OZ Investing: IRS Guidance Dramatically Alters Expected Investment Strategy
Friday’s IRS release of 80 pages of guidance is a step toward clarity and reduced compliance risk if not the final word on topics covered. While the IRS presumably crafted its proposed changes to optimize on its key program objectives subject to the input of the myriad of market participants who have lobbied, market participants have 60 days to provide additional feedback. That said, the IRS states that the proposed rules may be relied upon if the taxpayer applies them “…in their entirety and in a consistent manner.”
Several of the topics covered in these documents have come up in conversations I’ve had with family office clients and below, I attempt to distill the voluminous official documents down to key points and implications.
Key Issues Clarified
Revenue Ruling Rev. Rul. 2018-29 on the topic of Substantial Improvement:
Tax Basis of Land is Excluded from Capex Threshold applicable to Existing Buildings ==> Value-Add Business Plans are Incrementally More Feasible: Initial code language implied that for an existing building to qualify as Qualified Opportunity Zone Property (QOZP), a Qualified Opportunity Zone Fund (QOF) would have to, over some 30-month period, make additional capital investments equivalent to a property’s (land + building) initial purchase price (plus incremental capex and minus depreciation taken since purchase). E.g., if one purchased a building for $100 including land basis of $20, and began immediately began a renovation, one would need to invest an additional $100 to satisfy Substantial Improvement. The IRS has clarified that for existing buildings, the actual threshold is one’s basis in the structure alone which is $100 - 20 = $80. Previously a subset of lawyers even speculated that one might need to find a way to separately “substantially improve” the land under a building to comply (not the case). This guidance lowers the bar, particularly in high density, high GDP per capita urban locations where land value can comprise a higher percentage of a property’s purchase price. It is noteworthy that this distinction introduces the likelihood that certain investors will, by specious appraisal, inflate land value to reduce required capex. It is unclear what this means for the interpretation of Substantial Improvement in the context of purchasing/developing previously vacant land.
Land Cannot Qualify under “Original Use”: Purchasing Vacant Land as a Development Option (e.g. parking lot) may be Incompatible.
Existing Buildings cannot (yet) Qualify by “Original Use”: While the IRS doesn’t currently allow this, it is explicitly seeking investor commentary on this topic, and whether there are conditions wherein a building has been long vacant or could otherwise productively employ the OZ incentive according to some lower bar of capital intensity. The Revenue Ruling explicitly disallows this. I’ve written about this before, but repurposing existing assets is a much more capital efficient way to simulate activity in blighted urban emerging markets, where ground-up development is uneconomic due either construction costs (e.g. it costs as much to build equivalent product in blighted parts of the Bronx as in Manhattan excluding land value and fee differences; a robust development pipeline in Manhattan means higher labor prices for development across the NYC Metro), or rents are so depressed that new development doesn’t pencil even when labor is otherwise idle (e.g. Detroit). One outstanding question is how “existing building” will be defined. Will the IRS set the demarcation line at certificate of occupancy? Could a development that is nearing completion, and yet has never been occupied, qualify as QOZ property to a new OZ Fund or OZ Business (QOZB) under “Original Use?” While such a strategy would not catalyze new development as directly, it could improve expected exit liquidity and pricing for developers with conventional equity sources that are considering building in OZs, providing incremental incentive to build.
Broader Guidance from Proposed Regulation
Only Realized Capital Gains Qualify for Deferral through investment in a QOF: Prior uncertainty derived from unclear statutory drafting (section header denoted capital gains but not the statutory language), and vacillation of the drafters between capital gain and broader gain (capital and ordinary) through prior iterations of the code.
Who is the "Taxpayer" in a Partnership / Pass-Through Entity and what Other Types of Entities Can Invest? Wherein property sold at a capital gain is held by a partnership, the IRS has designed a sequential process whereby, if the entity makes an eligible investment into a QOF and elects to defer (all or part of) the capital gain, no part of the gain deferred need be included in distributive shares to the partners under §702 and the gain is not subject to §705(a)(1). If the partnership does not defer but instead distributes gain to its members, to the extent this capital gain is eligible, the members may defer their respective capital gains by making eligible investments in QOFs and making the required deferral election. Analogous rules apply to other pass-through entities (including S corporations, decedents’ estates, and trusts) and to their shareholders and beneficiaries. Further, the IRS has defined eligible taxpayer types as individuals, corporations (incl. RICs and REITs), partnerships, common trust funds under Section 584, qualified settlement funds, disputed ownership funds, and other entities taxable under §1.468B.
Leverage is not treated as "Mixed Funds”; Leverage doesn’t Compromise one’s Ability to Elect Exemption from Aggregate Holding Period Capital Gains: In the IRS vernacular, deemed contributions of money under 752(a) do not result in the creation of a separate investment in a QOF. This means that if a taxpayer makes an eligible investment in a QOF, at exit (10+ years later), regardless of how much of the QOF’s capital structure is debt vs. equity, the taxpayer can elect to set the tax basis of the investment equal to fair market value at sale to avoid incurring capital gains tax. Previously investors had feared that if one had, for example, a 50/50 debt/OZ equity capital structure, half the capital gains one generates over the holding period might be subject to capital gains tax just as it would be if one invested 50/50 OZ equity/fresh equity (or otherwise made a deferral election for only half the equity). Further, investors may borrow against their equity interests without triggering compliance issues.
