The Opportunity Zone Incentive is almost two years old. Many Qualified Opportunity Funds (QOFs) now have a track record of raising money and deploying cash into real estate projects located in Qualified Opportunity Zones (OZs).
Two tranches of proposed regulations have been issued and the incentive is not lacking any complexity. Traps for the unwary exist. Therefore, having an appropriate due diligence process is critical for any QOF. This becomes more amplified where the QOF is investing in a third-party Qualified Opportunity Zone Business (QOZB).
An entity needs to satisfy a number of different requirements in order to qualify as a QOZB. Failure to qualify as a QOZB can result in penalties on the QOF and potentially on its investors. This article assumes that the QOZB will be organized as a domestic limited partnership or limited liability company treated as a partnership for federal income tax purposes.
This article describes the requirements to be a QOZB and focuses on what should be included in a due diligence checklist for a QOF when investing in a QOZB that will be acquiring, constructing, developing, and leasing a real estate project in an OZ. This checklist, which focuses on the OZ incentive only, should serve as a starting point for developing a more comprehensive due diligence assessment.
THE 90% ASSET TEST
A QOF is required to hold at least 90% of its assets in Qualified Opportunity Zone Property (OZP), which is determined by taking the average of the percentage of OZP held by the QOF, as measured on the last day of the first six-month period of the taxable year of the QOF, and on the last day of the taxable year of the QOF. Cash is generally not considered to be OZP. Intangible property is also not considered to be OZP. Prior to the issuance of the most recent proposed regulations, a QOF needed to convert cash into OZP prior to each measurement date. The recent proposed regulations provide QOFs with a minimum period of at least 6 months and a maximum period of up to 12 months to convert the cash into OZP, depending upon when the QOF obtained the cash contribution.
The most common structure being employed involves the QOF making a contribution of cash to an entity in exchange for equity where such an equity investment satisfies certain requirements to qualify as OZP. OZP includes certain shares of stock or partnership interests in a domestic corporation or partnership, respectively, that are issued to the QOF after Dec. 31, 2017, in an original issuance (or through an underwriter, with respect to a corporation), in exchange for cash, as long as the entity is a QOZB, on certain testing dates (which may include the date of the cash investment by the QOF), and during at least 90% of the QOF’s holding period with respect to such shares of stock or partnership interests.
A QOZB is a domestic corporation or partnership for federal income tax purposes engaged in a trade or business that satisfies five requirements that are discussed below. The instructions to Form 8896 provide that the QOZB must be organized for the purposes of being a QOZB.
Checklist for certain OZP/QOZB Requirements when investing in a third party QOZB: Obtain and Review from the QOZB
• All organizational documents that are filed with the state.
• Any shareholder agreements, partnership agreements, or LLC operating agreements.
• Any previously filed federal and state income tax returns.
• Any previously prepared financial statements.
• A sources and uses schedule for the project.
Confirm:
• The entity is a domestic corporation or a domestic entity that is or will at the time of the cash contribution (depending upon the circumstances) be treated as a partnership for federal income tax purposes.
• Certain purpose language is included in the formation and governing documents of the entity.
Failure of an entity to meet the requirements described below to be a QOZB would result in the QOF owning an asset (i.e. equity in the entity that failed to qualify as a QOZB) that does not qualify as OZP. This could result in the QOF failing the 90% Asset Test described above. This means that the due diligence process on whether the entity will satisfy the requirements to be a QOZB is critical for the QOF.
THE FIVE QOZB REQUIREMENTS
The following are the five requirements that need to be satisfied in order for a domestic entity that is a corporation or a partnership for federal income tax purposes to be considered to be a QOZB.
70% REQUIREMENT
With respect to an entity attempting to qualify as a QOZB, one of the requirements is that the entity be engaged in a trade or business in which at least 70% of the tangible property, owned or leased, by such entity is Qualified Opportunity Zone Business Property (OZBP). At this point, it is unclear when the 70% Requirement needs to be tested. Some have speculated that this should be tested on the same measurement dates as are required for the QOF’s 90% Asset Test.
