By Valerie Grunduski

Nearly every week, there are multiple reports of new Qualified Opportunity Funds launching. Once a sleeper provision of the Tax Cuts and Jobs Act, the opportunity zone incentive has spurred a great deal of activity as of late. While we are still awaiting additional guidance from Treasury and the Internal Revenue Service, fund managers have begun to feel they have enough direction to start laying the groundwork in this new investment space.

The opportunity zone program was introduced with the intention of spurring investment in low-income communities. With over 8,700 identified qualified opportunity zones, the potential impact is significant. This program provides tax deferrals and gain exclusions for investors who place capital gains into a new investment vehicle known as a “Qualified Opportunity Fund” (QOF). A QOF is an entity that self-certifies that at least 90 percent of its assets are Qualified Opportunity Zone Property (QOZP). QOZP consists of qualified opportunity zone stock, qualified opportunity zone partnership interests, or investment into qualified opportunity zone business property (QOZBP). As a result, investments into QOZBP can be direct or indirect, and it is important to understand how the statute and proposed regulations provide different guidelines for these two strategies.

What is the difference between a direct and indirect investment?

Direct investment into QOZBP occurs when the fund directly owns the tangible property. An indirect investment layers in another tier, a qualified opportunity zone business (QOZB). When investing in this way, the fund infuses equity into a separately regarded operating entity (via stock or partnership interest) that holds the tangible property and business operations.[1] While there is an expectation that there is business activity in either structure, the current guidance provides different definitions and tests for direct versus indirect investments. The indirect form of investment received desirable leniencies in the first round of proposed regulations, but it also comes with additional statutory restrictions.

What is qualified opportunity zone business property?

Regardless of the chosen structure, every QOF has an underlying investment in a QOZBP. A QOZBP is defined as tangible property used in a trade or business that the QOF acquired by purchase after Dec. 31, 2017 from an unrelated party. Either the original use of the property must commence in the Qualified Opportunity Zone (QOZ) with the QOF or the property must be substantially improved[2] by the QOF. Additionally, substantially all of the use of such property by the QOF must be in an opportunity zone during substantially all of its holding period.

How much of the funds’ assets are required to be QOZBP?

As discussed above, 90 percent of a QOF’s assets must be qualified opportunity zone property. Failure to maintain this 90 percent threshold results in penalties assessed at the QOF level. In a direct investment into a QOZBP, 90 percent of the QOF’s assets would need to meet this tangible property definition. If a fund uses the indirect structure, while 90 percent of the QOF’s assets must be invested in the next tier, the QOZB is granted a “substantially all” threshold for QOZBP it must own. The first set of proposed regulations define “substantially all” for these purposes to be 70 percent. Accordingly, use of an indirect investment structure allows for more liberty in the composition of the business assets.

Take caution: While missing the 90 percent test results in a penalty computed in relation to the shortfall, missing the 70 percent test might mean that 100 percent of the QOF’s assets are not qualified.

How much time is allowed to hold cash used to construct or improve qualified property? The 90 percent test applied at the QOF level is measured every six months with a caveat on these dates in a QOF’s initial year. Accordingly, any cash that a direct investment holds on a test date is not eligible as a 90 percent qualified asset. On the contrary, the first round of proposed guidance introduced a working capital safe harbor for a QOZB. When utilizing an indirect investment method, a business can treat otherwise non-qualified property as qualified if they meet a number of requirements. To use the working capital safe harbor, the QOZB must have a written plan identifying that these funds are held for acquisition, construction or substantial improvement, as well as a written schedule of planned deployment of such funds within 31 months of receipt. Additionally, the QOZB must have reasonably complied with both the plan and schedule.

Introduction of this working capital safe harbor allows a QOZB a larger timeframe to deploy cash into construction or rehabilitation expenditures. With the possible exception of being able to prove reasonable cause, current opportunity zone guidance does not provide a QOF or a direct investment a similar safe harbor for holding cash without penalty. Are there any stipulations on production of business income?

As written, the guidance does not reference the income of a direct investment QOF. When utilizing an indirect investment strategy, a QOZB is required to derive 50 percent of its gross income from the active conduct of a trade or business. The proposed regulations further expanded this requirement to say that the income must be derived in the zone. The guidance did provide leniency, however, in regards to income generated by reasonable working capital under the safe harbor.

These requirements for gross income in an indirect investment have created uncertainty about what sort of business operations will meet the active conduct test and how gross income will be sourced in applying the “in the QOZ” test. Such uncertainty has caused a chilling effect on QOF investments into operating businesses. As a result, most of the QOF investments that have closed to date have been in real estate developments. As a word of caution, QOFs investing in real estate developments utilizing an indirect structure can’t just ignore the gross income test. Such test could be problematic for landlords that lease property under a triple net lease, since the tax law is generally well established that a triple net lease does not constitute the active conduct of a trade or business. Consequently, QOZBs that derive more than 50 percent of their gross income from tenants under triple net leases may not be able to satisfy the gross income test.

Are there any other requirements placed on an indirect investment into a QOZB?

The statute places limits on an investment into a QOZB that do not appear to apply to a QOF’s direct investment into a QOZBP. These limitations include a requirement that a substantial portion of intangible property is used in the active conduct of business (though there is no limit as long as the business requirement is met), less than 5 percent of property is nonqualified financial property (unless covered by the working capital safe harbor), and restrictions on operations of “sin businesses[3].” While intangible property and nonqualified financial property would be subject to the 90 percent t