By Debbie A. Klis

The Tax Cuts and Jobs Act of 2017 (TCJA) made substantial changes to many aspects of the Internal Revenue Code (IRC) including the creation of a program deemed by many to be the most transformative development in real estate and venture capital in many years. It encourages investment in economically distressed communities known as “Qualified Opportunity Zones” (QOZs) in all 50 states. The QOZ program grants favorable tax treatment for an unlimited number of investments in QOZs during the life of the program, unlike certain federal tax credits, which are available on a finite basis annually.

The singular goal of the program is to tap into trillions of dollars of unrealized capital gains to spur economic development and job creation in low-income communities designated as QOZs by the Treasury Department. The TCJA requires that QOZ investments occur through Qualified Opportunity Funds (QOF) rather than directly in a business or asset within a QOZ.

Structuring a Qualified Opportunity Fund

A QOF is an entity taxed as a partnership or corporation (including an LLC that is taxed as a partnership or corporation) that is organized to facilitate investments in QOZs on a tax-advantaged basis that will deploy at least 90 percent of its capital into qualifying investments in a QOZ. Newly enacted Section 1400Z-2 of the Internal Revenue Code of 1986, as amended (the Code), enacted by the TCJA, governs QOFs and permits self-certification as to “qualified” status by filing Form 8996 with the entity’s tax return.

On Oct. 19, 2018, the Treasury issued proposed regulations as additional guidance related to QOFs, and Form 8996. The proposed regulations provide that an entity must specify the month in which it will be first treated as a QOF in the Form 8996. Careful completion of the initial Form 8996 is essential because capital gain invested in an entity before its first month as a QOF is not a valid QOF investment. In addition, QOFs must file a newly completed Form 8996 annually with its tax return to report whether it has met the investment standard during its preceding tax year.

The TCJA requires that investors make an “investment” in a QOF, which means that subscribers must acquire an equity interest in a QOF in exchange for their respective contribution of eligible gain (a loan or commitment to tender capital in the future is not a valid investment). Moreover, investors can receive the full suite of tax benefits under the TCJA in connection with their interests even if their relative portion of appreciation in the underlying QOF’s assets are not proportionate to their capital invested. Likewise, in connection with a QOF manager’s eligibility for QOF tax benefits, although the proposed regulations do not address carried interests specifically, it is unlikely that managers would receive tax benefits without investing eligible gains.

Investment Selection

A QOF’s investment strategy and objectives should be in sync with the TCJA’s intended purpose of stimulating positive growth within designated communities and procuring the prescribed tax benefits to its investors. A QOF’s operational strategies to maintain capital and achieve income and growth, must incorporate the inextricably linked investment restrictions requiring that at least 90 percent of its assets are comprised of “qualified opportunity zone property” (QOZP). A QOF’s remaining investments are not regulated.

QOZP falls in three categories, each of which is subject to a set of rules to qualify under the program:

Stock in a U.S. corporation provided the QOF acquires the stock at its original issue after Dec. 31, 2017 (directly or through an underwriter) from the corporation in exchange for cash, when the QOF acquires the stock, the corporation was a Qualified Opportunity Zone Business (QOZB)[1] (or if newly formed, it is being organized for purposes of being a QOZB), and during substantially all of the QOF’s holding period, the corporation qualifies as a QOZB.

An interest in a U.S. partnership (capital or profits) provided the QOF acquires the interest after Dec. 31, 2017 from the partnership solely in exchange for cash, when the QOF acquires the interest, the partnership was a QOZB (or if newly formed, it is being organized for purposes of being a QOZB), and during substantially all of the QOF’s holding period, the partnership qualifies as a QOZB.

