at least 90% qualified OZ property. An OZ fund may elect to apply each instance of the 90% assets test without taking into account any cash, cash equivalents or debt instruments with term of 18 months or less received by the fund in the six months preceding the test date. An OZ fund will be required to pay a penalty for each month it fails to meet the 90% asset test. The proposed regulations contemplate that OZ funds may from time to time sell or otherwise dispose of qualifying assets and provide that OZ funds will be given up to 12 months following a disposition to reinvest proceeds from such transactions without facing a penalty. 

To become an OZ fund, an eligible corporation or partnership self-certifies by filing Form 8996, Qualified Opportunity Fund, with its federal income tax return. Unlike some other economic development incentive programmes, such as the New Markets Tax Credits programme, there is no formal approval process for an entity to become an OZ fund. Form 8996 is also filed annually by an OZ fund to either certify that it continues to meet the statutory requirements or to calculate the penalty for non-compliance. The proposed regulations contemplate that OZ funds could be decertified under some circumstances; the forthcoming regulations are expected to identify the conduct that could result in the decertification of an OZ fund.

Qualified Opportunity Zone Property

The statute requires that an OZ fund hold 90% of its assets in qualified OZ property, which can be either the stock or a partnership interest in a qualified opportunity zone business (OZ business) or qualified opportunity zone business property (OZ business property). An OZ fund thus has two options for making qualifying investments: it may (i) make one or more equity investments in an eligible corporation or partnership, or (ii) directly own the qualifying property that is used in the business of the OZ fund, in which case there need be no separate OZ business entity that is the recipient of the investment. The programme provides flexibility to invest in a specific project or business or in a diversified OZ fund that invests in an array of businesses and projects.

Qualified Opportunity Zone Businesses

Qualified OZ stock and OZ partnership interest mean stock in a US corporation or an interest in a partnership or limited liability company that qualifies as an OZ business. The proposed regulations allow the OZ fund’s equity interest in an OZ business to include preferred stock or a partnership interest with special allocations, and the regulations also permit the owner of the equity interest to pledge the interest as collateral to secure debt. The stock or interest must be acquired by the OZ fund after 31 December 2017, at original issue and solely in exchange for cash. The business entity must be an OZ business at the time the equity interest is acquired by the OZ fund (or, in the case of a newly formed entity, organised for purposes of being an OZ business) and must remain qualified as an OZ business for substantially all of the time the OZ fund holds the stock or interest.

An OZ business is a start-up or a pre-existing trade or business in which at least 70% of the tangible property owned or leased by the business is OZ business property, discussed in more detail below. An OZ business may not be a private or commercial golf course, country club, massage parlour, hot tub facility, suntan facility, racetrack or other gambling facility, or any store the principal business of which is the sale of alcoholic beverages for consumption off the premises. In addition, at least 50% of the OZ business’s gross income must be derived from, and at least 40% of the OZ business’s intangible property must be used in, the active conduct of such business within an OZ.   

The proposed regulations provide three safe harbours and a facts and circumstances test for determining whether sufficient income is derived from a trade or business in an OZ for purposes of the 50% gross income test. OZ businesses only need to meet one of these safe harbours to satisfy the requirement.

The first safe harbour in the proposed regulations requires that at least 50% of the services performed (based on hours or compensation paid) for such business by its employees and independent contractors (and employees of independent contractors) are performed within the OZ. The second safe harbour provides that if at least 50% of the services performed for the business by its employees and independent contractors (and employees of independent contractors) are performed in the OZ, based on amounts paid for the services performed, the business meets the 50% gross income test. The third safe harbour provides that a business may satisfy the 50% gross income requirement if (i) the tangible property of the business that is in an OZ and (ii) the management or operational functions performed for the business in the OZ are each necessary to generate 50% of the gross income of the business. If a business only has a PO Box or other delivery address located in the OZ, the presence of the PO Box or other delivery address does not constitute a factor necessary to generate gross income by such business.

Businesses not meeting any of the other safe harbour tests may satisfy the 50% requirement if, based on all the facts and circumstances, at least 50% of the gross income of the business is derived from the active conduct of a trade or business in the OZ.

Finally, the average of the aggregate unadjusted bases of the OZ business’ property attributable to 'non-qualified financial property' must be less than 5%. Non-qualified financial property generally includes debt, stock, partnership interests, options, futures contracts, forward contracts, warrants, notional principal contracts, annuities and other similar property specified in Treasury regulations. Non-qualified financial property does not include, however, reasonable amounts of working capital held in cash, cash equivalents or debt instruments with a term of 18 months or less.

