How Can Debt Impact Your Qualified Opportunity Zone (QOZ) Investment?

Posted Dec 5, 2022


Like traditional real estate investment vehicles, Qualified Opportunity Zone Funds (QOZF) may strategically use financing to help maximize returns. Using debt or leverage has its pros and cons; it has the first priority of payment, it magnifies returns in both directions, and it also provides income tax shelter. All else equal, more debt offers a higher risk/return ratio for investors.

QOFs will be financed similarly to traditional development or redevelopment projects. Any previous experience that you may have with commercial real estate financing will be applicable here. Most QOFs focusing on ground-up development projects and plan to use debt are expected to obtain short-term financing for the construction period and refinance into longer-term debt once the property is stabilized. As we will explain later in the article, the refinancing presents QOZF investors an interesting opportunity. 

Expect Similar Terms

While many local communities provide incentives to attract investments into their QOZs, lenders do not. Lenders still must evaluate the risks of the investment. Lenders will evaluate the QOZF’s investment strategy and business plan as they would any investment opportunity; the QOZ designation is not expected to impact the financing terms. 

Second Round of Regulations and Debt

Debt Financed Distributions — The second round of QOZ regulations, released on April 17, 2019, allow for debt-financed distributions from refinancing or recapitalization events. To avoid recognizing taxable income, any fund that is taxable as a partnership can distribute loan proceeds to investors but cannot exceed the investor’s partnership interest cost basis.

Two conditions can trigger recognition of deferred gains:

  • Debt-financed distributions occurring in the first two years after an investment in the Fund.
  • Any debt-financed distributions considered as a disguised sale as defined under Internal Revenue Code Section 707.

In other words, once the QOZF Sponsor refinances the initial short term debt on the property, they can distribute the proceeds to investors, up to a certain threshold. Investors could potentially receive a sizable portion of their initial investment in the first couple of years of the investment. Those funds may come in handy to investors when the capital gains tax deferral ends in December 2026, and investors need to pay the tax bill while maintaining their investment in the QOZF.

How PNC Is Taking Advantage Of QOZs Through Loans

The QOZ program provides advantages for lenders, as well. The program has increased commercial real estate loan activity. Besides providing debt financing, some banks are getting involved by injecting equity directly into QOZs through bank-created funds. QOZ loans are feasible for banks because of the associated CRA credit.

One bank that is taking advantage of QOZ loan opportunities is PNC. It is involved in both QOZ equity and loan deals. Last year, PNC allocated $75 million to QOZ loans, according to American Banker

To receive QOZ credit for their loans, banks have to ensure they fully qualify. This is not such a straight-forward process for banks. However, PNC is confident that each of its deals so far will receive the credit.

For smaller banks, QOZ loans may present more risk than they are willing to take on. However, more transparency into QOZ deals will help smaller banks to evaluate better how these deals are performing.

“Greater transparency will help so we can learn who’s doing what,” Jeannine Jacokes, CEO of the Community Development Bankers Association, told American Banker.

The Bottom Line

Even with the second round of QOZ regulation updates earlier this year, lenders are cautious about QOZ opportunities. At the end of the day, QOZFs are more likely to obtain financing from larger lenders. This isn’t to say that smaller lenders should be completely ruled out, as we are likely to see them get more involved as the number of QOZ debt-financed deals increases. 

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