Behavioral economics informs us that investors are generally rational as well as risk-averse when making investment decisions. Given the latent uncertainties surrounding the Qualified Opportunity Zone (QOZ) legislation and the proposed rules and regulations promulgated under the Tax Cuts and Jobs Act of 2017, there should be no surprise that stakeholders in the QOZ marketplace are now requesting opinions of counsel before launching qualified opportunity funds or making investments in them. Let’s briefly examine both the need for legal opinions in this space and the content of the opinion letters being rendered in the marketplace.
MARKET CONDITIONS
For anyone who has had the pleasure of listening to Dr. Ben Carson, U.S. Secretary of Housing and Urban Development, or Scott Turner, who now serves as President Trump’s Executive Director of the White House Opportunity and Revitalization Council, speak on the subject, it becomes clear that the architects of the QOZ program and others within the current administration are very enthusiastic about this new tax program, which has been designed to channel investors’ capital gains into lower income communities in need of that investment capital. Naturally, those with investment capital require more than enthusiasm before committing to a new program that has not yet been fully vetted by our legal system. The proposed QOZ rules and regulations promulgated by the U.S Treasury Department in October 2018 and in April 2019 leave many unanswered questions, and the Internal Revenue Service has not yet tested some of the structures being developed by practitioners in the marketplace.
By analogy, investors and sponsors who first sought to rely on the real estate investment trust (REIT) structure in order to avoid two levels of federal taxation faced similar uncertainties a half century ago. What eventually emerged was an established opinion practice, by which law firms render specific opinions in relation to new REIT offerings. Broker-dealers, placement agents, due diligence providers, and sophisticated investors have come to expect such opinion letters.
Prior to the U.S. Treasury Department’s release of the first set of proposed rules and regulations in October 2018, very little deal activity occurred in relation to the QOZ program. For many practitioners, client pressure began to mount and attorneys began to prepare offering documents in anticipation of the rules and regulations. Although the October regulations were thin, the first tranche of Qualified Opportunity Fund (QOF) offerings were launched in the fourth quarter of 2018. Most were structured as single-asset QOFs. A few were pooled funds. Numerous uncertainties remained, however, in the wake of the October regulations, and many industry stakeholders encouraged additional guidance from the U.S Treasury Department. Throughout this period, law firms were reluctant to provide any formal opinions of counsel, and many investors kept their capital on the sidelines given the perceived risks.
The gap between the first and second sets of proposed regulations was stretched on account of a record-setting government shutdown, but on April 17, 2019, the U.S. Treasury Department released the long-awaited guidance, and with it, industry practitioners finally had enough of a roadmap to advise clients. Several key uncertainties remain, including the political uncertainties surrounding the program’s future and the potential for increased regulations, compliance, and effective tax rates following the Trump administration. Nonetheless, interest in the QOZ program continues to expand rapidly, as does actual deal activity. Single-asset construction projects with budgets in excess of $100 million are now breaking ground in opportunity zones across the country, along with myriads of smaller projects. From Hollywood to Tampa, from Portland to Brooklyn, capital has begun to flow into QOZ projects.
ANATOMY OF A QOZ TAX OPINION
To ease the fears of those investors participating in QOZ projects, law firms advising on these projects have been tasked with developing a new opinion practice. So what opinions are firms willing to render in this uncertain world?
Predictably, this new opinion practice has focused on the correct formation of the QOF and the Qualified Opportunity Zone Business (QOZB) entities, their qualification as partnerships, if applicable, and the activities of both as they relate to the requirements set forth in the regulations. The anatomy of a typical tax opinion in the QOZ space may also include an analysis of the underlying project asset(s) held by the QOF or QOZB. Specifically, do those project assets meet the requirements of “qualified opportunity zone business property” within the meaning of Section 1400Z-2(d)(2)(D) of the tax code?
In addition, fund or project-specific opinion language has been requested by financial intermediaries raising capital for larger QOZ projects. As an example, one national broker-dealer asked the issuer’s counsel to opine on whether the future disposition of condominium units within a QOZB would be deemed an inclusion event within the meaning of the proposed regulations. That type of opinion naturally involves an analysis of legal principles as well as the correct application of the facts memorialized in a certificate executed by the issuer’s principals.
As larger risk-averse institutions, such as life insurance companies, which frequently supply a majority of debt financing in the capital stack for large commercial and multi-family development projects, become active in this space, lawyers should anticipate increased demand for these opinions. Similarly, underwriters, placement agents, broker-dealers, and other financial intermediaries raising equity on behalf of QOFs are increasingly likely to require sponsors to obtain tax opinions issued by reputable law firms in connection with the launch of a private placement of securities.
Since many family offices have formed captive QOFs, which then invest directly into QOZBs, the need for legal opinions at that level may vary from those conforming to the above description.
Lastly, many QOZ projects that have successfully raised the capital required to break ground are joint ventures between a developer and a balance sheet partner. For these transactions, some practitioners have observed an initial trend of intense negotiation between the joint venture partners requesting representations, warranties, and indemnification to address specific QOZ risks. As an example, many developers seek to contribute land previously owned by the developer, and the balance sheet partner wants some comfort in relation to the affiliate transaction rule contained in the proposed regulations. Naturally, these representations and warranties are fiercely opposed. As the QOZ opinion practice continues to develop, joint venture partners may increasingly turn to counsel for a solution.