Opportunity Zone Investing: Indirect Questions

Having described program strictures related to direct investing in Qualified Opportunity Zone Business Property (“QOZBP”), in this post we describe the constraints to indirect, or joint venture investing in real estate, which describes investment positions across a continuum of investor control, ranging from passive stakes in a commingled fund[I], to separate accounts (e.g. family office or corporation allows investment manager to invest its capital into a QOZB alongside a developer subject to control over key decisions). In either case, the investment manager is placing joint venture equity into a QOZ business entity that is formed to invest in QOZBP. We begin with a line-by-line exploration of the relevant constraints before shifting to a more holistic discussion of investment strategy implications.

Qualified Opportunity Zone Business Requirements

1 Single Asset Fund Indirectly Investing in Real Estate Development

By investing indirectly, wherein a Qualified Opportunity Fund (“QOF”) purchases a partnership interest or freshly issued shares in a Qualified Opportunity Zone Business (“QOZB”) that in turn invests in QOZB property (“QOZBP”), individual investments must qualify by compliance with the prerequisites of QOZBs and QOZBP. Per section (A) of the code below, indirect investing is marked by a QOF purchasing QOZ stock or partnership interests, which qualifies as the fund’s QOZP. The bulk of the code that defines QOZB is at the bottom, spanning (d)(2)(B) on stock, (d)(2)(C) on partnership interests, and (d)(3) on QOZBs in general.

Acquisition Requirements[ii]: The CDFI seeks to stimulate fresh investment activity and local economic expansion. In fact, substantial structuring may be necessary to conform an investment in an existing business to the code. IRC §1400Z-2(d)(2)(B) and IRC §1400Z-2(d)(2)(C) layout the terms for acquiring QOZ stock or a partnership interest in a QOZB, which includes purchasing post Dec 31, 2017, directly from the QOZB and in exchange for cash. Unable to hold > 5% nonqualified financial property (incl. cash), the QOZB must put the infusion of cash to work by purchasing tangible or intangible assets, the former being subject to the requirement that substantially all of the QOZB’s tangible property is QOZBP and hence qualifies by original use or substantial improvement. Meant to fuel expansion, QOZB investments, whether in real estate or operating companies are growth oriented. Congruent with the QOF limitation on purchasing interests in other QOFs, purchasing shares or partnership interests on the secondary market is not allowed.

Substantially all tangible property owned/leased by taxpayer is QOZBP: Based on the data and parsing the language, we can assume that “substantially all” means some percentage markedly greater than 50%, while noting that this term has not been defined specifically for this section of code and that there are several interpretations of “substantially all” across IRS code. in the New Markets Tax Credit (“NMTC”) program’s tangible property test, "substantially all" means 40%, with instances of 85% in other code sections. Across programs it averages 80%. Steve Sharkey of DLA Piper believes that in the case of the proportion of tangible assets that must be QOZBP, substantially all should mean 90% such that the standards are consistent across QOZF and QOZBP[iii]. While clear that a majority of a firm’s tangible property must be QOZBP and hence purchased post Dec 31, 2017 from an unrelated party and satisfying original use or substantial improvement (growth oriented), observe that unlike QOFs, which are bound by the 90% asset test to hold 90%+ tangible assets, QOZBs could be comprised exclusively of intangible assets as long as a substantial portion[iv] of them are used in the active conduct of the business.

Greater than 50% of the total gross income of such entity is derived from the active conduct: Active conduct is not well defined. In the NMTC context, it indicates the expectation of earning revenue from business activity within three years (requiring that vacant land for development be utilized to generate some, if trivial, income). This usage appears contextually incorrect. A more likely interpretation is active management, which could preclude passive operations such as ground or NNN leases in favor of management intensive real estate or manufacturing. Steve Sharkey of DLA Piper doesn’t believe this code, drawn from IRC §1397C(b)(2) on Empowerment Zones, is “particularly relevant” to real estate. Steve Mount, a tax credit expert from Squire Patten Boggs[v] doesn’t believe the CDFI aimed to deter NNN deals, but doesn’t go so far as to say that the section is impertinent to real estate. If attempting to “thread the needle” of the code today, favoring more operationally intensive lease structures could limit expected non-compliance risk. Even if the latter interpretation prevails, attributing gross income to QOZ based manufacturing vs. sales or warehousing in other regions will likely be subject to nuanced interpretation and likely legal opinions.

A substantial portion of the intangible property of such entity is used in the active conduct of any such business: likely to mean that QOZB-owned intangibles pertain to the business; e.g. a QOZB cannot serve as a warehouse for unrelated patents. As Steve Sharkey of DLA Piper notes, this is not particularly relevant to real estate, which doesn’t involve much IP.

Less than 5% of the average of the aggregate unadjusted bases of the property of such entity is attributable to nonqualified financial property: This limitation covers debt, stock, partnership interests, options, futures contracts, forward contracts, warrants, notional principal contracts, annuities, and similar property. It is subject to a reasonable working capital allowance (i.e. cash, cash equivalents, or debt instruments with a term of < 18 months as well as accounts receivable / payable). Note that the partnership interest restriction precludes QOZ businesses from having subsidiaries (regarded for Federal Tax purposes)[vi].

