Clarification on Working Capital, Substantial Improvement and Use of Leverage will Drive Investment ActivityDevelopers intuitively understood the powerful nature of the new Opportunity Zone legislation, but their enthusiasm was hampered without further guidance. The answer to their calls for clarity came on October 19th when the Treasury Department issued proposed regulations, as well as Revenue Ruling 2018-29. Developers quickly recognized that the overall tenor of the newly issued guidance is "investor-friendly" and speaks to an overall theme of driving unbridled economic activity to the targeted opportunity zones. Specifically, three key points stand out to accelerate the flow of investment into Opportunity Zones, namely (i) flexible timing to deploy capital; (ii) a less-restrictive test on how measure substantial improvement; and (iii) making use of leverage to maximize development.
Reasonable Timing to Deploy Working Capital – The Safe Harbor
As drafted, the Opportunity Zone legislation purposely creates a sense of urgency to make investments in such areas by requiring that 90% of the Qualified Opportunity Fund's ("QOF") assets be invested within a short time frame which requirement is measured twice a year during the QOF's taxable year. Left alone, the testing dates pose certain developer conundrums – most projects either do not need to be 90% funded within six months of construction or, if the total capital is raised, it is nearly impossible to complete construction in that timeframe.
The proposed guidelines solve this issue with the creation of a reasonable "working capital safe harbor" so long as the capital is held at the qualified opportunity zone business ("QOZB") level (as opposed to the QOF level). The safe harbor allows QOZB to hold monies for future use for a period of up to 31 months subject to certain conditions. The safe harbor will apply so long as the QOZB (i) has a specific written plan that identifies the property in the Zone to be improved, (ii) follows an established written schedule for the deployment of such capital consistent with its ordinary operations, and (iii) substantially complies with its written schedule.
An example demonstrates the value of the working capital safe harbor for developers. Assume Developer D establishes a QOF to substantially improve a building and capitalizes such QOF with $1,000x of gain dollars. The QOF is established on October 1 and, therefore, must deploy 90% of its assets (or $900x) on or before December 31, only three months later. To satisfy such requirement, and avoid penalties, Developer D will have the QOF form a QOZB that in turn owns the property to be developed. On or prior to December 31, the QOF must deploy no less than 90% of its assets (in this example, $900x) into the lower-tier QOZB. The monies at the QOZB level will be subject to the required plan and schedule. In so doing, the QOF satisfies the Opportunity Zone conditions and has 31 months to utilize such cash without penalty so long as the expenditure of such funds is substantially consistent with its written plan and schedule.
Substantial Improvement Test – Allocating Dollars Toward Building Improvement
The proposed guidelines make it easier for a Developer to receive the benefits of the Opportunity Zone legislation by clarifying the amount of total investment needed to improve a building in a Zone. A preexisting building has to be "substantially improved" in order for the investment to qualify for Opportunity Zone benefits. Revenue Ruling 2018-29 states that “substantial improvement” is based on the adjusted basis in the building only and excludes any value attributed to the land. Going forward, Developers will now seek as part of their acquisition to establish land and building value allocations either through an independent source (such as an appraisal) and/or through its purchase contract.
Only counting the building valuation to meet the substantial improvement test has immediate benefits. First, in Zones where neglected and run-down buildings are immaterial to the property's overall value, any new development will easily meet the Opportunity Zone substantial improvement test. Second, in areas of high land value relative to the improvements (e.g., certain metropolitan areas), less dollars will be needed to be raised and dedicated toward new construction for Opportunity Zone compliance. In both of these scenarios, overall development/economic activity is encouraged by lowering the compliance threshold.
Use of Leverage
The use of leverage is fundamental to real estate investing. The proposed regulations, designed to encourage investment, do nothing to hinder this principle. Developers will find that the proposed regulations contain two key investment-friendly provisions related to debt: first, the use of debt will not dilute an investor's tax benefits in any way; and second, an investor may pledge its interest in a QOF as collateral for a loan without negative impact to the investor.
An example will help illustrate these points. Developer D forms a QOF and capitalizes it with $300x of capital gains. In Year 1, the QOF purchases a property in an Opportunity Zone using $300x of debt and $300x of cash. In Year 4, Developer D takes out a personal loan for $100x and pledges its interests in the QOF and uses such proceeds to purchase a personal residence. In Year 6, the QOF refinances its existing loan using $450x of new debt and distributes $150x to Developer D. Finally, in Year 11, Developer D sells its interest in the QOF for a sales price of $850x.
Analysis: Developer D's acquisition loan is not considered a contribution to the QOF. Developer D's loan and pledge in Year 4 is a non-taxable event to Developer D and does not impact Developer D's tax position with respect to the QOF investment. The distribution to Developer D may have certain tax consequences to Developer D depending on its particular tax situation. In Year 7, Developer D must pay capital gains tax on 85% of its original investment in the QOF. In Year 11, the QOF uses $450x of the sales proceeds to repay the Year 6 loan, leaving Developer D with $100x of new gain, all of which is exempt from capital gains tax.
The Sullivan & Worcester O-Zone multi-disciplinary team advises many stakeholders, including Developers, in the Opportunity Zone universe. Please visit www.sandw.com for more information about our Opportunity Zone Practice.