Safe Harbour for Working Capital

The proposed regulations recognised the challenge presented by the requirement limiting the non-qualified financial property that may be held by businesses, which may need a period of time to develop a business or to acquire and/or improve tangible property and put such property to active use in OZs. The proposed regulations established a safe harbour that treats cash, cash equivalents and debt instruments with a term of 18 months or less as reasonable working capital that may be held by an OZ business for a period of up to 31 months if the following requirements are satisfied: (i) there is a written plan that identifies the financial property as property held for either the development of a business or the acquisition, construction or substantial improvement of tangible property in the OZ, including both real property and other tangible property used in a business; (ii) there is a written schedule consistent with the ordinary start-up of a business for the expenditure of the financial property within 31 months; and (iii) the working capital assets are actually used in a manner that is substantially consistent with the written plan and schedule. 

If the tangible property is expected to qualify as OZ business property as a result of the planned expenditure of the working capital assets, then that tangible property will not be treated as failing to satisfy the programme requirements solely because the scheduled consumption of the working capital is not yet complete. In addition, if any gross income is derived from the working capital assets, then that gross income is counted toward satisfaction of the requirement that at least 50% of an OZ business’ gross income must be derived from the active conduct of a trade or business within an OZ. The requirement that a substantial portion of an OZ business’ intangible property be used in the active conduct of the business within an OZ will also be satisfied during any period in which the OZ business is proceeding in a manner consistent with the safe harbour requirements.

Qualified Opportunity Zone Business Property

Regardless of whether the OZ fund makes an equity investment into a separate OZ business or directly owns qualifying property for use in its own trade or business, the same definition of OZ business property will apply. OZ business property means tangible property that is used in a trade or business of either an OZ fund or an OZ business and that was purchased by the OZ fund or OZ business from an unrelated party after 31 December 2017 or was acquired by the OZ fund or OZ business under a lease entered into after 31 December 2017. Unlike tangible property that is purchased by an OZ fund or OZ business, the proposed regulations do not require leased tangible property to be acquired from a lessor that is unrelated to the entity that is the lessee under the lease, provided that certain requirements are satisfied. During substantially all of the OZ fund’s or OZ business’ holding period for such property, substantially all of the use of the property must be in an OZ. Finally, the original use of such property in the OZ must commence with the OZ fund or OZ business, or, alternatively, the OZ fund or OZ Business must substantially improve the property. 

Substantial Improvement and Original Use

For purposes of determining whether tangible property satisfies the original use requirement, the proposed regulations provide that the original use of leased tangible property in an OZ commences on the date any person first places the property in service in the OZ for purposes of depreciation (or first uses it in a manner that would allow depreciation or amortisation if that person were the property’s owner). Used tangible property satisfies the original use requirement if the property has not been previously so used or placed in service in the OZ. The proposed regulations further provide that if property has been unused or vacant for an uninterrupted period of at least five years, original use in the OZ commences on the date after that period when any person first uses or places the property in service in the OZ. 

OZ business property is substantially improved for purposes of meeting these criteria if, during any 30-month period following the acquisition of such property, the OZ fund or OZ business makes capital expenditures in an amount at least equal to the adjusted basis of the property as of the beginning of the 30-month period. The proposed regulations clarified that, with respect to the purchase of land in an OZ on which an existing building is located, the basis attributable to land on which a building sits is not taken into account in determining whether the building has been substantially improved. Thus, the property will qualify as long as the building basis additions exceed the original adjusted basis in the building, and the land does not need to be separately substantially improved. The proposed regulations intended that excluding the basis of land from the dollar amount that needs to be doubled in order for a building to be deemed substantially improved would facilitate repurposing vacant or underutilised buildings in OZs, even if a building is located on land that comprised a significant portion of the purchase price of the property.

As an example, an OZ business that after 2017 purchases land and an existing building located in an OZ for USD50,000, with USD30,000 allocable to the land and USD20,000 allocatable to the building, need only make at least USD20,000-worth of improvements to the building to satisfy the substantial improvement requirement. The OZ business does not need to separately improve the land or take the basis of the land into account in order for the property to satisfy the requirement.

OZ Businesses and OZ Business Property

As noted above, at least 70% of the tangible property owned or leased by an OZ business must qualify as OZ business property. The 70% threshold provides an OZ business with some flexibility to acquire a limited amount of tangible property that would not otherwise qualify as OZ business property, including, for example, assets used outside of the OZ, assets acquired before 2018 and assets obtained from related parties. The requirement also creates an incentive for OZ funds to invest in separate business entities rather than owning OZ business property directly because OZ businesses are subject to a lower standard than OZ funds (70% as opposed to 90%). 

