In 2017, US Congress established the Federal Opportunity Zones Program, which was in many ways a stroke of genius. This Program provides investors tax relief while at the same time gives a serious capital injection to deprived and under-served communities across the country. US Secretary of the Treasury Steven Mnuchin expects opportunity zones to attract USD100 billion in investment.
With approximately 8,700 opportunity zones certified by the US Department of the Treasury, the potential for real estate and private equity investors to revitalize communities has huge appeal, as this type of ‘impact investing’ has gained major traction recently. Investors can invest in these designated areas and receive preferential tax treatment by forming a Qualified Opportunity Fund (‘QOF’).
The tax benefits of this new program are well documented, but for those looking closely at this space, there are a lot of nuances, and indeed risks, that need to be considered. After all, no one can yet possibly know how successful a new real estate asset (such as a shopping mall) will be, or what the internal rate of return on a fund investment might be after 10 years, at which point any appreciation of underlying assets in a QOF becomes tax-free.
In this report, consideration will be given to some of those nuances, to help fund managers determine, in the first instance, whether such a product is actually a right fit for their business.
This will then be followed by key insights from various players in the service chain – the tax/accounting specialist, the legal counsel, the fund manager – to lay out a road map for how to set up and operate a QOF.
First order considerations
1. Filing Dates
As mentioned, the tax relief associated with opportunity zones has dominated the headlines but the reality is this is a new, largely untested area of the market. As such, many potential fund sponsors are still unsure as to what the ecosystem looks like: who services it? What are their roles and responsibilities?
One of the first points to consider is that there are two different filing dates that need to be adhered to. In principal, a QOF is required to hold at least 90 percent of its assets (real estate or private equity) in Qualified Opportunity Zone Property.
However, as Steve Rosenthal recently wrote for Forbes, the IRS now provides additional flexibility to those Funds “who make qualifying investments in a business where a minimum of 70 percent of its assets (‘tangible property’) is in the Zone.”
Assuming this is a standard QOF, it must reach the 90 percent mark by the last day of the Fund’s initial six months, at which point the sponsor must do an initial filing with the IRS. It is then necessary to do a second filing at the end of the tax year. Here’s where the nuance comes in.
“As I recently discovered,” says David Young (pictured), President of Gemini, a leading US fund administrator, “if that opportunity zone fund holds an interest in a subsidiary operating company, the fund sponsor can move cash into the subsidiary, in which case they then have 31 months to deploy the cash, so long as the deployment is pursuant to a plan and the Fund reasonably complies with the plan.
“That’s a world of difference: a real estate developer can do a tremendous amount of work in that time, compared to six months. There are numerous tax nuances that one needs to be aware of. In addition, before considering this type of fund, it is important to clarify what each person’s role and responsibility is, either as a fund manager or a property developer. What does legal counsel need to focus on and prioritize? What does the fund administrator need to excel at?”
Certainly, laying out these considerations can make it a lot easier for fund managers to understand the moving parts and ultimately determine whether a QOF is suitable for their business or not.
“Ongoing communication with the fund administrator, tax/accounting team, and the fund manager is crucial to ensure seamless tracking of investments and reporting in order to adhere to filing deadlines mentioned above,” advises Skyler Steinke, Gemini SVP of Business Development, Alternative Funds.
As mentioned, there are over 8,700 opportunity zones across every US state, offering multiple investment opportunities for property developers, PE/RE investment managers and other businesses. In order for QOF assets to qualify under the opportunity zone statute, the business property on which the building/development work is being done must be located within an opportunity zone.
Young says that the initiative was created by the US government to get private capital moving quickly. “They want funds to be deployed and put to work right away. This will likely be a really hot asset class for the next 2 or 3 years, and I think you’re going to see a lot of fund activity over that period,” asserts Young.
As such, anyone considering a QOF should have a very clear idea of where and what they wish to invest in. Whether it is to build a new car park, or simply to re-energize the fortunes of a failing company or piece of commercial real estate, the fund sponsor should have a well-defined investment strategy at the pre-investment stage so that when it comes to raising capital, it is able to deploy it swiftly, in keeping with the spirit of the initiative.
“Some of the considerations relate to how quickly you need to deploy the capital and where it needs to be deployed,” says Young. “What opportunity zones do you intend to focus in on? What kind of projects will the capital be used for? One cannot, for example, use an opportunity zone fund to build a casino.”
Other assets that do not qualify for a QOF include private or commercial golf courses, liquor stores, country clubs and racetracks.
The investor has 180 days after realizing a capital gain to roll it into a QOF in order to defer the taxes on that capital gain. “It is important for the investor to communicate with the manager where they are at in the 180-day window,” says Steinke, “in order to make sure their capital investment is moved into the QOF on time within the 180 days.”
From an investor’s perspective, these are clearly long-term multi-year investments, and as such should be regarded as highly illiquid. An investor’s capital will need to be locked up for several years in order to benefit from certain aspects of the tax relief.
“You may receive distributions but those are going to be taxed, whereas the appreciation of the assets in the fund will not be,” says Young. “If you invest for more than seven years in one of these funds you can defer your tax gains, through to 31st December, 2026 and effectively reduce your total tax liability on capital gains to 85 percent.”
Young’s view is that, because of the nuances of QOFs, potential sponsors have to appreciate that there are “time sensitive elements” to setting one up. If someone does not have the appetite for complexity, he says, it may not be the right path to follow, despite the obvious tax benefits.
“This may not be suitable for smaller fund managers who don’t have the resources, the governance framework in place, etc,” comments Young. “There is a clear level of sophisticated fund management and compliance that needs to be applied to one of these Funds.”
In short, anyone considering one of these products needs to have the resources and framework in place to manage a professional investment fund.