By Kevin McDowell and Joyce Soriano-McDowell
The Opportunity Zone Program is bringing considerable excitement to the commercial real estate market. This tax advantage could result in significant proceeds to investors. Not since the creation of 1031 Exchanges, REITs and crowdfunding has the U.S. real estate market been inundated with anticipation and enthusiastic expectation. Qualified Opportunity Funds are new investment vehicles that have been created based on the Opportunity Zone program included in the 2017 Tax Cuts and Job Act. Due to the expected tax incentives and community impact this novel investment program is expected to bring, the real estate industry is rushing to this new frontier, much like the gold rush era of the 19th century.
Due to the significant tax benefits that investors may potentially obtain, investing in OZ funds will most likely be popular until the program expires in December 2026. Multi-billions are expected to be deployed by the end of this year to fully take advantage of the tax benefits. However, since this is a new field for everyone, savvy and new fund sponsors will be entering the market. Analogous to the overall real estate industry sentiment of “cautiously optimistic” as it pertains to the status of the real estate market, investors should also approach investing in OZ Funds in a “cautiously optimistic” manner. Be cautious in fund sponsor choices but be optimistic with the expected profits.
How can investors minimize the potential mistakes they may make in OZ Fund investments? Let’s highlight the pertinent issues that must be the focus of due diligence. The main factors that investors should consider while evaluating an investment in OZ Funds are compliance reporting, designation maintenance, fund agreements, sponsor pedigree, investment strategy, exit considerations and risk tolerance. The goal is to educate, communicate and encourage investments in opportunity zones since there are numerous advantages and incentives for all participants - seasoned and inexperienced investors, fund sponsors, government officials, and the designated low-income, underserved communities.
COMPLIANCE REPORTING
The IRS requires a significant compliance reporting component that must be performed annually in order to fulfill the conditions for a Qualified Opportunity Fund (QOF). Some of the requirements are: satisfaction of the 90 percent Asset Test, self-certification, and working capital.
One of the most important prerequisites for a QOF is that 90 percent of fund assets must be held in a Qualified Opportunity Zone Property (QOZP). A QOZP is one of the 8,761 census tracts in the country and U.S. territories that were certified as Opportunity Zones. In addition, QOF must not invest in ineligible Qualified Opportunity Zone Businesses (QOZB) meaning businesses that fall under the categories of golf courses, country clubs, massage parlors, hot tub or suntan facilities, racetracks, gambling and liquor. Although, cannabis hasn’t been specifically excluded in the list of “sin businesses” as defined by the IRS, it would be advisable to err on the side of caution and eliminate this type of investment since it’s not yet federally-regulated. Secondly, for a QOF to self-certify, Form 8996, Qualified Opportunity Fund must be filed annually with its income tax return. Lastly, if a QOF constructs or develops QOZP directly, then a working capital reasonableness test is applicable.
The IRS has not issued the final regulations regarding the OZP so there are many uncertainties and unanswered questions that remain. As a consequence, tax guidelines are still being finalized and other compliance issues are still incomplete. Nonetheless, annual compliance reporting is a critical provision to maintain the QOF designation, so investors need to thoroughly scrutinize the accounting firm that is engaged to perform this procedure.
OPPORTUNITY ZONE FUND DESIGNATION MAINTENANCE
It is imperative that a QOF designation is maintained throughout the life of the fund otherwise investors may not fully realize the tax benefits projected. For example, an investor who has held its investment in the OZ Fund for 10 years and later determine that the fund has a lapse in its designation may be hard pressed to regain its investment if that designation isn’t retained continuously. It is essential for investors to request a copy of Form 8896, the self-certification form, on an annual basis as proof of fund designation maintenance.
FUND AGREEMENTS
Uncertainties will prevail until final regulations are published by the IRS, so the law firm engaged by the QOF is extremely crucial. Make sure the lawyer preparing the entity structures, fund documents and operating agreements is an Opportunity Zone expert. Single project QOF have easier structures since the IRS guidance provides more clarity. However, multi-asset QOF are more complicated so more due diligence is required.
