The benefits of what Qualified Opportunity Zones offer to investors are clear -- deferral of their gain until 2026 with a partial elimination of gain if the investment is held for a certain period plus a total exclusion of gains on the appreciation in their QOF investment if that investment is sold after 10 years. Often overlooked, however, are the benefits developers and business owners can experience by developing a project or growing a business in a QOZ.
Ways That Developers Can Benefit
There are two primary ways that developers and business owners (hereafter referred to as sponsors) can benefit from having a project or business in a QOZ. The first is to roll their own gains over into the project. To do this, the sponsor would have to not already own the land, due to the QOZ related party rule, and they would need to set up a QOF to put their gains into prior to closing on the property. The second way is to use a QOF to set up for their project to attract investors. This can be done before or after the sponsor closes on the land, although investment from the fund into the project should be made before breaking ground or at the very least early in the development process in order to meet the QOZ significant improvement test.
Characteristics of Opportunity Zone Investors
OZ investors offer several benefits to sponsors. A project in an OZ has a competitive advantage in the marketplace of investors due to the tax incentives; there are investors specifically looking for OZ projects, therefore, they naturally have fewer options available to them. However, the tax benefits are not so significant that being in a QOZ can save a bad deal: if the project doesn’t make money, then there are no gains to exclude in 10 years. An OZ investor also offers patient equity, as they will want to maintain their interest in the fund for 10 years or more. A project can still be sold in this time period as long as the fund then rolls the proceeds from the sale into another OZ project under the QOZ regulations.
How OZ Investors Are Involved in the Project
A sponsor can either set up their own fund specifically for their QOZ project or they can take investment from an outside QOF. The primary difference is the amount of control that the sponsor will maintain over the project; outside funds will typically require a degree of control over the project or will want to own the project outright. Importantly, while there are related party rules dealing with property transferred to the QOF (or QOZB) there are no other “control” type rules in the QOZ provisions. In other words, the sponsor can control the QOF which invests in the sponsor’s project or the QOF can be controlled by a third party, e.g., the QOF’s general partner. In either situation the investors will be limited partners only. Their interest in the fund must be equity only (a debt investment in the fund does not qualify for QOZ tax benefits). When the fund is unrelated to the sponsor, it will act primarily as a “silent” partner; however, it will typically have some veto rights to protect the interests of the LPs. These rights are negotiated but would typically include a veto over any sale or other disposition of the Qualified Opportunity Zone Business (QOZB) or its assets. The fund makes an investment into a QOZB that holds the project, and other non-OZ investors can also invest side-by-side in the QOZB, which allows the sponsor to seek other equity and not affect the tax advantages of the QOZ investors.
Putting this all together, if structured properly, a QOF can provide long-term patient capital for a sponsor. That capital, in turn, can serve as the foundation for other necessary capital providers, including non-QOF investors and construction and permanent lenders.
Structure of a Qualified Opportunity Fund
The structure of a QOF will vary depending on the project, particularly if there is a large business component as opposed to a real estate only investment; however, there are several fundamental structural elements to a QOF and a QOZB that should be universal.
The first structural element is that there is both a QOF and a QOZB. This is often referred to as the “two tiered” approach and it offers significant benefits over having solely a QOF. Using a QOZB as a vehicle means that the threshold for the percentage of property held that must be “opportunity zone business property” is 70% as opposed to 90%, and it allows for equity to be held as working capital for up to 30 months if certain requirements are met. This has several strategic implications for the sponsor, including having capital ready for future stages of development. Having a QOZB between the sponsor and the QOF also is a much cleaner relationship and allows for other investors and parties at the QOZB level.
The second structural element is that there are two parties to the QOZB: the QOF and the sponsor. There may be other parties to the QOZB if other non-OZ investors come into the project and it is simplest to have those other parties invest at the QOZB level, or they can invest into the QOF but if they do so without qualified capital gains, they will not get any favorable tax treatment on that investment. In this structure, the sponsor will contribute the land or business to the QOZB as part of their investment in the QOZB vehicle.
The third universal structural element is protection for the investors, particularly for the LP’s if the QOF fails to qualify as an opportunity zone fund. As one might imagine, the LPs and the sponsor have different perspectives. From the sponsor’s standpoint, it does not want to be liable if the fund fails to qualify through no fault of the sponsor. From the LP’s standpoint, they do not want to lose a huge sum of money (in the form of tax benefits) if the fund fails to qualify as a QOF, e.g., because the sponsor-run QOZB fails to qualify as a qualified opportunity zone business. The sponsor also does not want to have the fund GP have to OK every decision that they make in relation to the project as that would be cumbersome to administer and would likely slow down the project. There are a range of solutions to these competing interests, ranging from an outright sponsor indemnity to the sponsor’s “best efforts” undertaking to ensure that the QOZB (and, therefore, the QOF) will qualify under the statute. Accompanying this overall risk allocation will also be sponsor undertakings to provide periodic information to the fund, particularly with regard to the QOZB’s assets, income and qualification under the various QOZB tests set forth in the QOF regulations. The exact solution in a given QOF will depend on the relative complexity of the proposed business and each party’s negotiating leverage. Of course, whatever solution is negotiated, it is in each party’s interest to do everything in their power to have the fund qualify under the statute.
A sponsor can use a Qualified Opportunity Fund as a valuable part of their capital stack provided that the correct structure is in place, and that the limitations and risks of OZ investments are understood by both the sponsor and the limited partners.
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