The proposed regulations provide the following illustration, which assumes that an OZ fund with USD10 million in assets intends to invest all of its assets in real property. If the OZ fund holds the real property directly, then at least 90% or USD9 million-worth of the real property must be located within an OZ in order for the OZ fund to avoid paying a penalty. If the OZ fund instead makes a USD10 million equity investment in an OZ Business, only 70% of its total investment or USD7 million-worth of the real property need be located within an OZ. Because only 90% of the OZ fund’s assets must be qualified OZ property, the fund is only required to invest USD9 million in the OZ business. Because that OZ business is only required to hold 70% of its property in the OZ, the OZ fund could receive the maximum federal income tax benefits while only investing 63%, or USD6.3 million, of its total USD10 million in an OZ.   

However, this requirement could, as a practical matter, exclude many pre-existing businesses from qualifying as an OZ business to the extent that more than 30% of a business’ otherwise qualifying property was acquired before 2018. In light of Congress’ intent to encourage OZ funds to invest in both new and existing businesses in low-income communities, the IRS and Treasury have requested public input on whether there might be any statutory flexibility to facilitate the qualification of a greater number of pre-existing businesses.


The flexible structure of OZ funds allows taxpayers to invest in a variety of opportunities in many of our country’s distressed communities. The designers and supporters of the new law envisioned a flexible programme where the market would determine how our country’s wealth might be better utilised in underserved communities. Early beneficiaries of the programme include OZ real estate developments, such as commercial developments (warehouse, hospitality, office, etc), residential rental property (including affordable housing), and mixed-use and industrial developments. However, the OZ programme can benefit many other businesses, including energy businesses, transportation and infrastructure projects, agriculture businesses, manufacturing businesses, and start-ups and expanding businesses of all types. The OZ programme can be layered with other economic and community development initiatives, including disaster recovery and other HUD programs, workforce development programmes, small-business lending, tax increment financing districts, brownfield redevelopment, and private activity and industrial development bonds. The tax incentives available under the OZ programme can also be used in conjunction with tax credit programmes, including low-income housing tax credits, new markets tax credits, state job tax credits, and state and federal historic rehabilitation tax credits. Given the generous financial incentives and the substantial interest among private investors, the Opportunity Zone legislation may ultimately attract billions of dollars in private capital to economically distressed communities across the country, and it has the potential to become one of the most significant economic development programmes in US history.

Fishman Haygood LLP

201 St. Charles Avenue
Suite 4600
New Orleans, LA 70170-4600

+1 504 586 5252

+1 504 586 5250
Author Business Card

Law and Practice


King & Spalding LLP has a Real Estate team composed of 27 partners and 40 qualified lawyers with a national reputation for representing domestic and offshore investors in large-scale commercial real estate assets in the United States. The firm has represented clients in all major US markets (New York, San Francisco, Houston, Washington, D.C. and Chicago) on national marquee transactions over the past year. Its holistic, business-focused platform draws on the expertise of real estate partners, private equity partners, finance and restructuring partners, M&A partners and tax partners who constitute a team of dedicated, cross-disciplinary professionals with deep roots in the industry, regularly assisting clients with raising, structuring and deploying equity and debt capital in the public and private markets and completing real estate acquisitions, dispositions and developments with that capital. Particular areas of focus also include complex joint ventures, real estate funds, development and M&A, financial restructuring, public and private capitalisation strategies, domestic and cross-border tax structuring and Islamic finance.

Trends and Development


Fishman Haygood LLP provide a full range of corporate, financing and litigation services to its real estate clients. The firm's real estate practice comprises 13 real estate attorneys located in Baton Rouge and New Orleans, Louisiana. Fishman Haygood also has an affiliated title company that is an agent for most of the major US title insurance companies. The firm's key practice areas include commercial construction, development, finance, land use, leasing, governmental incentives, planning and title insurance. Fishman Haygood's real estate attorneys have been involved in numerous landmark real estate transactions, including major commercial, office, healthcare, hospitality and industrial projects, representing clients across the spectrum in Louisiana and throughout the USA. Leading real estate investors, lenders, and developers rely on Fishman Haygood’s renowned knowledge of commercial real estate transactions.

Compare law and practice by selecting locations and topic(s)


Select Topic(s)

loading ...

Please select at least one chapter and one topic to use the compare functionality.