Fund agreements should clearly articulate the investment strategy, potential exit plans, investor return calculations and terms of the QOF during the entire investment period. Although, the IRS has not provided specific guidelines regarding fund agreements, investors should be able to understand the pertinent investment matters.
SPONSOR PEDIGREE
Opportunity zones is a new playing field for veteran and new fund sponsors. Real estate and non-real estate fund managers are also joining the marketplace, so investors have a lot of venture choices. As a result, a comprehensive due diligence is vital in the selection of the right fund sponsor. Although, opportunity zone investment falls under impact investing, investors still have an expectation to receive considerable investment returns commensurate with the project risks.
Some of the indispensable elements investors may evaluate fund sponsors are as follows: Integrity and honesty, creativity in the fund strategy, business and real estate experience and execution capability.
Investors should look beyond the past track record of the sponsor and carefully analyze the investment strategy of the QOF. Since the designated opportunity zones are low-income communities, these are not considered ideal and financially-viable locations by traditional real estate sponsors so they were mostly overlooked.
There may be new fund sponsors who may bring innovative investment ideas, strategies and alternatives that may bring higher investment returns and simultaneously revitalize these underserved areas. In some cases, these emerging fund managers may have better options since they bring creative thinking and an agility to a rapidly changing environment.
INVESTMENT STRATEGY
A well-thought out investment strategy must be carefully reviewed prior to investing in QOF to ensure that a sound plan is going to be systematically executed by the fund managers especially when it pertains to direct construction or development projects. The OZ Program stipulates that a property must be “substantially improved” within 30 months of acquisition and in some cities, this requirement may not be realistically accomplished due to a lengthy entitlement process and development approvals.
In addition, a well-formulated investment strategy will distinguish the insightful fund manager and make it more compelling to the appropriate investors even if the fund sponsor may not have an extensive track record. A fund sponsor should convey that the investment strategy may not issue the same gross returns as conventional real estate investments but may outpace other investments when calculated net of tax. OZ Funds are also ideal for socially-conscious investors who require a certain amount of investment return combined with sustainable, economic impact.
Finally, it is important to remember the intent of the OZ program – to revitalize low-income and economically-distressed communities with private capital injections. For this reason, investors should ascertain that the investment strategy is capable of producing risk-adjusted returns while simultaneously contributing to the long-term advancement of the community.
EXIT PLANS
The OZ Program has three tiers of deferred capital gains tax reduction by which investors can benefit. Investors who invest within a 5-year term will be able to reduce 10 percent of original deferred capital gains tax. Investors who invest within a 7-year term will be able to reduce 15 percent of original deferred capital gains tax. Investors who invest within a 10-year term will be able to eliminate the entire deferred capital gains tax invested.
As a consequence, a review of the exit strategy prior to investment is important to ensure that the appropriate investment goals for each respective investor can be met by the fund sponsor. Just like any typical investments, investor objectives must be aligned with the investment strategy of the QOF so a mutually-beneficial connection exists.
RISK TOLERANCE
Although investing in OZ funds brings significant tax benefits for investors, inherent risks are still present. In general, investing requires moving outside comfort zones and knowing one’s tolerance for gambling. An assessment of project risk, adjusted returns, financial capacity, mutual compatibility and investment merits is useful. As American entrepreneur and Chairman of Research Affiliates, Robert D. Arnott said, “In investing, what is comfortable is rarely profitable”.
A WINDOW OF OPPORTUNITIES
OZ Funds is a novel investment alternative and deserves appropriate due diligence to ensure investment returns are met, objectives are accomplished, alignment of interests by all parties are achieved, and communities are well-served. “Cautiously optimistic” is an apt description of the approach that investors must utilized since this new program can bring significant returns, tax benefits and community impact if executed properly.
Until final regulations are published by the IRS, all interested participants will need to continue to keep abreast of any future changes. However, this should not deter investors in investing in QOF. Just be sure that the following considerations are applied when evaluating fund sponsors: compliance reporting, fund designation maintenance, fund agreements, sponsor pedigree, investment strategy, exit plans and risk tolerance.
There is a short window of opportunity that is open to investors who are willing to take the risk and derive substantial benefits to this obscure program that was buried in the 2017 Tax Reform Reconciliation Act. As Warren Buffett famously said, “Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble.”