Paving the Way for Impact Investors & Fund Managers to Deploy Capital into Opportunity Zones: A Summary of the New Guidance by Chintan Panchal
Since the Opportunity Zone legislation was enacted in December 2017, it has received a great deal of attention, primarily because of the potential for the tax incentives associated with this legislation to drive new investment dollars into impactful projects located within these designated economically distressed areas around the country. However, thus far the originally expected inflow of impact capital to Qualified Opportunity Zones (QOZs) has not materialized. This has been largely due to a lack of clarity in the legislation and the initial round of proposed regulations released in October 2018. In particular, there has been ambiguity around two key elements related to how Qualified Opportunity Funds (QOFs) can be structured and how they can invest. First, it has so far been unclear whether and to what extent QOFs are permitted to invest in assets and operating businesses in QOZs beyond real estate and other tangible assets physically located in these zones. Second, inadequate guidance has been available to sponsors seeking to establish and structure QOFs as true “funds” – i.e., as pooled investment vehicles aggregating capital from multiple investors and investing in (and out of) a multi-asset portfolio of investments.
This uncertainty has generally led to the sidelining of a good deal of impact capital from investors who are otherwise excited to work creatively to leverage the Opportunity Zone legislation to achieve meaningful impact in the various QOZs around the country. Critics have also expressed wariness that the legislation may primarily be most leveraged by real estate developers who would otherwise already be investing in projects in QOZs, leading to gentrification, displacement and other potentially harmful effects. Thus far the overwhelming majority of QOFs Funds launched do seem to have been special purpose vehicles formed for real estate development projects within QOZs.
However, we expect the focus of the impact community on Opportunity Zones to intensify, and for dollars to finally begin to flow into these geographies, now that the IRS and Treasury issued some long-awaited additional guidance on Opportunity Zones on Thursday April 17th. This new guidance addresses the above-mentioned issues which have thus far worked to hold impact capital at bay. Among other things, the new proposed regulations make it clear that QOFs may be formed to invest in a broad range of operating businesses located in QOZs and also provide somewhat greater instruction for sponsors seeking to structure true “funds” in order to aggregate capital and deploy it into multiple QOZ investments in order to maximize impact.
While there remain significant unanswered questions on these and other important issues relating to QOFs, in this new guidance, the government has shown a willingness to go as far as possible to interpret the Opportunity Zone legislation in a way that is intended to maximize the stated purpose for its enactment – to benefit the economically disadvantaged communities located in QOZs. This willingness, together with the enhanced clarity provided by the proposed regulations, may be a signal that the time has come for impact investors and sponsors to begin deploying capital to QOZs through QOFs in earnest.
Below is a high-level summary of some of the key points addressed by the new Opportunity Zone regulations and a synopsis of their practical effect from an impact investing perspective.
I. The opportunity for startups and other operating businesses just got real.
Under the Opportunity Zone legislation and the initial set of regulations, there were ambiguities and missing details that posed substantial hurdles to investors seeking to invest capital in Qualified Opportunity Zone Businesses (QOZBs) — i.e. startups and other operating businesses in QOZs. As discussed below, the recently released guidance paves the way for investors to invest in a wide range of operating companies and enterprises, including startups, located in QOZs.
The 50% Test. A QOF must invest only in businesses that are QOZBs. A QOZB must, among other things, derive at least 50% of its total gross income in a given taxable year from the active conduct of a business in a QOZ. Absent further clarification, the requirement that such a substantial percentage of a QOZB’s business be actively conducted in a QOZ has been viewed as severely limiting the types of businesses that could qualify, and accordingly, excluding the most interesting businesses for investors, such as technology companies (who have customers all over the world). The new regulations provide greater certainty to investors looking to invest in startup and other operating businesses in QOZs by establishing three safe harbors for determining that a business has satisfied the 50% test.
- First, a business can qualify if at least 50% of the services performed by its employees and independent contractors are performed from within the QOZ (hours worked basis).
- Second, based on the amounts paid to employees and contractors, a business can qualify if at least 50% of the services performed for the business are performed within the QOZ (payments made basis).
- Third, a business can qualify if the tangible property of the business located within the QOZ and the management or operational functions performed in the zone are each necessary to generate at least 50% of the business’ gross income (management basis).
Finally, if no safe harbor is satisfied, a business may still satisfy the 50% test if, based on all the facts and circumstances, at least 50% of the gross income of a trade or business is derived from the active conduct of a trade or business in a QOZ. These safe harbors and related commentary illustrate the intent of the IRS and Treasury to allow businesses which may be national or even international in scope, but which nonetheless have significant underpinnings in a QOZ, to qualify as QOZBs.
Leased Tangible Property. QOZBP is defined as tangible property acquired (as opposed to leased) by a QOZB. This was viewed as inconsistent with the manner in which most new operating businesses operate and spend available capital. A startup will generally lease its office space and significant equipment, rather than devote limited available cash to buying (or financing the acquisition of) such assets outright. The requirement that QOZBP be acquired was also at odds with the requirement in the original legislation that substantially all (at least 70%) of the tangible property owned or leased by a QOZB be QOZBP. The uncertainty around whether and how a QOZB might lease its QOZBP had been a substantial impediment to a business’ ability to qualify as an investible QOZB.