Digression on Code Uncertainty

While the path to compliance through direct investing involves some uncertainty, indirect investing code introduces several additional instances of poorly defined terms or processes. We have already noted the uncertainty around “substantially all”, but if we assume it translates to 90%, how is compliance measured across owned and leased assets? Are leased assets valued on a present value basis per GAAP capital lease accounting rules? Using what discount rate? Are owned assets to be compared based on fair market value or tax basis? How frequently? Additionally, what does it mean for a leased asset to be QOZBP? For example, does the IRS really intend that QOZBs only lease property from QOF-owned buildings? What might this mean for lease rates that QOZBs pay relative to market rates, even those paid by non-QOZB tenants within the same buildings? While requiring QOZBs to lease from QOZBPs could catalyze the development or renovation of real estate to serve it, such a requirement could also severely restrict a QOZB’s growth. If rents don’t support new development or deep renovation, a non-real estate focused QOZB must either misallocate its capital toward investing in real estate to satisfy its space needs, or agree to pay a developer above-market rents along with credit enhancement and lease term sufficient to justify developing despite market conditions. The QOZB’s expansion would also be delayed by the building acquisition or development process.

What this means for Investors

QOZ businesses will serve as the main channel through which passive equity will flow into QOZ real estate, in addition to better enabling certain investment strategies across JV and wholly-owned structures. Investing through a QOZB instead of directly from a QOF enables one to circumvent the time constraints imposed by the 90% asset test’s non-compliance penalty, which limits a QOF’s ability to hold cash, in favor of the requirement that it hold no more than 5% non-qualified financial property (excluding reasonable working capital). It is possible that this NQFP requirement, through the “reasonable working capital” limiter, will simplify the cash management challenges direct investment presents in matching volatile, illiquid capital gains[vii] with construction draws. That said, it currently appears to introduce excess compliance risk. Whereas the 90% asset test has a corresponding non-compliance penalty, which implies that the CDFI did not intend the test to be an existential qualifier for QOF status, code offers no concomitant non-compliance penalty or grace period for the NQFP test, implying it is Boolean. Indirect also adds the likely requirement that a QOZB derives > 50% of gross income from QOZ-located operations (depending on how “active conduct” is defined) and a restriction on investing in sin businesses. If investment partnership structure doesn’t force the indirect vs. direct issue, investors may find that select business plans fit more easily within the confines of one type or the

Example Code Compliant Strategies

Setting up a QOZB-structured subsidiary within a QOZ to grow an existing business located outside the QOZ

•  Subsidiary’s assets could qualify by being “originally used” by the new entity in a QOZ
• 50% of subsidiary’s gross income from active conduct could be more easily substantiated
• Working capital could be shifted between parent and subsidiary to avoid > 5% NQFP

Real Estate Joint Ventures: fresh acquisition of land & subsequent development

• The QOZB is likely structured as a pass-through partnership; the QOF’s partnership interest is funded with cash. QOZ equity serves as limited partner; code does not constrain the LP/GP equity split, nor does it confine QOZB’s ability to perform a cash-out recapitalization wherein it buys GP/ developer out at deal stabilization.
• < 5% NQFP requirement forces thoughtful matching of capital gains harvesting and construction draws[viii]
• Presuming development satisfies “substantial improvement” and site is purchased in 2018+ from a QOF that satisfies the related party rule, the development, which is the QOZB’s sole asset, is indeed QOZ business property.
• > 50% of gross income derived from active conduct: unlikely to preclude NNN leases (legal opinion might be useful if forthcoming IRS guidance doesn’t obviate the issue)

Real Estate Joint Ventures: OZ recapitalization of existing development

• The QOZ business is likely structured as a pass-through partnership; the QOF’s partnership interest is funded with cash. OZ equity serves as limited partner to a developer / GP that already owns the site. The newly formed partnership, which purchases the land from the developer and thereafter builds, must not trip the related party rule at the strict 20% standard (prior owner of site cannot collect > 20% of profit from newly formed purchasing / developing entity). As such, in typical deals wherein QOF is providing relatively passive LP equity, GP’s stake in the QOZB is likely < 10%.
• < 5% NQFP requirement forces thoughtful matching of capital gains harvesting and construction draws
• Substantial Improvement: Code narrowly allows recapitalization of developments that are under construction as well as those wherein the developer has only purchased the land (valuation becomes higher variance if construction is underway and market conditions have changed since ground-breaking).
• > 50% of gross income derived from active conduct: unlikely to require NNN leases (legal opinion might be useful)

The Lines: Code Applicable to QOZ Businesses (Indirect Investing)

IRC §1400Z-2(d)(2) Qualified opportunity zone property

A. In general: The term “qualified opportunity zone property” means property which is

• I.    qualified opportunity zone stock
• ii.  qualified opportunity zone partnership interest, or
• iii. qualified opportunity zone business property.

