Just about anyone familiar with the Qualified Opportunity Zone (QOZ) program understands the basics of how it operates. The initiative, part of the Tax Cuts and Jobs Act of 2017, led to the designation of approximately 8,700 federally designated lower-income census tracts -- opportunity zones. In order to stimulate economic development in these zones, investors funnel their capital gains into Qualified Opportunity Funds (QOFs).
QOFs spearhead projects, with the goals of urban improvement and job growth. Investors, in the meantime, benefit from tax deferrals on capital gains. An even nicer advantage is that investors owning their QOZ investments for longer than 10 years aren’t required to pay taxes on capital gains generated from their QOZ/QOF holdings.
Yet, in all of the discussion about investments, capital gains, and holds, not a whole lot is understood about the role, or applicability, of debt in the QOZs.
Substantial improvement
An important aspect of the QOZ program is that of economic improvement, better known as the substantial improvement clause. The QOF is required to double a QOZ property’s adjusted basis within 30 months of buying the asset. Even if the QOF has enough capital to spruce up that opportunity zone retail center or apartment building, the chances are pretty good that the fund will seek out debt financing to help substantially improve the property.
There are many benefits to taking out a loan. It frees up capital to invest in other projects, thus expanding and diversifying a portfolio. The loan’s sponsor can deduct the interest amount from taxes. And, while the value and rents of a property increase year after year, the loan repayment does not, meaning potentially greater returns for the QOF (and its investors).
While acquiring a loan can be a great prospect for the QOF sponsor, lending institutions might have another viewpoint. Traditional lenders don’t treat QOZ properties differently from any other real estate asset under consideration. An opportunity zone designation doesn’t make the property any better or worse than any other deal.
Before opening their checkbooks, lenders examine the investment risks, including the QOF’s strategy and business terms. In some cases, lenders are more cautious about QOZ opportunities, partly because the program is still so new. Much as we’ve advised investors to examine a QOF manager’s previous track record before investing, banks and other lending institutions are doing the same, before issuing loans.
Refinancing and distribution
Another issue revolving around the opportunity zone program and debt is what happens in the event of a refinance. For example, if the only initial debt available to a QOF was a higher-interest, shorter-term mezzanine loan, the question arose as to what would happen when the debt matured. In the non-QOZ world, refinancing is an obvious solution. However, in the QOZ universe, concerns were that refinancing debt could trigger deferred capital gains recognition. QOF investors might not have been too happy about this state of affairs, as it would have meant that their tax-deferred investment might require, well, tax payments.
This concern was assuaged in April 2019, when the IRS and U.S. Department of the Treasury issued its second round of guidance. Much to the relief of both investors and QOF managers, refinancing and recapitalization activities can take place without triggering deferred capital gains recognition. Furthermore, the guidance allows QOF managers to distribute the refinance proceeds to investors, up to a certain threshold. So, not only does refinancing NOT trigger recognition (meaning potentially more taxes), it means more money in investors’ pockets.
Bringing liquidity to QOZs, one loan at a time
While the idea behind the opportunity zone program was that of equity capital (courtesy of those trillions of dollars in capital gains), debt is just as important, especially given the stringent substantial improvement requirements that are part of the program. As such, investors should understand the role debt plays in a Qualified Opportunity Fund’s plan.
For additional information about the Qualified Opportunity Zone program and its investments, contact Realized Holdings by logging on to www.realized1031.com, or by calling 877.797.1031.
There are material risks associated with investing in QOZ properties and real estate securities including liquidity, tenant vacancies, general market conditions and competition, lack of operating history, interest rate risks, the risk of new supply coming to market and softening rental rates, general risks of owning/operating commercial and multifamily properties, short term leases associated with multi-family properties, financing risks, potential adverse tax consequences, general economic risks, development risks, long hold periods, and potential loss of the entire investment principal.
Past performance is not a guarantee of future results. Potential cash flow, returns and appreciation are not guaranteed. IRC Section 1031 is a complex tax concept; consult your legal or tax professional regarding the specifics of your particular situation.
This is not a solicitation or an offer to sell any securities. There is no guarantee that the investment objectives of any particular program will be achieved.
