Investments for many large real estate projects that are eligible for opportunity zone (OZ) federal tax incentives are now proceeding because of the release of a second set of clarifying Treasury regulations. The first set of regulations, released at the end of October 2018, did not fully address some significant tax issues that are of particular concern to multi-investor, multi-project opportunity zone development funds. The second set of regulations has now been issued and there should be more significant projects announced as a result.
An OZ investment must be made through a Qualified Opportunity Fund (QOF).
There are four tax advantages of OZ investments:
(1) If a capital gain is invested in a QOF, the tax due on the gain is deferred until the earlier of the sale of the QOF or December 31, 2026.
(2) If the investment is held for at least five years, the amount of the gain to be taxed will be reduced by 10%.
(3) If the investment is held for at least seven years, the amount of the gain to be taxed will be reduced by an additional 5%.
(4) If the QOF is held for at least 10 years, the taxpayer’s basis in the QOF is stepped up to the fair market value of the QOF at the time of its sale. In other words, any appreciation in value of the QOF is tax exempt after 10 years.
This benefit is separate from the capital gains deferral. The tax on deferred capital gains will be due by December 31, 2026 at the latest even if the investment in the QOF is being held past that date in order to qualify for the 10-year exemption.
Even after the second set of regulations, there are a number of significant issues worth considering when lenders review opportunity zone projects to finance. These issues arise from the structure of the law and are not necessarily susceptible to being addressed by regulations. Among them are requirements that equity invested in an OZ project remain in the project and the consequences of failing to meet the requirements of the OZ rules.
Restrictions on Investments Remaining in Projects
It is important to understand that the OZ rules require the tax-advantaged investor to make an equity contribution to the project and that the equity contribution remain in the project for the entire term of the tax-advantaged investment (at least 10 years in order to qualify for maximum tax advantage). If the investor’s interest is impaired or eliminated, the investor may lose its tax advantages. Therefore, an investor would naturally want to avoid a lender taking title to OZ property in the event of a foreclosure. If an OZ property is foreclosed and ownership of the property shifts away from the QOF (or an entity owned by the QOF that directly owns the OZ project), then the QOF no longer meets the requirement of holding OZ property. Restated, a troubled project can’t be recapitalized in a way that shifts equity ownership away from the QOF.
As a result, investors would want sufficient protection built into the loan agreement to minimize the risk of a foreclosure (for example, an interest reserve to avoid an interest payment default). Also, an investor will want to make sure that there is a robust capital call provision to ensure that all other investors are appropriately motivated to contribute any equity funds required to cure a loan default and to prevent the property from being foreclosed.
Consequences of Failing to Meet OZ Requirements
If a qualified opportunity fund fails to meet the statutory requirement that 90% of its assets be invested in OZ business property, then there is a penalty calculated monthly applying the IRS underpayment rate (currently around 5.5%, the federal short-term rate plus 3%) to the amount of the shortfall. However, failure to meet some of the other requirements of the OZ rules presumably means that the taxpayer’s OZ investment may not receive the hoped-for tax benefits of the program at all. In addition to not qualifying under the technical requirements of the OZ rules, there is a broad anti-abuse rule in the second set of regulations that gives the IRS the power to recast transactions “as appropriate to achieve tax results that are consistent with the purposes” of the OZ statute.
For example, one of the tests of being a “qualified opportunity zone business” is that the business (think of this test as relating to the LLC that owns the project) is required to “substantially improve” the property if the OZ project involves the rehabilitation of an existing property. The substantial improvement test is met if, during any 30-month period beginning after the acquisition of the property, additions to the basis of the property are greater than the adjusted basis of the property at the beginning of the 30-month period.
If the OZ project fails to meet this requirement (remember, this is just one example of a requirement), the would-be OZ investors would not have deferral and reduction in capital gains tax, but rather the tax would be due and payable in full. Also, there would be no exemption from capital gains tax payable on the increase in value of the investment. The economic consequences to the investors would be substantially greater than, for instance, the occurrence of a recapture event in a historic rehabilitation tax credit project.
Therefore, to the extent that a lender is required to make future advances after closing (as is frequently the case in construction loans) to fund that substantial improvement, then lenders need to be particularly concerned about potential liability for failing to advance funds to a project if the conditions to those advances have arguably been met, since the harm to the investors would loom large. The OZ investors may well seek recourse from the developers and deep-pocketed lenders if there is a failure to meet the statute’s requirements, so those parties should consider how these possibilities are addressed in the deal documents, particularly the need for indemnification from creditworthy parties.