There are different methods to measure the value of the assets for purposes of the 70% Requirement. The most common method appears to be using the cost basis of the assets. With respect to tangible property leased, for federal income tax purposes, to the QOZB, the valuation is generally based upon the present value of the lease payments, as further discussed in the recently proposed regulations.
OZBP is tangible property used in a trade or business of the QOZB that was acquired by the QOZB by purchase from an unrelated person after Dec. 31, 2017, and during at least 90% of the QOZB’s holding period for such property, at least 70% of the use of such property must be in an OZ.
An additional requirement for tangible property to be considered to be OZBP is that either: the original use of the tangible property in the OZ is required to commence with the QOZB, or the QOZB is required to substantially improve the tangible property. The substantial improvement requirement provides that during any 30-month period commencing after the acquisition date of the tangible property, additions to the income tax basis “with respect to” such property in the hands of the QOZB must exceed an amount equal to the adjusted income tax basis of such property at the beginning of such 30-month period in the hands of the QOZB.
Checklist for the 70% Requirement: Obtain and Review
(To the extent that the Property is being leased or subleased to the QOZB for federal income tax purposes, the discussion on “Leased or Subleased Property” should supplement this section)
• List of the current property.
• Purchase, lease, or sublease agreements.
• The current fair market value of the property via an appraisal.
• Title reports and deeds.
• Construction contracts, and a construction budget and timeline.
• Fee agreements.
• Information on how the property was obtained (i.e. by purchase, lease, sublease, contribution for equity, gift, etc.), and the date that the property was obtained.
• The purchase price of the property.
• The current federal income tax basis of the property and the tax basis of the property at the time of acquisition.
• Current and historical locations of all property.
• Organizational chart of the seller of the property, which includes all direct and indirect owners.
Confirm:
• The property is located entirely in an OZ, unless it straddles an OZ – then see the recently proposed regulations.
• The seller was not or is not directly or indirectly related to the QOZB (taking into account any owner attribution rules).
• The property was obtained after Dec. 31, 2017.
• The costs of construction with respect to any acquired property will exceed the acquisition price of the property, unless the property involves the acquisition of a building which will be rehabilitated – then supplement this with the discussion under Acquisition of a Building.
• Fees that are capitalized for federal income tax purposes and will be paid to a person related to the QOZB are not significant enough to be problematic under the 70% Test assuming such payment (or accrual of payment, if necessary) will be treated as an acquisition of tangible property from a related party.
• All of the property that has been or will be acquired will be used in the trade or business of the QOZB.
50% GROSS INCOME REQUIREMENT
It is required that at least 50% of the gross income of a QOZB is derived from the active conduct of a trade or business in the OZ.
The recently issued proposed regulations provide that the ownership and operation (including leasing) of real property is considered to be the active conduct of a trade or business. However, these regulations provide that “merely entering” into a triple net lease with respect to real property that is owned is not the active conduct of a trade or business. Having a meaningful obligation that will occur within the OZ appears to be important here. The lease should probably require the QOZB, as landlord, to be obligated to undertake certain meaningful activities that will occur at the property within the OZ, such as frequent and ongoing property management and maintenance obligations. It could be possible for the QOZB to contractually delegate these obligations to another.
Checklist for the 50% Gross Income Requirement: Obtain and Review
• Copies of any leases or subleases of real property and personal property owned, leased, or subleased by the QOZB to another.
• Copies of any ancillary agreements with respect to the real property, such as property management agreements.
• Any material business terms of any expected lease or sublease by the QOZB to another.
Confirm:
• Any lease by the QOZB to another is not or will not be a triple net lease.
• The QOZB will have a contractual obligation to perform certain meaningful obligations at the property under the lease or sublease.
INTANGIBLE PROPERTY REQUIREMENT
It is required that at least 40% of the intangible property of a QOZB must be used in the active conduct of a trade or business in the OZ. It is unclear how to meet the Intangible Property Requirement. It does not appear that the Intangible Property Requirement is critical for real estate projects where the QOZB will be leasing the real property to another.
