Status of the Gulf Opportunity Zone Act of 2005 and Its Effect on the Gulf Coast Region a Year After Katrina

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1 August 29, 2006 Rules of Professional Conduct in some of the states in which the Firm has offices require that we state "this is an advertisement." Status of the Gulf Opportunity Zone Act of 2005 and Its Effect on the Gulf Coast Region a Year After Katrina August 29th marks the one-year anniversary of Hurricane Katrina. The nation and the Gulf Coast are still recovering from the country s worst natural disaster, but recovery efforts are significant and underway. On this historic occasion, we would like to give you an executive update on the status of development efforts regarding the Gulf Opportunity Zone (GO Zone) Act of We hope this is helpful in understanding the true state of affairs and in considering opportunities in one of our nation s largest reconstruction efforts. Introduction In response to the devastation caused by Hurricane Katrina across the Gulf Coast region, Congress enacted significant federal legislation to promote recovery in the affected area. To date the relief legislation has taken two tracks: federal appropriations of direct subsidies, and tax code changes to promote investment. The federal appropriations are significant. In addition to the $60 billion in emergency relief to fund FEMA activities, the Fiscal Year 2006 Department of Defense Appropriations Act included $29 billion for Mississippi, Louisiana and Alabama for specific needs ranging from homeowner assistance to social services; rebuilding of federal facilities in the affected areas (e.g., levees, VA hospitals); and helping states that are housing evacuees. The Appropriations Act included $11.5 billion in community development block grants, $550 million in social services block grants, $2.75 billion for highway reconstruction, $125 million in workforce training and $75 million in coastal restoration funds. In addition to direct subsidies and appropriations, Congress enacted the 2005 Gulf Opportunity Zone Act (Act) to provide federal tax incentives to promote rebuilding and investment in the Gulf Coast region. The Act has generated a significant amount of activity and interest. General Overview of Effect of the Act When the Act was first passed, many investors and developers began to consider how best to put the tax incentives to work. The area designated to receive the benefits of the Act is expansive and includes 49 counties in Mississippi, 31 parishes in Louisiana and 11 counties

2 in Alabama. This provided many opportunities for investment and development not only in the coastal areas that were hardest hit by the hurricane, but also in the areas less affected by damage. The most significant interest initially related to the bonus depreciation provisions that allow a taxpayer to write off half of the cost of qualified property. Developers also closely analyzed the benefit of new tax exempt bonds that could be issued to finance new projects. Other incentives also quickly became relevant, in particular the $2,400 credit for newly hired employees. Although the Act generated a lot of interest, practical limitations soon set in and slowed down the use of the benefits. Notwithstanding the benefits of the incentives, labor and supply shortages continue to limit redevelopment along the Gulf Coast. And in areas where the damage was less dramatic, the markets often do not demand significant capital expansion or development. At this point the rush to build and reap the tax benefits has slowed down, but the initiative to rebuild is still present. Significant use of the tax incentives will likely be delayed to the point when large redevelopment is more feasible, but investors and developers are clearly expecting to use the tax incentives to promote investment. Working Under the Bonus Depreciation Rules When the Act came out, many investors and developers immediately focused on the bonus depreciation allowance. By being allowed to write off half of the cost of qualified property in its first year of use, taxpayers are able to recover the cost of the property much quicker. The benefit is most useful in real estate developments, where the normal recovery life is around 40 years. Developers have been working the tax benefits into their financial models or using the possibility of bonus depreciation when marketing properties. In fact, many advertisements for condominiums on the Gulf Coast state that the condos qualify for bonus depreciation. For many taxpayers, however, the restrictions of the bonus depreciation rules make it difficult to qualify. One of the biggest hurdles is the requirement that the property be used in an active trade or business. For some taxpayers, including many condo investors, an investment in property is intended to be a passive investment and thus the property would not qualify for bonus depreciation. It has also created problems for developers of commercial rental properties. The Internal Revenue Service has issued guidance that property leased on a triple net basis is not used in an active trade or business, and therefore does not qualify. Another difficulty created by the bonus depreciation rules is the placed-in-service requirements. For property to qualify, it must be placed in service before January 1, 2008 for personal property, and January 1, 2009 for real property. The dates have not been a significant problem in areas in the GO Zone that did not suffer heavy damage, but they pose a problem for developments along the Gulf Coast and for very large real estate developments because it may not be feasible to built large developments in that time frame.

