Saul Ewing Arnstein & Lehr LLP attorneys Ronald Fieldstone, Rohit Kapuria, Jay Rosen and Roger Bernstein attended the Opportunity Zone Expo Conference in Los Angeles on January 25, 2019.  Much to their surprise, the attendance was over 1,000 people, which may be a record from an OZ attendance standpoint.

The program itself was extremely well presented and in attendance were representatives from all disciplines, including fund managers, fund advisors, private equity firms, developers, investors, professionals, fund administrators, as well as government officials who were there to actually make presentations on the government aspect of the OZ program.

Our takeaways from the conference are as follows:

1. The OZ program is extraordinary popular and is attracting players who are both involved in the real estate industry as well as those parties that actually want to establish businesses in Opportunity Zone areas.
2. There is still uncertainty and confusion in the industry and clearly the public is getting up to speed on how the program really works, subject to the fact that regulations on many open questions have yet to be issued (although it is hoped that further regulations will be issued in March of 2019, which should answer some but not all open questions). It likely will take some time before all major details are addressed by the Treasury Department.
3. There was a lot of confusion from the attendees as to their understanding of what structures work, what structures do not work, and what structures may work based upon the current regulations and the anticipated provisions to be contained in the updated regulations.
4. Our firm was impressed with the overall quality and diversity of the attendees and the panel members who participated in the conference.
5. There is clearly an offshoot of participants in the EB-5 Program who are now interested in the OZ program since to some degree, the OZ opportunity is an extension of EB-5 given the similarities as to the fact that the project must be located in a depressed/high unemployment area.  EB-5 involves an investment of capital that creates jobs and maintains an at-risk investment for a period of time in order to enable investors to obtain residency and citizenship in the United States.  Opportunity Zone investments have significant tax benefits if both investors and investments meet specific requirements: easy to satisfy for investors but harder for the investments.

Overview of Fundamental Tax Requirements:

A.    Need to track the timing for each investor’s direct capital gains deployment –Need to match 180 day period either after sale date or fiscal year + 179 days if a pass through entity capital gain generation.

B.    Qualified Opportunity Zone Funds ("QOF") Requirements

(1)    QOF must be either a corporation or partnership structure.

(2)    QOF must be organized for the purpose of investing in qualified opportunity zone property (“QOZP”). QOZP can include QOZ business property (:QOZBP”), discussed below, qualified opportunity zone stock (“QOZ stock”), and qualified opportunity zone partnership interests ("QOZ partnership interests").

(3)    At least 90 percent of QOF’s assets must be QOZP. 10 percent can be non-QOZ property, including offering costs. A QOF can invest in subsidiary partnerships or corporations. For stock or partnership interests to qualify as QOZ stock or QOZ partnership interests, the corporation or partnership (a "QOZ subsidiary") must be engaged in an active trade or business in an OZ, but it can have no more than 30 percent non-OZ property.

(4)    Only cash contributions qualify as rolled over capital gains. If an investor contributes land to a QOF or QOZ subsidiary, then the investor does get capital gains deferral or exclusion with respect to that contribution, and the asset is treated as a non-qualifying asset.

(5)    QOZBP means tangible property used in a trade or business that meets all of the following criteria:

(a)    the QOF purchased the property from an unrelated party (generally, someone with no more than 20 percent ownership in the Fund, including after application of attribution rules) after December 31, 2017,

(b)    the original use of the property in a QOZ starts with the QOF, or the QOF substantially improves the property,

(c)    to satisfy the requirement of the definition of substantially improved: QOZB property will be treated as "substantially improved" by a QOF only if during any 30-month period beginning after the date of the property’s acquisition its basis is increased by an amount exceeding its initial cost basis in the existing building improvements, and

(d)    substantially, all of the use of the property was in a "qualified opportunity zone" during substantially all of the time the QOF holds the property.

(6)    Ownership of QOZ stock or QOZ partnership interests must satisfy the qualified opportunity zone business (“QOZB”) test, meaning the issuing entity must be engaged in a QOZB. Many QOZB requirements are not applicable to QOZBP owned directly by the QOF, so if the QOF acquires QOZBP directly, there are fewer restrictions on the QOZBP.

