The Lifecycle of an Opportunity Zone Investment: Part 5

Once your qualified opportunity fund has been seeded with eligible capital gains, the focus turns to the investment phase. As noted earlier in this series, the “do’s and don’ts” of effectuating an opportunity zone compliant investment are the most complicated and least understood aspect of this process. While the final opportunity zone regulations are long and detailed, they do not (and cannot) clearly address the virtually unlimited variety of deal structures and issues that may arise in the marketplace. That will require years of practice, audits, further guidance and court cases, of which there are currently none, so a fair amount of uncertainty remains for some opportunity zone investments. There are, however, a number of key considerations that dictate the structure and operation of qualified opportunity zone investments.

For the reasons described earlier in this series, the vast majority of transactions are being structured as “indirect investments” – that is, the qualified opportunity fund is investing in the opportunity zone through its ownership interest in a qualified opportunity zone business (a “QOZ Business”), and not directly acquiring or owning qualified opportunity zone business property (“QOZ Business Property”). With indirect investments, the focus becomes whether the target business meets all of the requirements of a QOZ Business (described in more detail below). The level of complexity and uncertainty varies depending on the type of investment under consideration. For example, a real estate development located entirely in a zone involves less uncertainty and planning than an investment in a start-up business which may operate or sell products or services both in a zone and outside of any zone and which (hopefully) will grow and change extensively over the ten plus years of an opportunity zone investment.

At a minimum, every QOZ Business must satisfy each of the following five tests during the life of the investment:

1. Substantially all (at least 70%) of the tangible assets of a QOZ Business must be QOZ Business Property. The definition of QOZ Business Property is among the most complex in the opportunity zone regulations. To qualify as a “good asset” for the 70% threshold, the property must, among other things, be acquired (which generally can include leased property) from an unrelated party after December 31, 2017, and either have its original use in the zone with the QOZ Business or be substantially improved by the QOZ Business. The rules around each of the italicized words above, as well as other requirements, are lengthy and complex and need to be considered carefully.
2. A QOZ Business may not maintain more than 5% of its property in nonqualified financial property, which includes debt, stock, options, and other securities, but which excludes a reasonable amount of working capital held in cash, cash equivalents and certain short-term debt instruments. The rules include a safe harbor for funds of a QOZ Business to be treated as “reasonable working capital.” The safe harbor requires that the business have a written business plan with a schedule that shows the working capital funds being used in the company’s business in the opportunity zone over the ensuing 31 months (but up to 62 months in some circumstances); and that the funds actually be used in accordance with the plan/schedule.
3. A QOZ Business must derive at least 50% of its gross income from the “active conduct of a trade or business” in an opportunity zone. So purely passive investments will not suffice. For example, the ownership of real estate that is triple net leased by the owner/landlord would not constitute an active trade or business. The rules offer QOZ Businesses several ways to calculate the amount of gross income derived in an opportunity zone, including that 50% or more of the company’s services are performed in the opportunity zone – based on hours worked by employees and independent contractors or amounts paid to employees and independent contractors – or that the property and management of the company located in the opportunity zone are each necessary for the generation of at least 50% of gross income.
4. At least 40% of the intangible assets of the QOZ Business must be used in the conduct of business in an opportunity zone.
5. Finally, a QOZ Business must not engage in certain so-called “sin businesses” specified in the statute, including golf courses, country clubs, massage parlors, hot tub facilities, sun tan facilities, racetracks and other gambling establishments, and liquor stores.

As has been a theme throughout this series, there exists considerable nuances in all of the regulations discussed in this article, and investors would be wise to consult their professional advisors well in advance of taking the initial steps to pursue an opportunity zone compliant investment. For a more in-depth discussion of the opportunity zone program, including the statute, proposed and final regulations, please read our Opportunity Zones Client Alerts which you can access via the following links: https://martinllp.net/category/opportunity-zone/

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While this series will serve as a helpful primer on the opportunity zone regulations and compliance framework, the devil is always in the details. If you are considering making an opportunity zone investment in the near future, or just want to learn more than this primer can cover, the attorneys at Martin LLP are always available to consult with you.

In the meantime, stay tuned for Part 6

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Part 1 / Part 2 / Part 3/ Part 4

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