Opportunity Zone Funds: Q&A with Blank Rome’s Michael Sanders
At Peltz International’s seminar “Opportunity Zone Funds and Other Disruptors in 2019,” Michael Sanders, lead partner at Blank Rome’s Washington DC office tax group, discussed what opportunity zone funds are, the requirements, the current guidance, possible answers to outstanding questions, and advice to investors.
Q. What is the current status of Opportunity Zone Funds?
A. Michael Sanders: The Opportunity Zone Fund legislation was inserted at the eleventh hour in the 2017 Tax Act. It is very complex technically, poorly drafted and many questions are still unanswered. Treasury wants to see what people are saying before they issue a second set of answers. Significant comments have been filed. Treasury was waiting for the second hearing scheduled in January. So, the government shut-down has slowed down the process. A year from now, it is likely that significant guidance will remain open.
Q. How do you define Opportunity Zones?
A. Michael Sanders: An Opportunity Zone Fund is any corporation or partnership organized to invest in opportunity zone property and holds at least 90% of the assets in that property.
The advantage to investors is that if you have a capital gain, instead of paying tax on the gain in 2018, you can roll it into an Opportunity Zone Fund and defer paying tax until 2026. So the investor is able to invest the gains that would otherwise be paid in taxes currently. Thus, the investor has use of the funds in the interim.
If you hold the invest five to seven years, you step up your basis by 15%. This reduces the amount of taxes you pay in 2026. If you hold for 10 years, the step up is equal to the fair market value. The appreciation will not be subject to tax.
Q. Why did the government do this?
A. Michael Sanders: The idea was to get wealthy people to roll over dollars into an Opportunity Zone that could be developed. It can be combined with other tax credits e.g. New Market Tax credits.
Now it is limited to capital gains but 1250 recapture may ultimately be included.
Q. What general approaches can be taken?
A. Michael Sanders: Two approaches exist:
- Individuals that have gains can set up a “captive fund.” In 180 days, you have to roll cash equal to a gain in a fund which can be a limited liability company. You can hold it for another six months or so before you actually invest the Opportunity Zone property. You can also attract investor funds by using a PPM.
- If you’re going to start a business, start it in an Opportunity Zone Fund.
We are getting calls regarding development deals in the real estate sector as well as calls from start-up or incubator businesses.
If I had a new business – e.g. new software development – think about setting up in an Opportunity Zone. That business, as it appreciates, the gain will never be subject to tax if held for 10 years.
Q. How should investors select from the many Opportunity Zone Funds that are springing up?
A. Michael Sanders: Lots of people are getting publicity by claiming that they’ve raised a lot of money for Opportunity Zone Funds.
Slow down! From the investor standpoint, I recommend that you do your due diligence in steps. Look at the general partner and his track record. You have to see if the sponsor has property under contract. Compare the assets and the locations. Spend a lot of time on competitive opportunities in the designated funds.
In examining the fund or private placement – what are prefs to the investor relative to cash flow? Where does the GP fit in waterfall? Is there a clawback? Investors will want to make sure there is a clawback in case the targeted IRR isn’t met.
Q. Until further guidance is provided from Treasury, many unanswered questions still remain. What are some of the questions you’re hearing?
A. Michael Sanders: Let’s say someone sets up an LLC in an Opportunity Zone Fund and invests $10 million. What happens if next year they want to terminate the fund? There is no guidance on de-certification. If it doesn’t work, the person can roll onto another tax year. I don’t expect a lot of guidance from Treasury on this.
Another often-heard question is refinancing. If someone uses the partnership structure, conventional partnership rules should apply. It provides outside basis when you refinance inside the partnership.
Another question is what happens with distribution of excess refinancing proceeds representing the “appreciation”? You should be able to distribute the appreciation tax free. Take $10 million, borrow $30 million, develop the property, increase the value and then distribute the excess proceeds.
How much time does the Opportunity Zone Fund have to invest? There hasn’t been guidance on how much time you have. Based on the 90/10 rule – 90% of the Opportunity Zone Funds have to be invested – otherwise penalties will be incurred. The first measurement date is six months from the time the money is received. The second measurement date is six months hence or December 31, whichever is sooner. Otherwise, penalties will be incurred. However, you can drop 90% of equity into Opportunity Zone business partnership to buy more time subject to technical requirements.
Q. What are some of the other questions?
A. Michael Sanders: How does one deal with capital needs down the road? We invest the fund from an Opportunity Zone Fund into another partnership (lower-tier) that is going to develop the property. Down the road, you may need more money. There is no problem with a lower tier partnership doing a joint venture with another new Opportunity Zone Fund.
Original use is another issue. There is no guidance on original use. When it comes to vacant land, if it is located in the OZF property, it should qualify. You won’t have to deal with substantial improvements.
Tangible property? What if the business does a lot of business outside of the zone? The 50% test says 50% of the income /revenue be generated within the Opportunity Zone.
Software is an intangible. If one is manufacturing intangibles within the Opportunity Zone that should be fine. Gross income related to those intangibles should qualify; as to those intangibles outside the zone, we don’t have enough guidance. That isn’t an issue with real estate because all the property is located in the zone.
Q. Do you see any expected changes to the legislation?
A. Michael Sanders: The legislation was supported by both Republicans and Democrats. Senator Cory Booker was a big proponent. If the program is successful over the next few years and we see some positive results, there may be a push to expand Opportunity Zone Funds or modify them. We may see some amendments to attract more funds.
New Market Tax Credits have been enormously successful. But they do not extend beyond 2019. There may be a push in Congress to use Opportunity Zone Funds instead of tax credits. Areas with stress e.g. hurricanes, fire, can be included in an expanded opportunity zone fund. I’m relatively optimistic that we’ll see further legislation and expansion.
Q. What is your advice to investors interested in Opportunity Zone Funds?
A. Michael Sanders: My advice: The rules aren’t precise. It could take one-to-two years to get answers to the questions. We think if you’re in good faith and attempting to meet the rules, you should be okay.
Take advantage of the opportunity, don’t wait until Treasury answers all the unanswered questions. If you do, the opportunities may be gone.
Caution: you always need to look at the investment and the economics and put the tax benefits to the side, i.e., the investment must stand on its own. You can monetize tax benefits and combine with some of the tax credit benefits. Tie up the opportunities in designated tracts that make sense. But don’t invest solely because of the tax benefits.
"Opportunity Zone Funds: Q&A with Blank Rome’s Michael Sanders," was published by Peltz International, Inc. on January 31, 2019.