Tangible personal property that is used in a trade or business provided (a) the QOF acquired such property from an unrelated party after Dec. 31, 2017; (b) the original use of the property commenced with the QOF or the QOF substantially improves[2] the property; and (c) the property was owned during substantially all of the QOF’s holding period in a QOZ.[3]

According to the proposed regulations, the basis attributable to land is not used in determining whether substantial improvement to a building occurred; assume a QOF acquired property in a QOZ for $2 million and allocated $800,000 to an existing building and $1.2 million to land. The property would qualify as QOZP if the QOF incurs at least $800,000 in costs that are capitalized into the building’s basis within the 30-month period beginning the date the QOF acquired the property. Simply put, a QOF may invest in the construction of new buildings and the substantial improvement of existing buildings; in the case of an existing building, the QOF must invest more in the improvement than it paid to purchase the building and the development must be completed within 30 months of purchase.

Compliance with the 90 percent Asset Test

A QOF must demonstrate compliance with the 90 percent asset test on the last day of the first six-month period of the QOF’s taxable year and on its last day of the taxable year. The proposed regulations provide that the first 6-month period of the taxable year of the fund means the QOF’s first six months of the year and month in which it first requested QOF treatment, as it designated in its Form 8996. By way of example, a QOF formed in January of 2019 for which its principals chose March 2019 as its first month as a QOF – the first 90 percent asset-testing period for year one is Aug. 31 and the second is Dec. 31, 2019.[4] Thereafter, the 90 percent asset test will occur on June 30 and Dec. 31.

To complete the asset test, the proposed regulations require that if a QOF has an “applicable financial statement” (defined in §1.475(a)-4(h)(1) of the Regulations), and it must use the asset values contained therein. Without an applicable financial statement, its asset values must be measured using the cost of each asset. At the Internal Revenue Service’s (IRS) open hearing on the proposed regulations on Feb. 14, 2019, witnesses testified that GAAP-based financial statements are too burdensome and may lead to unforeseen results such as a decline in an asset’s value over time due to depreciation required under GAAP. The testimony included suggestions that the final regulations permit QOZBs and QOFs to rely on a tangible asset’s unadjusted costs basis for the asset’s value despite the presence of the asset’s value in a financial statement.

QOF Timing Considerations

QOFs, and the QOZB in which the QOFs invest, have important timing considerations. First, the QOF may have as much as a six-month window to deploy its investors’ funds into a QOZB in order to remain compliant with the 90 percent-asset reporting test to the IRS. Second, to address the 5 percent non-qualified financial property limitation, the proposed regulations provide a 31-month safe harbor period commencing when the QOF contributes cash to a QOZB. The QOZB, which must have at least 70 percent of its tangible property (owned or leased) is QOZB property, can treat the contributions as working capital for disbursement during a 31-month period provided it designates the amounts in writing, maintains reasonable written schedule to deploy the funds, and uses the funds in a manner that is substantially consistent with the schedule. Additional regulatory guidance is expected regarding a QOF’s investment in a QOZ business property including with regards to the substantially all test to qualify as a QOZ business.

The third timing issue concerns exiting investments; for example, the proposed regulations did not address the mechanics of exiting investments in 2026 when the initial capital gains invested in OZFs are due or when a QOF sells an asset before 2026 but reinvests the proceeds in QOZ. A stampede of liquidations by countless QOFs could occur in 2026, as investors struggle for funds to pay their deferred tax (perhaps an opportune time to acquire assets?) Uncertainty surrounds a QOF’s sale of an asset to accommodate redemption of an investor who desires to exit early, as to whether only the investor faces tax if the QOF reinvests nearly all of the proceeds in a QOZ except the funds used to redeem the investor. To avoid the sale of assets, the QOF can permit the investor to sell her interest to one or more fellow investors, assuming the partnership agreement authorizes the sale.[5] Without a buyer to acquire the partner’s interest, the QOF’s likely options are to refinance or sell the asset.  

One option is to form the QOF as a corporation with the stock linked to one of the emerging SEC-regulated secondary private equity index markets.[6] Investors acquire an equity interest in the corporation structured as a QOF but can sell the stock if needed through the secondary market. Additional guidance is expected soon, which may address the timing, exit, reinvestment, compliance, and other issues of concern to QOFs sponsors.

