Opportunity Zone Investing Series: Investment Strategy Prerequisites—Coloring within the Lines (part 1)

Before discussing investment strategy, we will first discuss its vital inputs, program constraints and the way we might expect the Qualified Opportunity Fund (“QOF”) after-tax return premium to map unevenly to identical deals executed across geographies. As the primary lens through which we will evaluate geographies and investment strategies, we begin with a three-part discussion of the constraints that the tax code imposes upon investment selection, starting with those that derive from fund structure in the context of direct QOF investments[i]. After describing investment constraints that derive from QOZ Business Property requirements (in our next post), we will return to the topic of investing indirectly through a Qualified Opportunity Zone Business.

The code is a work in progress. While the Economic Innovation Group developed the Opportunity Zone concept in 2015, the legislation was signed on December 22, 2017 in a flurry of activity and edits. As such it contains several terms and internal inconsistencies wherein we can only interpolate meaning using precedents set in other areas of the tax code. The IRS expects to release guidance over the next 3-6 months that should obviate a subset of the estimations below. Note also that I am attempting to highlight only those points of uncertainty that could impact investment strategy.

The Lines: Vehicle Structure Restrictions

The basic mechanics with which one must comply to obtain the tax benefits associated with § 1400Z-2 begin with investing capital gains[ii], realized within the prior 180 days, into a QOF. Unlike the 1031 exchange program, in which one must contribute the entirety of a prior investments sale proceeds in order to defer capital gains tax, in this case one must only reinvest the capital gain to obtain deferral. The following are key QOF constraints:

• IRC Section 1400Z-2(a)(2)(B): Capital gains must be realized before Dec 31, 2026 to qualify
• IRC Section 1400Z-2(d): Qualified Opportunity Funds (“QOFs”) satisfy the following:
  • any investment vehicle which is organized as a corporation or a partnership
  • for the purpose of investing in qualified opportunity zone property (other than another qualified opportunity fund)
  • that holds at least 90 percent of its assets in qualified opportunity zone property, determined by the average of the percentage of qualified opportunity zone property held in the fund as measured—
    • on the last day of the first 6-month period of the taxable year of the fund, and
    • on the last day of the taxable year of the fund
• IRC Section 1400Z-2(f): If a QOF fails the 90% test above, it owes a monthly[iii] penalty of: Penalty Rate * (90% of its aggregate assets) / (total QOZP it holds). Penalty Rate = (Federal AFR Rate + 300bps) / 12, unless it can establish “reasonable cause,” which one might establish through proof of acquisitions activity or other deployment roadblocks.
• IRC Section 1400Z-2(c): Special rule for investments held for at least 10 years: While section (d) above establishes the direct requirements for QOFs, as Neil Faden of Manatt, Phelps & Phillips, LLP[iv] and several others have noted, the language used in section (c) creates the implied requirement that, in order to obtain the FMV election benefit[v], taxpayer must sell its interest in the QOF (“such investment”). Prior sales of QOF assets at capital gains in taxable transactions may exempt the taxpayer from receiving its FMV election benefit.

Investment Implications

Constraints (perhaps unintended) regarding selling individual assets from a multi-asset fund could shift capital to single asset QOFs or narrowly focused QOFs that invest only in high-liquidity locations and product types: While its clear that QOFs must be formed as corporations or partnerships, uncertainty is higher regarding optimal structure. A subset of the legal community maintains that LLCs taxed as partnerships will qualify, whereas Shearman & Sterling (see part IV on pg 6) provides counterpoint in the precedent of the New Market Tax Credit program, wherein a CDE cannot take the form of an LLC. A more material area of uncertainty is that of a QOF fund manager’s ability to sell individual assets without impacting the FMV election benefit[v]. The Shearman & Sterling briefing presents the REIT liquidation process as a potential solution to this quandary, with REITs also attractive due to the 20% deduction US domestic individuals may claim against REIT dividends (through 2025).[vi]

Trade offs to Single vs. Multi-Asset QOFs (assumes multi-asset vehicle cannot sell individual assets)

Single asset liquidity has substantive implications across topics such as investor idiosyncratic risk exposure, QOF funding risk, investment outcome optimization, the relationship of investor fees to aggregate performance, and even QOZ program efficacy. If investors must choose between single asset vehicles and exiting monolithically at the fund level, they face the tradeoffs displayed in the inset comparison. The REIT structure presents an elegant solution, shifting the balance in clear favor of a multi-asset pool. If the REIT structure, or IRS guidance does not make permissible the sale of individual assets from a multi-asset QOF, such funds, if utilized at all, may only be utilized to pursue parochial strategies of product type specific development focused on single, mainstream product types within core or core-adjacent locations to maximize fund-level liquidity. The ability to sell assets individually not only supports maximum QOF liquidity and aggregate pricing across a range of scenarios (portfolio-level pricing being more volatile than that of underlying assets), but it frees investors to focus on seeking the best set of investments, regardless of product type or business plan. The latter would incentivize capital to avoid the marginal locations this program was designed to stimulate.

Exclusion of capital gains realized after Dec 31, 2026 disincentivizes late stage redevelopment: While unlikely to be an active constraint, this clause limits a QOF’s ability to call capital 10 years to fund, for example, a redevelopment in a secondary location that took two cycles for market rents to exceed replacement levels. The statute is silent on whether the QOF, if holding cash after 2026, can still invest it.