Investors may Purchase after 2018 / Hold Beyond 2028 without Losing Fair Market Value Election Right: “The ability to make this election is preserved under these proposed regulations until December 31, 2047, 20½ years after the latest date that an eligible taxpayer may properly make an investment that is part of an election to defer gain under §1400Z-2(a).” The OZ program was intended to attract long term capital to these markets; the IRS’ stated rationale for mandating that investors sell positions by 12/31/2047 in order to avail themselves of the election to set tax basis equal to FMV at exit (eliminating holding period capital gains) is to limit compliance costs and related staffing (long after the actual value has been created).
Taxpayers Can Trade out of / into QOF Investments without Triggering Taxes ==> Average OZ Business Plan Shifts from “Build-to-Core” toward Pure Development: As noted on the IRS’ Explanation of Provisions (p9) within its broader Proposed Regulation, if a taxpayer acquires an original interest in a QOF in connection with a gain-deferral election and later sells / exchanges its entire initial investment (triggering inclusion of the deferred gain in taxpayer’s gross income), and if the taxpayer makes a qualifying new investment in a QOF within 180 days, then the proposed regulations provide that it may elect to defer the entire noted gain. Additional guidance is forthcoming on this topic, likely on compliance with the 90% Asset Test when selling close to a testing date as well as whether the reinvestment in a QOF would be treated as if it were a fresh OZ investment (e.g. 10 year clock to election to set tax basis = FMV at exit resets) or a continuation of the prior. Regardless, this is a fundamental change to the program and may only take shape (in terms of logistics) in subsequent IRS releases. It transforms allowable OZ investment strategy from almost exclusively “build-to-core” (or some development / redevelopment followed by a core hold) to “one or several” periods of development value creation followed by a core hold. This flexibility could eventually draw additional value investor capital into the program.
Capital Recycling Allowed Within OZ Funds: According to the IRS’ Explanation of Provisions (p21), “Soon-to-be-released proposed regulations will provide guidance on these reinvestments by QOFs.” For now its states that §1400Z-2(e)(4)(B) will allow QOFs “a reasonable period of time to reinvest the return of capital from investments in qualified opportunity zone stock and qualified opportunity zone partnership interests, and to reinvest proceeds received from the sale or disposition of qualified opportunity zone business property.” As an aside, this verbiage intimates that the IRS recognizes the need for QOFs or lower level entities to divest of assets in a manner that retains program benefits. Hopefully the next batch of guidance explicitly enables QOFs to sell the assets funded by taxpayer investments of 10+ years individually and freely, rather than by way of liquidation mode for those QOFs structured like REITs (with taxpayers invested in funds otherwise structured being forced to sell their interest in the fund to retain the FMV election). However, the topic of capital recycling within QOFs or between them is non-trivial. When a QOF sells part of its asset base, capital gains flows to its partners by way of existing tax law. The partners/taxpayers must then reinvest into QOFs and the QOF must manage changes to its allocation to cash (90% test).
Along with the above section, which enables a taxpayer to manage harvesting and redeployment of OZ equity into sequential development deals, this provision could allow QOFs to provide such portfolio management internally. One might find it surprising that, in light of the program’s stated desire to attract long term capital, it is attempting to enable investors to trade out of positions at will. However, this flexibility could expand the pool of interested capital.
If funds can “trade” out of stabilized assets and into new development positions without it being a taxable event, the propensity of the program to transform OZ streetscapes could be many times larger; not only would additional investment capital be attracted to the program, but the fund managers chooses to recycle after three years in each development, capital that could have developed one “build-to-core” deal over 12 years could instead develop four sets of developments (15 deals of equivalent total project cost if all deals perform, all equity is reinvested, and if not for the developer’s promote limiting capital available to redeploy).
90% Asset Test Valuations to Rely on Fund’s Financial Statements: To limit compliance costs (quarterly appraisals, etc), the IRS has opted to allow investors to utilize the values they have claimed on their financial statement for the taxable year, as defined in §1.475(a)-4(h) of the Income Tax Regulations. When financial statements aren’t available, investors should use project cost.
QOFs can Manage Calculation of 90% Asset Test in Year One (§1400Z-2(d)(1)): If an entity chooses to become a QOF beginning with a month other than the first month of its first taxable year, will occur after the first six months of the entity’s tax year in which the entity was a QOF throughout. The IRS uses the example that “…if a calendar-year entity that was created in February chooses April as its first month as a QOF, then the 90-Percent-Asset-Test testing dates for the QOF are the end of September and the end of December. Moreover, if the calendar-year QOF chooses a month after June as its first month as a QOF, then the only testing date for the taxable year is the last day of the QOF’s taxable year. Regardless of when an entity becomes a QOF, the last day of the taxable year is a testing date.”