It is possible that a QOZB can acquire a tenant’s interest in a leasehold interest via an assignment of the lease. This acquisition could be viewed as the acquisition of intangible property. However, a discussion of this subject area is beyond the scope of this article.
PROHIBITION ON SIN BUSINESSES
An entity cannot qualify as a QOZB if it is engaged in a trade or business involving any private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store where the principal business is the sale of alcoholic beverages for consumption off premises. It is very possible that the final regulations could prohibit a QOZB from renting property to a person or entity engaged in a sin business on the premises. Therefore, a QOF should ensure that the QOZB has not leased and will not lease the property to a person or entity that will engage in a sin business on the premises. Although a trade or business involving cannabis is not listed above, it currently should be treated as a sin business for these purposes.
Checklist for sin business prohibition: Obtain and Review
• Any leases or subleases of property by the QOZB to another.
Confirm:
• The QOZB will not engage in any of the sin businesses and does not plan to lease the property to a tenant that will engage in any of these businesses on the premises.
• Need to ensure that all expected leases and subleases will contain appropriate use restrictions.
NONQUALIFIED FINANCIAL PROPERTY (NQFP) LIMITATION
The last requirement is a limitation that no more than 5% of the average of the aggregate unadjusted tax bases of the property of the business can be attributable to nonqualified financial property. The NQFP Limitation requires testing each taxable year using the average of the aggregate unadjusted bases of property of the entity that may be attributable to NQFP. NQFP means debt, stock, partnership interests, options, futures contracts, forward contracts, warrants, notional principal contracts, annuities and other similar property specified in the regulations. NQFP does not include reasonable amounts of working capital (RWC) held in cash, cash equivalents or debt instruments with a term of 18 months or less (Working Capital Assets), nor does the term include accounts or notes receivable acquired in the ordinary course of business for services rendered or from the sale of inventory.
A loan made by the QOZB to another with a term of more than 18 months is problematic. A prepayment of rent by the QOZB could be treated as a loan for federal income tax purposes. Additionally, a lease of property to another could be in substance a sale for federal income tax purposes resulting in the QOZB being treated as selling the property and providing seller carryback financing. This could happen where the lease term is too long in relation to the useful life of the property, or the lessee has an option to acquire the property for a nominal amount.
The recently proposed regulations provide a safe harbor for RWC. This safe harbor provides that Working Capital Assets will be considered to be RWC by satisfying the following three requirements:
• The amounts are designated in writing identifying the Working Capital Assets being held for the development of a trade or business in an OZ, which includes the acquisition, construction, and/or substantial improvement of tangible property in an Opportunity Zone;
• There is a written schedule consistent with the ordinary start-up of a trade or business for the expenditure of such assets and the schedule demonstrates that the working capital assets will be spent within 31 months of receipt by the business; and
• The Working Capital Assets are actually used in a manner that is substantially consistent with this written plan.
Checklist for the NQFP Limitation: Obtain and Review
• Construction schedule with details on the amounts to be expended over the construction timeline.
• Financial projections for the operation of the property over at least a 10-year period.
• List of all NQFP assets as of the first day of the taxable year and as of the date of the QOF investment.
• List of any loans made by the entity, the material terms of the loans which includes the maturity date, and a copy of any loan documents.
• A current balance sheet (with the current cash balance) and a balance sheet (with the cash balance) for the first day of the taxable year.
• The current income tax bases of all of the assets and the income tax bases of all of the assets as of the first day of the taxable year.
Confirm:
• The amount of NQFP on the first day of the taxable year and the last day of the taxable year is less than 5% of the aggregate unadjusted tax bases of all of the assets of the QOZB.
• There are no restrictions in any agreement (including a loan agreement) that would prohibit the entity from distributing cash to avoid violating the NQFP Limitation.
• With respect to any real property or personal property that is being leased or subleased by the QOZB to another, the lease or sublease is not treated as a sale for federal income tax purposes.