(6)    It may be easier to hold through QOZ subsidiaries because QOZ subsidiaries have a 70 percent rather than 90 percent test – and QOZ subsidiaries can hold cash as "working capital" (subject to further requirements regarding business plan and actual use of cash over a 31-month period). However, there are more requirements for QOZ subsidiary business activities to be qualifying activities than there are for a QOF.

(7)    The entity to be used as a QOF must be organized in the United States, District of Columbia, or a U.S. possession (with an additional "purpose" criteria for U.S. possessions).

What Works, What Doesn't Work and What May Work

(1)    What happens if a QO Fund sells its QOZ Business Property after the ten-year holding period?  Under current law absent changes to the Regulations the gain would be recognized.  The interest in the Fund must be sold to get the step up in basis.

(2)    What happens if a QO Fund sells an asset before the ten-year holding period has expired?  Under current law, same problem.  We hope that new proposed regulations will allow for asset sale and redeployment of funds in another OZ Project without triggering a taxable gain and also maintain deferred capital gain eligibility, but it is risky to plan on that until the regulations are issued.

(3)    A plethora of partnership tax accounting issues still need to be addressed.  Does a QO Fund have to reduce the basis of its assets to reflect the fact that the investors in the QO Fund have a zero "outside" basis (or is there a huge disparity between "inside" and "outside" tax basis)?  How does the recognition of capital gain by December 31, 2026 affect the "outside" and "inside" basis?

(4)     Suppose investors fund a QO Fund with equity.  After the QOZ Business Property is substantially improved, and leased up, the property is financed (or refinanced) on a nonrecourse basis and the proceeds are sufficient to return all capital previously contributed (and maybe more).  Under current real estate tax law, the refinancing or new financing should be neutral: Invested financing increases basis and distributions reduce basis.  Nothing in the statute or currently proposed regulations changes this.

(5)     The proposed regulations say that land costs are ignored for purposes of determining whether the building has been "substantially improved."  What about capital expenditures for things like equipment (e.g., laboratory equipment or manufacturing equipment that is affixed to the real estate) and building systems?  Does that count as additions to the basis in the "building"?  Or can the QO Fund only count expenditures that are added to the depreciable basis of the building itself? It is generally hoped that all types of expenditures should count and not just additions to the real estate component, but regulations could come out either way.

(6)     Suppose a developer (who has no capital gains to be deferred) forms a QO Fund satisfying all other requirements for a QO Fund (including purchase from an unrelated party) and using as much leverage as possible. At what points After the QOZ business property (e.g., an office building) is completed, can the developer start selling interests in the QO Fund to investors who have capital gains they want to defer?  Will the investors qualify for the QOZ tax benefits (even though they are just replacing existing capital)?  Is this a way for a developer (with no need for QOZ benefits) to monetize a project located in an O Zone?

(7)     What if the developer or other promoter of a QO Fund makes a "qualifying" investment (i.e., he had capital gain income and timely invests cash and makes a deferral election), but the developer’s interest includes a "promoted" interest in addition to the "regular" interest in the QO Fund that all the other investors get (e.g., a 20 percent profits interest that is paid after all investors, including the developer or promoter, get their investment back). Will the profits interest qualify for the exclusion from gain after ten years?

General Structuring Issues:

General structuring issues to be taken into account include the following:

1. Single Asset Preference.  Whether to do a single asset fund with a subsidiary structure or have a multiple asset fund with multiple subsidiaries that undertake OZ Projects.  At this time under the proposed regulations, the preference in the industry is to do a single asset fund whereby the OZ requirements are easier to satisfy since only a single asset would need to be taken into account in complying with the OZ requirements.  In addition, based upon the status of the current law, the only clear path to exit an OZ investment and receive the capital gains appreciation tax free is to sell an interest in the OZ fund and receive a step up in basis.  In other words, the sale of the asset at this time would not provide for a step up in basis to enable a tax-free event.  As a result, if the OZ fund controls multiple assets, then by selling the interest in the entity, the OZ fund would need to sell its interest in multiple assets, which may be much more difficult to market to the public as opposed to a single asset sale.
2. Structuring the Fund Capital Stack.  Another interesting concept is the structuring of the capital stack of a fund, including the preferred return and capital gain/profit sharing formula for investors.  Clearly, OZ investors who use capital gains proceeds will receive significant tax benefits that can easily be quantified in connection with their investment in the fund.  In discussing this situation with fund managers and fund advisors, it is apparent that the industry will need to come to grips with how to allocate the value of the tax benefits and the potential rate of return to investors and the promotes, including the preferred return and bank and profit allocation paid to investors.  Again, this will be subject to negotiation on a deal by deal basis, but the general feeling in the industry is that sponsors will be able to pay a smaller preferred return and provide a smaller internal rate of return and/or multiplier on the exit of the Project.