B.  Qualified opportunity zone stock

• I. In general Except as provided in clause (ii), the term “qualified opportunity zone stock” means any stock in a domestic corporation if—
  • I.  such stock is acquired by the qualified opportunity fund after December 31, 2017, at its original issue (directly or through an underwriter) from the corporation solely in exchange for cash,
  • ii. as of the time such stock was issued, such corporation was a qualified opportunity zone business (or, in the case of a new corporation, such corporation was being organized for purposes of being a qualified opportunity zone business), and
  • iii. during substantially all of the qualified opportunity fund’s holding period for such stock, such corporation qualified as a qualified opportunity zone business.
• ii. Redemptions: A rule similar to the rule of IRC §1202(c)(3) shall apply for purposes of this paragraph.

C. Qualified opportunity zone partnership interest: The term “qualified opportunity zone partnership interest” means any capital or profits interest in a domestic partnership if—

• i.   such interest is acquired by the qualified opportunity fund after December 31, 2017, from the partnership solely in exchange for cash,
• ii.  as of the time such interest was acquired, such partnership was a qualified opportunity zone business (or, in the case of a new partnership, such partnership was being organized for purposes of being a qualified opportunity zone business), and
• iii. during substantially all of the qualified opportunity fund’s holding period for such interest, such partnership qualified as a qualified opportunity zone business.

D. Qualified opportunity zone business property

• i.  In general: The term “qualified opportunity zone business property” means tangible property used in a trade or business of the qualified opportunity fund if—
  • I. such property was acquired by the qualified opportunity fund by purchase (as defined in section 179(d)(2)) after December 31, 2017,
  • II. the original use of such property in the qualified opportunity zone commences with the qualified opportunity fund or the qualified opportunity fund substantially improves the property, and
  • III. during substantially all of the qualified opportunity fund’s holding period for such property, substantially all of the use of such property was in a qualified opportunity zone.
• ii. Substantial improvement: For purposes of subparagraph (A)(ii), property shall be treated as substantially improved by the qualified opportunity fund only if, during any 30-month period beginning after the date of acquisition of such property, additions to basis with respect to such property in the hands of the qualified opportunity fund exceed an amount equal to the adjusted basis of such property at the beginning of such 30-month period in the hands of the qualified opportunity fund.
• iii. Related party For purposes of subparagraph (A)(i), the related person rule of IRC §179(d)(2) shall be applied pursuant to paragraph (8) [1] of this  subsection in lieu of the application of such rule in section 179(d)(2)(A).

(3) Qualified opportunity zone business

A. In general: The term “qualified opportunity zone business” means a trade or business—

• i. in which substantially all of the tangible property owned or leased by the taxpayer is qualified opportunity zone business property (determined by substituting “qualified opportunity zone business” for “qualified opportunity fund” each place it appears in paragraph (2)(D)),
• ii. which satisfies the requirements of the following paragraphs of IRC §1397C(b):
  • a. (2): > 50% of the total gross income of such entity is derived from the active conduct
  • b. (4): a substantial portion of the intangible property of such entity is used in the active conduct of any such business, and
  • c. (8): < 5% of the average of the aggregate unadjusted bases of the property of such entity is attributable to nonqualified financial property
• iii. which is not described in section 144(c)(6)(B) (exclusion of sin businesses: “…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 the principal business of which is the sale of alcoholic beverages for consumption off premises.”)

B. Special rule For purposes of subparagraph (A), tangible property that ceases to be a qualified opportunity zone business property shall continue to be treated as a qualified opportunity zone business property for the lesser of—

• i. 5 years after the date on which such tangible property ceases to be so qualified, or
• ii. the date on which such tangible property is no longer held by the qualified opportunity zone business.

Footnotes

[i] e.g. fund GP has full discretion to make investments into QOZB alongside a developer

[ii] (B)(ii) refers to section IRC §1202(c)(3) which provides restrictions on share redemptions / buybacks by a corporation. An unlikely scenario for a real estate fund vehicle, we will not treat this topic here.

[iii] While variance across data is high, taking the conservative and consistency-based position that substantially all translates to 90% is risk limiting (must mean something less than 100% or code would have used “all”)

[iv] Also not specifically defined

[v] Novogradac Tax Credit Conference, June 4, 2018

[vi] However, disregarded entities are not limited by this NQFP rule. Steve Sharkey of DLA Piper, July 2018 presentation

[vii] Partial stakes in real estate or other alternative assets typically suffer from an illiquidity discount (lack of control premium; lack of demand for partial stakes relative to 100% equity interests), forcing taxpayers to realize capital gains in a single event and contribute it to a QOF all at once, even if such a contribution far exceeds forward 12 month construction draws.

[viii] IRS guidance forthcoming is expected to provide grace / investment period. “Reasonable working capital” qualifier may also address this issue.