Minimum 10 year hold aligns capital with difficult-to-time urban growth. Inability to sell stabilized assets and redeploy into similar risk / return profile could imply “build-to-core” risk profile: There are several meaningful implications of the minimum 10 year fund interest hold requirement. It requires that capital say invested for approximately two cycles[vii], a requirement that better suits QOF capital to invest in the difficult-to-time urban growth than the typical 3-5 year equity matched with development. Combining this requirement with the substantial improvement qualifier (described in the next post and IRC Section 1400Z-2(d)(2)(D)(ii)), and the inability to sell individual assets inside of 10 years while retaining the FMV election, “build-to-core” could be the most logical QOZBP business plan. Covered land plays, wherein an investor purchases an existing asset that provides income to cover operating expenses while entitling the site for ultimate redevelopment, could also qualify but value creation later in the term will create funding complexities[viii].

Build to Core: Segments of Hold Period at Opposing Ends of Risk Spectrum (Example: Multi-housing development)

While the after-tax return premium will be helpful in attracting investors and developers, build-to-core is often a suboptimal match with developer and investor preferences. Developers and investors that seek value creation and have the risk tolerance for development are generally loathe to lock up their capital for, in this case 7-8 years at stable core returns. Such investors would prefer to exit and redeploy into another development deal. Core investors, on the other hand, are largely unwilling to bear development risk, though there are exceptions. If the risk adjusted returns to build-to-core are favorable, particularly with 300-500bps of excess after-tax returns on top, capital will likely flow freely regardless, with developers who seek a 3-5 year exit getting it by way of recapitalization. However, allowing investors to harvest stabilized assets and redeploy into other QOZBP could increase the productivity of QOF capital, perhaps by 2-4x, toward achieving the CDFI’s goals. It would likely also expand the depth of capital and the list of developers interested in participating.

Fund-of-funds investing is inconsistent with the program’s aim to trade transformational impact for tax incentives.

90 Percent Asset Test could incentivize speed-of-placement over quality, shorter development cycles (e.g. industrial product over office & apartments, entitled over unentitled), higher leverage (equity flows in sooner) and calling of capital just-in-time: Several industry groups are pressing the Treasury to attach an investment or “grace” period to each QOF capital commitment before such commitment is included in the calculation of compliance under the 90% Asset Test. This would eliminate the sense of time pressure to place proceeds that leads 1031 exchange buyers to notoriously overpay (or avoid submarkets or business plans that could require extended due diligence). It would also ensure QOF investors aren’t penalized for drawing down capital according to typical development timeframes. While an unentitled site could require months to years prior to groundbreaking, even an entitled site could require time to pull permits such that completion of equity draws prior to the six-month marker is quite unusual. Moreover, holding equity in cash or cash equivalents prior to construction draws should not be discouraged, particularly when the alternative isn’t for the taxpayer’s commitment to sit in low risk cash and cash equivalents awaiting a capital call as it might with an endowment or pension fund, but in volatile (hopefully hedged) unrealized gain positions wherein market declines can engender funding shortfalls and thereafter, distressed real estate. These modifications could take the form of multi-year investment period tied to the receipt of each capital allocation before said capital is included in the 90% Asset Test, with active developments rendering the subset of their corresponding future equity draws that are already sitting in cash and cash equivalents within the QOF to be qualified assets, until some measure of completion. As noted in a briefing by the Real Estate Roundtable, precedents for the above suggestions exist in current REIT rules and the Enterprise Zone code[ix].

[i] There are certain contextual merits to investing through a QOF into a QOZB, that would then invest in real estate, but I suspect direct QOF to real estate investing will be more prevalent.

[ii] While header language of code states “capital gains,” statutory language just says “gains.” Earlier drafts of the code, when clearing the Senate, specifically disqualified 1245 and 1250 recapture assets (ordinary gain). Drafters then stripped out "capital" from the statutory language along with references to 1245 and 1250. One could interpret this as an intentional edit. Regardless it is safe to assume that at a minimum, capital gains qualify.

[iii] Note that test is semi-annual but penalty is accrued monthly.

[iv] Novogradac 2018 Opportunity Zones Workshop

[v] FMV election benefit: 10 years after taxpayer invests capital gains into a QOF, it obtains the right to, at exit, elect to set the investment’s tax basis equal to its FMV (setting holding period gains to zero along with corresponding tax exposure)

[vi] Shearman & Sterling: see part IV on pg 6 & bottom of pg. 8: “…QOFs that also qualify as REITs may sell their assets in the context of a liquidation without eliminating their long-term investors’ ability to benefit from the FMV Basis Election.”

[vii] The average length of a business cycle (post WWII) is 60 months.

[viii] Either (volatile) capital gains are unrealized but perhaps hedged until the QOF fund manager calls capital from the initial investors in several years, capital is sitting in the QOF and paying the Federal ADR rate + 300bps per annum from day one until then, or the investor sources capital from a capital gains marketplace in real time to match sources & uses in real time (engendering valuation and profit participation issues). The IRS may reconcile this issue through asset test solutions presented herein.

[ix] I.R.C. §1394(b)(3)(B)(ii) and Treas. Reg. §1.1394-1(c)