Other items to be noted include the following:

1. The proposed regulations issued on or about October 19, 2018, can be relied upon, provided that the regulations are relied upon in their entirety (no picking and choosing).  Therefore, any investor and/or sponsor undertaking an OZ transaction that is finalized under the current proposed regulations should continue to qualify. It is unclear whether new rules would affect such a fund’s ability to make further acquisitions or investments after the effective date of the new rules.
2. Given the government shutdown, the updated proposed regulations have been delayed and are anticipated to be made available sometime in March. However, based on past experience, it is risky to rely upon the release date of any regulations.
3. There is a potential that there will be additional legislation that will clarify the ambiguities in the current legislation.  A recent article indicated that Senator Tim Scott (R), one of the two original sponsors of the OZ legislation, is leading a bipartisan effort to encourage the Treasury to provide OZ verifications which include the requirement that will clarify that 70 percent of an operating business’s property must be within an Opportunity Zone to obtain capital gains benefits.  Scott has requested that the Treasurer remove the requirement that Opportunity Zone businesses would require 50 percent of the gross income for an Opportunity Zones to be eligible for the program, claiming difficulty in attaching a specific location for business income.  Instead, he requested that at least 50 percent of business income must be from active conduct from an active trade or business.  He also supported the notion that funds invested in an Opportunity Zone could be reinvested elsewhere in order to remain eligible for the tax break, arguing that as long as investors do not take distributions from the Fund from the sale of any asset or sell their interest prior to meeting the 10-year holding requirement, the capital gains benefits should remain.  He also recommended that Treasury include reasonable reporting requirements at regular intervals for both QOZs and the investments they make that would reduce the abuse in the program and move more capital into the program.
4. State Concurrency Issues.  An interesting aspect of the OZ program is the fact that it only affects federal taxation and does not address how gains will be treated by the states and U.S. territories.  It will be interesting to see what jurisdictions adopt concurrency legislation that provides the same exemptions as the federal program with respect to the capital gains treatment.  Otherwise, investors will need to consider not only the state (or territory) tax consequences of where they reside in making an OZ investment, but also the state tax consequences for an investment made in a jurisdiction that has a state income tax as well.
5. Another key matter that has been debated among professionals is whether an OZ Project upon completion can be refinanced, with the net proceeds of the refinancing distributed to investors as a return of capital.  It is the general opinion of tax professionals that OZ Projects should be treated no different than other real estate projects whereby the refinancing of a project that entails excess loan proceeds being distributed to investors should have no negative tax consequences given the fact that the increase in debt would increase the investor basis and the distribution of such funds would correspondently reduce the basis. However, Treasury could issue "anti-abuse" rules limiting the ability to distribute refinancing proceeds.
6. OZ Program benefits do not exclude other benefits that may be derived with respect to an OZ Project related to other local, state and federal government programs.
7. OZ investments are not limited to real estate transactions but also include operating businesses.  There has been a significant interest in multiple businesses trying to locate in an OZ for various reasons, especially given the fact that there may be very affordable land available in an OZ that would enable certain industries involving energy production, manufacturing, or other similar activities to gain the benefit of the OZ program and enable access to affordable land that would support the development and operation of a business that is not based upon the advantages that re-gentrified real estate locations would provide to more advantages for projects such as hotels, office buildings, retail facilities and multifamily residences, whereby the location is far more relevant.

All in all, it is our impression that there are many moving parts in this industry that will hopefully get resolved in the near future, especially when the new proposed regulations are issued and final regulations are finally adopted in order to clear up industry uncertainty and motivate more investors to participate in the program.