From the moment that the OZ program was created, it garnered heavy attention from the real estate industry. A popular question asked during the program’s infancy was “What types of asset classes were best suited for these qualified opportunity zones?” Given that these OZs were intended to be in low-income communities; multi-family, low income housing, and industrial projects were all top of mind. Now, having the benefit of hindsight with the OZ program over two years into its existence, we see that Qualified Opportunity Funds (QOF) appear to be deploying capital into OZs for projects that run the gamut of asset classes (hotels, retail, office, etc.). This may be due in part to the fact that several of the areas that were ultimately designated as OZs were within or adjacent to increasingly attractive areas. “We were already planning to do projects in this area” was a reoccurring phrase said by developers as the OZ areas became designated. The attractiveness of an area coupled with the fact that the OZ benefits maximize the return to QOF investors has resulted in a diverse mix of real estate projects being done in OZs across the country.
COMMON OZ ISSUES FOR REAL ESTATE VENTURES
In order for investors to benefit from the OZ program, QOF and the QOZB they invest into need to comply with the various OZ rules to qualify for the designation as a qualified fund or business. Investors also need to follow certain rules to maintain the benefits of their qualifying investments. These various rules can present challenges for all real estate projects. Further, several asset classes can present their own unique challenges. Below are some common issues that may arise when forming and operating a real estate focused opportunity fund:
THE USE OF TRIPLE NET LEASES IN AN OZ PROJECT
To qualify as an QOF, the fund needs to deploy the capital it raises into active trades or businesses that operate within OZs. The active conduct of a trade or business is not clearly defined for this purpose. Further, the operation of a rental property qualifying as an active conduct of a trade or business has a long history of litigation between taxpayers and the IRS with conflicting judgements. This makes the active trade or business designation for a rental property heavily dependent on the facts and circumstances of a given venture. However, the OZ regulations make it clear that the ownership and operation of real property (including leasing) will be considered the active conduct of a trade or business for purposes of the OZ program. [1]
While this was welcomed guidance, the regulations go on to say that merely entering into a triple net lease with respect to real property owned by an entity is not the active conduct of a trade or business. This can be an issue for asset classes such as office, industrial, or retail that commonly utilize triple net lease arrangements with their tenants. QOF or QOZB should carefully consider the terms in the lease arrangements they are entering into with their tenants to insure that their level of activity will rise to the level of an active trade or business.
CASH BALANCES AT QOZB
One of the requirements to qualify as a QOZB is that cash and other nonqualified financial property makes up less than 5% of the average aggregate unadjusted basis of property owned by the QOZB. [2] This is sometimes referred to as the “5% test.” Initially, there was a concern that this 5% test would prevent ground-up development projects from qualifying as a QOZB, since in the early stages of a development project the entity would be carrying large cash balances to fund the construction of the property. However, the OZ regulations address this concern through the creation of the working capital safe harbor. [3]
Cash, cash equivalents, or debt instruments with a term of 18 months or less are not considered nonqualified financial property for purposes of the 5% test if they qualify as a reasonable amount of working capital. Amongst other requirements, the cash, cash equivalents, and debt instruments with a term of 18 months or less must be identified in writing as working capital and must be spent within 31 months of the receipt by the business of the assets to qualify as a reasonable amount of working capital.[4] The regulations also allow a QOZB to utilize multiple working capital plans for subsequent cash infusions for a period up to 62 months from the date of the first working capital plan. In response to the COVID-19 pandemic, the IRS recently issued guidance in Notice 2020-39 aimed at relief for OZs. Among other items, the notice provides relief for all QOZBs holding working capital assets before Dec. 31, 2020. This relief will allow these QOZBs to receive an additional 24 months to expend the working capital assets of the QOZB. The relief was previously provided for in the OZ regulations but this notice gave clear guidance on how the rule applies to QOZBs affected by the COVID-19 pandemic. It is important to note that in order to receive this additional 24 months, a QOZB has to fall under the working capital safe harbor outlined in the regulations.
While this safe harbor seems to address cash balances being used for the development of real property, it does not address other instances when a QOZB may need to carry large cash balances. For example, consider an office building that will have tenants whose leases are nearing the end of their term. As the entity’s leases with the building tenants near the end of the lease term, it is not uncommon that the entity will start holding back cash from operating distributions to reserve cash for upcoming tenant improvements needed to secure a lease renewal or a new tenant. Since this cash is from operations, it would be received on numerous dates throughout the year and it will be a laborious task to have a working capital plan in writing for each date of the receipt of said cash. Therefore, this cash reserve balance held at the QOZB will potentially not qualify for the safe harbor provided in the proposed regulations.
It is important to note that falling outside of this safe harbor definition of working capital doesn’t automatically mean that the cash, cash equivalents, or debt instruments with a term of 18 months of less at your QOZB is not reasonable working capital. It merely means that the entity would need to defend its classification of these amounts as reasonable working capital if the IRS ever challenged it.
DISTRIBUTIONS TO INVESTORS FROM QOF
The OZ regulations outline a number of “inclusion events” that would cause an investor to recognize some/all of the gain they deferred by investing into the opportunity fund. [5] One of these “inclusions events” relates to distributions from an opportunity fund formed as a partnership with respect to a qualifying investment. Distributions received by an investor in a QOF formed as a partnership that are in excess of the investor’s tax basis with respect to their qualifying investment will trigger an “inclusion event” and will cause the investor to recognize a portion/all of the gain that they initially deferred by making an investment into the opportunity fund.[6] Keep in mind that since the opportunity fund is formed as a partnership, the investor’s tax basis will include the investor’s share of the entity’s debt.
The OZ regulations also has a provision that looks to limit an investor’s OZ benefits if they receive large distributions in the earlier years of the opportunity funds existence. This provision exists to discourage funds from “cashing out” their investors by returning large amounts of their initial investments early in the funds life cycle. If an investor was subject to the provision it would reclassify a portion of an investors qualifying investment in an opportunity fund to be a non-qualifying investment. This would mean that the investor would be losing the 10-year holding period benefit with respect to this now reclassified non-qualifying interest. An example of when this provision may be applicable in a real estate focused QOF would be a debt financed distribution upon stabilization of a property that was acquired and substantially improved.
QOF should be mindful of these provisions in the OZ regulations when deciding when and how much distributions to make to its investors to insure that the distribution doesn’t inadvertently cause an investor to have an inclusion event or a reclassification of their qualified investment.
Applying the OZ rules to a real estate project can at times feel like trying to put a square peg through a round hole. If you are interested in forming a real estate focused QOF, it is important to consider the complete life-cycle of the project when forming the structure and deciding on the economic terms between the fund sponsor and the fund investors. It is also important that you partner with advisors who have a deep understanding of the OZ program and have experience serving the real estate industry.
Notes:
[1] Treas. Reg. section 1.1400Z2(d)-1(d)(3)(iii)(A)
[2] I.R.C. section 1400Z-2(d)(3)(A)(ii)
[3]Treas. Reg. section 1.1400Z2(d)-1(d)(3)(v)
[4] Treas. Reg. section 1.1400Z2(d)-1(d)(3)(v)(B)
[5] Treas. Reg. section 1.1400Z2(b)-1(c)
[6] Treas. Reg. section 1.1400Z2(b)-1(c)(6)(iii)