For Members of Partnerships or other Pass-Through Entities, Contribution of Capital Gains to an OZ Fund can Occur on Last Day of Tax Year +180 days ==> a Quasi-Investment Period for QOFs (advance notice of inflows): Per the proposed language, the default for starting the 180-day contribution clock begins on the last day of the partnership tax year in which the taxpayer realized a capital gain. Alternately, the partner can elect to start the clock as early as on the day on which the sale / exchange occurred (e.g. if it has knowledge of the sale / exchange event and the partnership’s decision not to defer the capital gain and also identifies a favorable investment prior to the end of the tax year). As such, while fund managers don’t yet have a formal “investment period” in which to deploy capital commitments, if they are in touch with taxpayers who would like to invest, and said taxpayers are able to realize gains early in the tax year, the taxpayer could provide the QOF nearly 18 months notice before that capital must be invested in the QOF and hence included in its next 90% Asset Test.
Working Capital Safe Harbor: Qualified Opportunity Zone Businesses may Hold Cash for up to 31 Months with Minimal Compliance Risk: QOZB are limited to holding a maximum of 5% non-qualified financial property (NQFP) excluding “reasonable working capital.” Guidance now allows investors to use the working cap definition in §1397C€(1)/ to property held by the business for up to 31 months if QOZB:
has a written plan that identifies financial property as property held for acquisitions, construction or substantial improvement; and
has a written capital investment schedule that details when cash will be invested within the 31 months; and
substantially complies with this schedule.
This clarifies a key question regarding development cash management. While current tax code enables a development entity to hold “reasonable working capital,” the language above places investors / developers in control of compliance through adherence to a mechanical process rather than compliance being subject to the vagaries of IRS staff decision making and legal precedent (expensive & risky). However, while this mechanism addresses cash management at the project / investment level, it may not be helpful to fund managers seeking an investment period or ability to manage the mismatch between:
Uses of capital that require immediate and unpredictable access to capital: The best deals typically involve some form of seller distress or an array of technical factors such that the investor must sell even if market conditions are not optimal. Being able to deploy capital quickly and with high probability is mandatory to compete on such investments.
Sources of capital that are abnormally illiquid: Typical institutional LPs hold capital commitments in cash and short term investments for expeditious draw down. Such LPs can respond quickly to capital calls. In the event capital is called but the deal blows up, such equity could be invested in a subsequent deal without penalty (apart from it not earning minimal interest in the hands of the LP and potentially accruing fund-level preferred return). OZ capital commitments are likely to be held in illiquid, complex positions (e.g. real estate, entity level investments, etc) that may take 6+ months to unwind, but cannot be unwound unless the taxpayer can be assured it can invest the capital gains into an OZ Fund within 180 days. In this case, calling capital and having excess cash on hand can result in a failure to meet the 90% Asset Test and its corresponding penalty, unless the OZ Fund is able to obtain mercy from the IRS through the “reasonable cause exception” (IRS’ posture of desiring and incorporating investor feedback to date intimates a likelihood of such an exception but it would still presents risk, delay, and legal expense).
While this language does not provide investors attempting to invest blind pool equity into a portfolio of individual assets with a formal or extended investment period, it might allow them to simulate one. A fund manager would likely not be OK holding multiple assets directly in a QOZB (NQFP limits lower level partnership interests) but its possible that it could shift cash into building-block sized, blind-pool, single-purpose-vehicle QOZBs that it could top up as necessary to fund specific equity checks. Combining this approach with the flexibility of working with members of partnerships or other pass-through entities wherein a QOF may have more than 180 days from taxpayer commitment to invest in the QOF, a QOF could better manage the tension between the above forces, albeit within constraints. The Treasury is still seeking feedback regarding the adequacy of the safe harbor and I suspect market participants will resoundingly request an investment period. However, the IRS does not believe it has authority to provide what it believes would require a statutory change.
Tangible Property owned / leased by QOZ Businesses need Only be 70% QOZB Property: Here the IRS defines “Substantially All” in one of its many instances (verdict still out on the rest). Only 70% of tangible property owned by QOZB need be QOZBP (§1400Z-2(d)(3)(A)(i)). This means that if an QOF invests 90% of its capital into OZ property, in this case a OZ Business, only 70% of that OZB’s tangible property need be OZB property. A QOF investing solely in (tangible) real estate need invest only 90% * 70% = 63% of its total capital into deals into OZ property. In dense urban areas like New York, this flexibility could lead to greater OZ impact (e.g. controlling a neighboring building, possibly outside an OZ or too valuable for Substantial Improvement to pencil on the aggregate deal, could make the difference between an OZ development penciling, particularly if the new addition is expected to create value that the existing structure will capture). That said, I’m surprised by the amount of flexibility this threshold engenders.
What Tax Rates will apply when Deferred Gain is Recognized? While we don't have confirmation that the tax rates in place at the time of investment would apply at gain recognition, the guidance does indicate that the nature of capital gain will remain constant, meaning that if you invest a short term capital gain, at gain recognition, the remaining capital gain (net of any step up in basis or reduction from investment losses incurred) should be taxed at the short term capital gains rate.