The structuring of an opportunity zone transaction can be quite complicated and require an analysis of many different alternatives in connection therewith. Below is a list of various types of structuring that need to be considered:
1. Direct QOF Investments
When the qualified opportunity zone fund (QOF) is formed, that entity itself could directly invest in a project providing it meets the 90%/10% test meaning that 90% of the proceeds would need to be invested in the project as of all the testing dates (June and December 31 each year) in order to meet the requirements related to the OZ program. This is not a typical structure but can be utilized in a very simple transaction where property is purchase and the monies are expended in a short period of time or monies are contributed over a period of time and spent to complete the project.
2. Utilization of QOZB
What is more common is for the QOF sponsor to establish a qualified opportunity zone business (QOZB), and the QOF will then invest in the QOZB. Both entities need to be taxpayer entities, which are typically limited partnerships or limited liability companies. The advantage of establishing a QOZB is the compliance requirements are more flexible. Again, the QOF would need to invest at least 90% of its proceeds into the QOZB although it is common for a QOF to invest all of its proceeds into a QOZB in order for all of the funds are utilized to develop the project. A QOZB would then only need to have the advantage of only having 70% of its assets utilized for project expenses as of each testing date, with available cash being utilized for project expense. Up to 30% of the assets in a QOZB could be invested outside of the opportunity zone, although the funds still need to be invested in accordance with the OZ Program and in accordance with the applicable business plan. This enables the QOZB to acquire the property and use cash over an extended period of time to fund the development of the project, since cash retained by the QOZB will be extended. There is a 31-month investment period subject to extension for an additional 31 months if there are reasons for delay in permitting or zoning approvals that were not contemplated in the original QOZB plan. It is of course critical in any situation that an appropriate business plan be established by the QOZB in order to justify the retention of cash for development. It is noteworthy that there is no definition in the OZ regulations as to what is an appropriate business plan but industry standards believe that a typical business plan used for financing purposes should be sufficient.
3. Multiple Projects
The next option is establishing a QOF that could invest in multiple QOZB transactions. There is no limitation on how many different projects a QOF can invest in that are located in Opportunity Zones. The negative of this structure is the liquidation process since there is a 10-year holding period from the day that the last investor invests in the QOF.
4. Multiple QOFs
Another structuring methodology involves the fact that many sophisticated investors have already formed their own QOF and desire to invest in a QOZB. In that manner, it is common for multiple QOFs to be accommodated to invest in a QOZB. Typically, the sponsor will form its own QOF for those investors that have not established their own QOF entities in order to accommodate same. The structuring would then involve a promote and fees charged at the QOZB level so that the distributions to the QOF would be net of the promote interest. Below is a proposed structure chart outlining this complicated structure that can be utilized to accommodate investors who have established their own QOF.
5. Securities Law Compliance
From a securities law standpoint it is important that there be proper disclosures provided to investors. This can be accomplished by utilizing a private placement memorandum (the PPM) which would have the normal disclosures that would otherwise be contained in a private equity offering for a normal real estate or business transaction. Otherwise, if there is a small number of investors, one can use a subscription package that provides much of the same information as the PPM with numerous exhibits listing all of the components necessary to be included in the offering documents. In either case, the disclosures are similar in nature. To the extent that the transaction is accommodating the investment by existing QOFs, the subscription documents need to be prepared to enable an investor either to invest directly into the QOF or to invest in a QOZB.
6. Other Key Structuring Factors
(a) To the extent that a property was acquired pre-2018, then a ground lease model may be appropriate whereby the property is leased to an affiliated entity but the requirements in the Final OZ Regulations must be complied with in connection with the Lease provisions in the structuring process to meet the safe harbor provisions related thereto.
(b) To the extent that a property is acquired after 2017, if there is an existing structure contained thereon, the project may have to meet the “substantial improvement test” to the extent that the property has been in active use (such as apartment rental project). However, if the use is being changed or the property has been vacant for more than 3 years, substantial improvement test should not apply. There is a complicated structure issue as to whether the existing property can be expanded and whether the expansion itself would be included in the substantial improvement test and whether properties could be aggregated in connection therewith.
(c) With respect to the actual economics, the following sponsor promote and fees need to be addressed in the disclosure documents and the corporate agreements:
(i) Acquisition fee;
(ii) Asset management fee;
(iii) Development fee;
(iv) Property management fees unless same are paid to an independent third party;
(v) Preferred return to investors;
(d) Promote Interest to Sponsors.
(i) In determining the promote interest, there could be a sliding scale whereby the promote increases as the internal rate of return to investors meets certain barriers prior to the increased promote interest being applicable.
(ii) A 20% promote is typical after investors receive a return of their capital contributions and the preferred return, plus a step up in the promote percentage based upon certain benchmark IRRs being obtained.
(e) Exiting from OZ Investments. This is an issue in and of itself. There needs to be a 10-year holding period based upon the time that the last investor invested in the QOZF in order to enable each investor to qualify if there is a sale. Accordingly, it is common that offerings have a limited time for funding in order not to extend the holding period prior to sale.
(f) Sale of Project. Another factor to be considered is that the project may not be performing adequately and can be sold by the QOZB, with proceeds returned to the QOF, and then reinvested in other projects. The sale itself will generate either a capital gain or a capital loss.
As apparent, the structuring of a proper OZ project is quite sophisticated and requires the consideration of all of the issues set forth above that will involve the guidance of OZ professionals to ensure that the structuring meets the requirements of the OZ Regulation.
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