3 A final concern related to using bonus depreciation has been the effect of the passive loss rules. Those rules limit the ability of a taxpayer to deduct a loss, including one created by the use of bonus depreciation, unless the taxpayer materially participates in the activity. There has been an increase in many out-of-state investors looking for investment opportunities that will offer bonus depreciation deductions to offset significant income events that the taxpayers may have previously incurred. However, unless the taxpayer will be involved in the day-to-day operations of the investment, many of the investors are finding that they are unable to use the tax loss that is generated. Notwithstanding these limitations, investors and developers continue to view the bonus depreciation allowance as a significant incentive. More sophisticated investment opportunities are being developed and marketed to work within the applicable rules, such as converting office space to condo units or structuring leases to move away from triple net status. In other instances, developers are simply sharing the tax incentives with tenants by quantifying the value of the bonus depreciation and offering tenants a lower rent based on the tax benefit received. And finally, wealthy investors continue to search for the right investments to allow them to generate tax losses to offset prior year income events. Bond Financing The Act provides states in the GO Zone with significant bonding authority pursuant to which they can issue tax exempt, private activity bonds referred to as Gulf Opportunity Zone bonds. Alabama is authorized to issue up to $2.1 billion in bonds, Louisiana is authorized to issue up to $7.9 billion in bonds and Mississippi is authorized to issue up to $4.9 billion in bonds. The bond proceeds may be used for the development of a wide array of commercial projects in the GO Zone, including many activities that previously could not qualify for such bonds, such as hotels and office building developments. Use of exempt bonds is an alternative to bonus depreciation, and as taxpayers have begun to understand the limitations on the use of bonus depreciation, there has been more interest in exempt bonds. Further, the developments being proposed at this time are in the areas that have no lingering effects of the hurricane and therefore are necessarily smaller developments. The greatest need for large developments is along the Gulf Coast, and there has been an expectation that the majority of the bonding authority would be used in those areas. Since the area is not yet in a condition for large scale redevelopment, there has only been limited use of exempt bonds. For example, while Mississippi was allocated $4.9 billion in GO Zone bonds, there have only been about six bond allocations approved for issue, totaling approximately $140 million. Of those, only three bond offerings have closed, and two of those were housing developments through the Mississippi Home Corporation, which is the Mississippi housing authority. Louisiana has allocated and approved more bonds in terms of absolute dollars, but not a significant portion of its bonding authority. Alabama appears to be the exception. It has approved approximately one-half of its bonding authority, and is holding back the remaining portion for potentially large developments.

4 Interpretive Guidance by the IRS The IRS has been fairly responsive in issuing formal guidance on its interpretation of the relevant rules of the Act. Although not always as favorable as taxpayers would like, the IRS has stated its position in many areas and thus created some level of certainty for investors. For example, the IRS has clarified that it believes triple net leases are passive by nature and therefore the property does not qualify for bonus depreciation. On the other hand, it has provided several concrete examples that demonstrate improvements made to an existing building generally qualify for bonus depreciation (assuming the other requirements are met). The Service has also issued two guides that provide a user friendly explanation of the Act s provisions and continues to maintain an up-to-date webpage for Hurricane Katrina victims, professionals and other parties interested in the Act s provisions. Legislative Changes There have been several attempts to expand or modify provisions in the Act. For example, a bill was introduced to extend the Act s provisions to areas affected by Hurricane Rita. This would include the metropolitan area of Houston and thus has a huge impact on many taxpayers. A bill was also introduced to extend the placed-in-service deadlines dictated by the Act. Other modifications have been attempted, but thus far no significant expansion of change has been successful. There is a general feeling among professionals, developers and some of those in the political realm that at a minimum the placed-in-service deadlines for counties and parishes on the coast will be extended. However, the delay in legislation has frustrated developers who do not want to commit to a project unless they know they have enough time to complete it in the relevant time frames. Conclusion The Act has created many significant and valuable tax incentives to promote redevelopment, but other factors such as labor and supply shortages have limited the ability to capitalize on those benefits. Additionally, restrictions in the Act itself have limited some developments, so the pace of development as a direct result of the Act s incentives has been fairly slow. But as developers and investors have had time to learn the relevant rules, new structures have been created to take advantage of the incentives. Ultimately, the feasibility of a development turns on factors that are non-tax related, but developers and investors are learning to integrate the tax incentives into their financial analysis. The Act can be expected to have a significant impact on the ability to move forward with many investments and developments. For more information, visit Baker Donelson's Gulf Coast Reconstruction website or contact: Stephen Edds sedds@bakerdonelson.com Jon D. Seawright jseawright@bakerdonelson.com Robert Nuzum rnuzum@bakerdonelson.com

5 Under requirements imposed by the IRS, we inform you that, if any advice concerning one or more U.S. federal tax issues is contained in this communication (including any attachments), such advice was not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any transaction or tax-related matter addressed herein. The Rules of Professional Conduct of the various states where our offices are located require the following language: THIS IS AN ADVERTISEMENT. IF YOU HAVE ALREADY HIRED OR RETAINED A LAWYER IN THIS MATTER, PLEASE DISREGARD THIS MESSAGE. No representation is made that the quality of the legal services to be performed is greater than the quality of legal services performed by other lawyers. Ben Adams, CEO and Chairman of the Firm, maintains an office at 165 Madison Avenue, Suite 2000, Memphis, Tennessee 38103, Baker, Donelson, Bearman, Caldwell & Berkowitz, PC