Additional Tips for QOZ Investments and Asset Acquisitions

While awaiting additional guidance, certain best practice tips include:

Due Diligence: QOF sponsors are encouraged to undertake meticulous due diligence of each potential investment, whose merits must be reviewed in a manner that is independent of the suite of QOZ tax benefits that will apply to investors. QOFs can rely on the QOZ tax benefits to enhance each investment’s return (ROI) and thus enhance the “pitch” to potential investors. However, securities laws and duties of care still apply and require thorough due diligence to avoid surprises that were discoverable. ROI can be further enhanced by adding other public incentives in the capital stack, which are compatible with the QOZ Program (e.g., LIHTCs, NMTCs, EB-5, etc.) that encourage socially responsible investing that benefits communities.

Post-Closing Assistance with Data Collection: In the course of negotiating term sheets and definitive purchase agreements related to acquire QOZ assets, partnership interests and stock, QOZ fund sponsors should consider inserting language to require the QOZB to cull operations data to ease the QOFs compliance burden. The data requested would be tailored to the size and nature of the asset but should reveal how much of its income was derived from within a QOZ during the reporting period. Venture capital QOFs are particularly cautioned to procure this assistance from QOZB in which they invest.

Representations and Warranties: If the QOF fails to meet the 90-percent asset test, a penalty will generally apply in an amount equal to the product of: the excess of the amount equal to 90 percent of the QOF’s aggregate assets, over the aggregate amount of QOZ property held by the QOF, multiplied by the underpayment rate.[7] QOF sponsors should consider whether to insert a representation in the definitive purchase agreement that if the QOF fails the 90-percent asset test because of the QOZB’s lack of cooperation to produce data or related breach of representations in definitive agreements, the QOZB might be required to indemnify the QOF. An additional QOZB representation to consider includes a covenant to remain within a QOZ and continue primary operations therein during the compliance period (subject to allowed exceptions).

Representations and Warranties Insurance: The widespread acceptance of representation and warranty insurance to underwrite the risk of loss associated with breaches of representations and warranties in the definitive agreements might be useful on many QOZ investments. A closing condition of the QOF could require the QOZB to obtain a representation and warranty insurance policy.

The proposed regulations clarify many of the questions relating to investments and compliance by a QOF. QOF sponsors, investors and developers have since communicated constructive feedback and it appears that the IRS and Treasury are listening. Hope is warranted that the final regulations will fine tune the program to encourage investment in the QOFs with lessened compliance and qualification standards. Meanwhile, QOF sponsors are encouraged to be steadfast in their adherence to all applicable guidance and proceed with the high standards of care.

Notes:

[1] An operating business may qualify as a QOZB if, among other requirements, at least 70 percent of its tangible property (owned or leased by its trade or business) is QOZB property and the business is not a golf course, country club, massage parlor, hot tub or suntan facility, racetrack or gambling facility or a store that sells alcoholic beverages for consumption off premises.

[2] A substantial improvement means that the additions to the basis of the property during the 30-month period commencing on the acquisition date must exceed the adjusted basis of the property as of the acquisition date.

[3] The New Market Tax Credits (NMTC) regulations allow an entity to meet the gross income requirement if 50 percent of the use of its tangible property is within a low-income community. IRS and Treasury are being urged to interpret the QOZBs gross income requirement as it does with NMTC.

[4] However, if the calendar-year QOF chooses July or later as its first compliance month, the QOF will have just one testing date for the taxable year on the last day of December, which may be shorter window than otherwise available.

[5] However, if the capital generated is not derived from capital gains, negative tax consequences could result.

[6] See https://blogs.cfainstitute.org/investor/2018/05/07/growing-trends-in-private-equity-secondary-market-investing/

[7] This penalty will not apply if the failure is due to “reasonable cause.”