Many have been riding the Opportunity Zone roller coaster since the Tax Cuts and Jobs Act of 2017 unleashed a flood of new regulations and tax forms.

A couple years later, most have figured out how to navigate those twists and turns to make most deals work. Many have been able to develop and collaborate on real estate deals including having the structure, organization and everything else needed to understand most single and multi-asset projects. The vast majority of qualified opportunity funds (QOFs) to date have focused on real estate investments.

However, real estate is only a small piece of what the qualified opportunity zone (QOZ) legislation was supposed to accomplish. The bigger opportunity was supposed to lie with qualified opportunity zone businesses (QOZB), so called operating businesses. While most real estate investments have a cap on the upside, the same is not true about operating businesses. Given the tax benefits available for holding investments for 10 years, this program can be massive for savvy QOZB investors.

So now, the key issue to answer is what other groups could take more advantage of QOZs? Private equity (PE) groups is the most logical choice.

WHY PRIVATE EQUITY

PE groups have vast amount of capital available to potentially invest in QOZs -- roughly $1 trillion in equity[1.] Despite a large amount of capital in these firms, many have yet to move into OZs.

Given the current economic climate due to the COVID-19 pandemic, it may be the perfect time for PE groups to look at QOZs as prices are low and there may not be other attractive investment options.

While there are some challenges PEs face in determining if a QOZ investment makes sense for their investors, the final regulations made it clearer for PE firms to move into QOZBs.

CHALLENGE ONE: INHERIT RISK OF QOZ

There is a total of 8,766 certified OZs available for investment. Some of these zones are concentrated in gentrified areas in prime urban markets that are very developable and do not have the inherent risk of many other QOZs. Accordingly, we have seen a focus of development in those zones early on in the program. However, the majority of QOFs are in need of significant capital investments and are in areas that may be less appealing to investors.

The average poverty rate in OZs is 28.9% compared to 14% across the U.S. Additionally, the median income is around $44,000 in a QOZ tracts compared to $70,000 nationally[2.]

Those dramatic differences are the reason the areas are QOZs, but it also means some types of investments may be unsuccessful there, making them less appealing to investors despite the tax breaks.

While many QOFs are taking an effort when they enter a community to speak with those within to help better determine the needs of the area, this ultimately doesn’t ensure the project will be successful.

Some PE groups may believe the risk compared to the tax benefits are too significant to warrant the possible change in their time-proven investment models.

On the other hand, there are over 8,700 zones covering approximately 12% of the U.S. and touching all major metropolitan areas, so there are definitely good opportunities out there for savvy investors.

CHALLENGE TWO: CARRIED INTEREST IN PE FIRMS

Another issue facing many PE firms is how to structure deals within the integrity of the proposed regulations while still satisfying the fund managers.

Typically, most PE deals are structured with a general partner (GP) and limited partner (LP) structure, where the GPs get a carried interest for managing the overall fund assets and the rest of the investors are the LPs. Under current regulations, one of the most common structures of a QOF is a partnership that invests in another partnership interest that is considered qualified opportunity zone property (QOZP).

For this to be a qualified investment, the QOZP must be obtained for cash, which could be a predicament since the carried interest is typically not exchanged for cash. Depending upon the value that could be assigned to this interest, it’s possible for the QOF to no longer hold 90% of its assets as QOZP, which might create issues for the QOF.

This brings us to how the value of the asset is going to be measured.

In the final regulations, The Treasury Department and the IRS determined that applying the alternative valuation method to partnership interests with a tax basis not based on cost, would be inconsistent with the intent and purpose of the statute. As a result, the final regulations provide that the alternative valuation method may be used to value only assets owned by a QOF that are acquired by purchase or constructed for fair market value. In such instances, the QOF’s unadjusted cost basis of the asset is determined under section 1012 or section 1013. The final regulations also provide that the value of each asset owned by a QOF that is not purchased or constructed for fair market value equals the asset’s fair market value. Thus, this would include any partnership interested owned by a QOF. A QOF determines that fair market value on the last day of the first six-month period of the taxable year and on the last day of the taxable year.

This would ultimately mean the profits interest would be re-valued at the QOF level twice a year, leaving the potential tests up in the air depending upon the type of profits interest and whether it has value. Therefore, it will be important the project is structured properly to avoid any bad implications of a profits interest that could result from this. This can be accomplished with diligent planning on the front-end to ensure the proper investment vehicles are set up.

CHALLENGE THREE: HOLDING PERIOD FOR ASSETS UNDER MANAGEMENT

One of the other predominant concerns with a QOF investment relates to the required holding period.

Typically, a PE fund is not tied into a pre-set timeline to deploy cash or to exit from an investment. But the largest benefit in investing in QOZs comes from each investor holding its fund interest for a minimum of 10 years.

That means PE firms need to seriously weigh how long they are comfortable keeping their capital parked in a QOF.

If they don’t hold QOZP assets for at least 10 years, investors in a QOF are required to recognize any gain or loss that occurs upon selling the underlying asset.

For example, let’s say the QOF invests in a business (structured as a partnership interest) that is going to build and rent an office complex.

Around year five, the manager of the QOF believes this particular investment has hit its peak and it’s an excellent time to sell the QOZP. The gain that the QOF will realize will be taxable because it has not met the 10-year hold requirement.

If the fund held real estate, there is a possible way around that tax. Regulations allow for an opportunity to utilize a §1031 like-kind exchange to defer and potentially eliminate gain at the fund level. Certain states may not conform to the Federal deferral rules, and there are also tax basis, depreciation, and other implications to consider, so it’s important to work with a tax advisor when considering a §1031 transaction.

PULLING IT ALL TOGETHER

Without a doubt, PE firms likely have the capital, clients, skillset and education to enter the opportunity zone market.

The inherent risks may not be enough to warrant the investment for some. However, the law was intended to be flexible enough to allow for investors with all sorts of different backgrounds to take advantage of the rules. And the tax benefits available may be too tempting for some to pass up.

Prior to the COVID-19 outbreak, investments in operating businesses were significantly lagging behind real estate and most PE firms have been sitting on the sidelines. While investments in almost all sectors have slowed significantly at the moment, investments in QOZs could be an important part of the recovery effort. Like many components of QOZs, everyone will have to wait and see how things play out.

Notes:

[1] Gottfried, M. (2019, June 18). Private-Equity Firms Are Raising Bigger and Bigger Funds. They Often Don't Deliver. Retrieved October 13, 2019, from https://www.wsj.com/articles/private-equity-firms-are-raising-bigger-and-bigger-funds-they-often-dont-deliver-11560859200

[2] Opportunity Zones Facts and Figures. (n.d.). Retrieved October 13, 2018, from https://eig.org/opportunityzones/facts-and-figures.