• With respect to any real property or personal property that is being leased or subleased by the OZB from another, there are no prepayments of rent to be paid by the QOZB resulting in a deemed loan for federal income tax purposes.
• At the time that the QOF will make a cash investment into the QOZB, the project can be specifically identified.
The written construction and expenditure schedule demonstrates that the cash contributions from the QOF will be expended by the QOZB for the acquisition, construction, and/or substantial improvement of tangible property in an Opportunity Zone over a period not to exceed 31 months from the date of the QOF’s cash contribution to the QOZB.
Note that there are additional safe harbors that are beyond the scope of this article addressing the use of cash held by the QOZB which is subject to a written plan described above that can be used to satisfy certain requirements set forth above.LEASED OR SUBLEASED PROPERTY
The recently proposed regulations provide that tangible property that is leased by the QOZB can be OZBP when certain requirements are satisfied. First, the property must be acquired by the QOZB under a lease entered into after Dec. 31, 2017. Second, at the time that the lease is entered into, the terms of the lease must be market rate (i.e., the terms reflect common, arms-length market practice in the locale that includes the OZ under the Internal Revenue Code).
It is possible for a lease of tangible property between a lessor and a related QOZB to be OZBP by satisfying some additional requirements. First, the lessee cannot make a prepayment in connection with the lease related to a period of use of the tangible property that exceeds 12 months. Second, with respect to leased tangible personal property, during the earlier of the last date of the lease term or the 30-month period that begins on the date that the lessee takes possession of the tangible personal property under the lease, the lessee must become the owner of tangible property that is OZBP having a value equal to or greater than the value of the leased tangible personal property. Additionally, with respect to leased tangible personal property with related parties, there is a requirement that both the leased tangible personal property and the acquired OZBP must be used by the QOZB substantially in the same OZs.
Checklist for Leased or Subleased Property: Obtain and Review
• Any lease or sublease agreements.
• Evidence of market rate rental value, such as an appraisal addressing rental rates.
• Organizational chart of the lessor or sublessor which includes information on all of the direct and indirect owners of the lessor or sublessor.
Confirm:
• The lease or sublease is treated as a lease for federal income tax purposes and not as a sale. If it is a sale for federal income tax purposes, then this section for leased and subleased property does not apply.
• The lease or sublease was entered into after Dec. 31, 2017.
• The lease or sublease terms are at market rate for Opportunity Zone purposes.
• If the lessor or sublessor is related to the QOZB, then there are no prepayments that relate to a period that exceeds 12 months.
• If the lessor or sublessor is related to the QOZB, and the lease involves tangible personal property, then there is a plan for the QOZB to acquire the requisite amount of tangible property that qualifies as OZBP and is used by the QOZB in the same OZs as the leased tangible property.
ACQUISITION OF A BUILDING
A special rule exists where the QOZB acquires real property involving land and a building. Specifically, where a building is acquired located on land that is wholly within the OZ, the substantial improvement requirement is measured in relation to the QOZB’s additions to the adjusted basis of the building only and there is no requirement to separately substantially improve the land upon which the building is located. Further, there is no requirement to substantially improve a building that the QOZB acquires which was vacant or unused for an uninterrupted 5-year period.
Checklist for Acquisition of a Building: Obtain and Review
• Appraisal that separates the land value from the value of the existing building.
• Construction schedule with timeline as to improvement expenditures.
• Construction contracts.
• Leases or subleases from the past 5 years and other evidence as to whether the building was vacant or unused over the past 5 years for such an uninterrupted period of time.
Confirm:
• The expected amount of the capitalized improvements to the building will exceed the amount of the acquisition price of the building by the QOZB within a 30-month period after the date of the acquisition of the property.
• The acquired surrounding land to the building will be used in the trade or business of the QOZB that involves the acquired building and such land is integral to such trade or business.
• Whether the building was previously vacant or unused for the past 5 years for such an uninterrupted period of time.
As evident above, the due diligence process is critical for QOFs because the stakes are high. QOFs need to create their own due diligence checklists. This description of the QOZB requirements and the related checklist will hopefully be a helpful starting point.