The recently proposed regulations make it clear that a QOZB may count both its leased and owned tangible property towards the requirement that substantially all (70%) of its tangible assets be QOZBP. Also, to provide additional flexibility for businesses to qualify as QOZBs, the regulations provide that certain requirements which apply to owned tangible property in order for it to qualify as QOZBP do not apply to leased tangible property. Namely, there is no requirement that the original use of leased QOZBP in the QOZ be by the QOF or that the QOF substantially improve (i.e., double the basis of) leased QOZBP. This guidance accounts for the way in which operating businesses in QOZs are likely to be structured and operate in defining QOZBP, and the QOZBs in which QOFs may invest. This should help broaden the base of investable operating companies available to be invested in by QOFs.
Original Use; Substantial Improvement. For owned tangible property to qualify as QOZBP, among other things, it must either have its original use in the QOZ by a QOF or QOZB or it must be substantially improved by the QOF or QOZB after its purchase. It was previously less than clear how the original use and substantial improvementrequirements can be satisfied with respect to owned tangible property.
The recent regulations clarify that the original use of owned tangible property occurs when it is depreciated or amortized or when it is used in a manner that would allow for depreciation or amortization. They also clarify other issues around original use, including how to determine the original use of used tangible property and that land can be treated as QOZBP if used in a trade or business of a QOZB or QOF.
The requirement that acquired tangible property be substantially improved is satisfied if the property’s basis is doubled, a requirement that seems more applicable to acquired real estate than to the items of personal tangible property likely to be purchased by operating businesses, making it challenging to determine whether many operating businesses can qualify as QOZBs. The new regulations acknowledge that whether the substantial improvement requirement is satisfied for items of tangible personal property must be determined on an asset-by-asset basis, and also that some items of acquired tangible personal property will not capable of being substantially improved. They also admit that applying the substantial improvement test to owned tangible personal property is likely to be administratively burdensome and otherwise unworkable for businesses, making it unnecessarily difficult for them to qualify as QOZBs. Accordingly, the government has requested comments on these issues and is exploring changes to make it easier for different types of operating businesses to satisfy the substantial improvement test as to owned tangible personal property and qualify as investible QOZBs.
From the perspective of leveraging human capital within economically disadvantaged areas, all of the above-described aspects of the proposed regulations should provide a significant boost to entrepreneurs and investors looking to develop and finance operating businesses within QOZs. Under the new guidance, a broader variety of business types should find opportunities to establish themselves within these zones, bringing with them jobs and local economic add-on effects.
II. Treasury is serious about “substantially all” of Qualified Operating Zone Business Property being put to use within the Opportunity Zone.
The Opportunity Zone statute and initial regulations use the term “substantially all” in a number of instances. For example, taking into account the new guidance:
- A QOZB is defined as a trade or business where, among other things, during substantially all (i.e., 90%) of the QOF’s holding period for such property, substantially all (i.e., 70%) of the use of such property was in the QOZ.
- QOZBP is defined as tangible property used in a trade or business where, among other things, during substantially all (i.e., 90%) of the QOF’s holding period for such property, substantially all (i.e., 70%) of the use of such property was in the QOZ.
- Qualified Opportunity Zone Stock or Partnership Interests, must satisfy the requirement, among others, that during substantially all (i.e., 90%) of the QOF’s holding period for such stock or interest, such corporation or partnership is qualified as a QOZB.
To allow a wider variety of operating businesses to qualify as QOZBs, commentators argued that certain of these substantially all percentages be lowered. However, the government balanced the benefit of creating more investible QOZBs against the detriment of diluting the stated purpose of the Opportunity Zone program by allowing for QOFs to deploy a reduced percentage of their invested capital into QOZs. The guidance points out that when the various substantially all percentages are read together, the possibility exists that a qualified QOF could have only as little 40% of its assets effectively in use within a QOZ. For example:
- a QOF could satisfy the statutory requirement to invest only 90% of its assets in a QOZB;
- only 70% of the tangible assets of that business need qualify as QOZBP;
- only 70% of that QOZBP need actually be located within the QOZ; and
- applying the minimum holding period of 90% results in only 40% of the business’ assets being used in line with the statutory purpose.
Accordingly, the newly proposed regulations resist further diluting any of the above-described substantially all percentages, with Treasury and the IRS unwilling to permit further dilution of the minimum possible impact that capital invested in QOFs must actually be required to have in QOZs.
The newly proposed regulations also include a broad general anti-abuse rule and request further comments from the public on the application of this rule. Essentially, under this rule the IRS has the authority to recast a transaction in a manner that denies the tax benefits associated with investment in a QOF if, in its view, the purpose of the transaction is to achieve a tax result that is inconsistent with the overall program objectives of “encourage[ing] growth and investment in designated distressed communities (qualified opportunity zones) by providing Federal income tax benefits to taxpayers who invest new capital in businesses located within qualified opportunity zones through a QOF”.
We view the above discussion around the various substantially all percentages and the anti-abuse rule, taken together, as a positive indication that the government is taking seriously its interpret the original legislation in a manner that protects the stated purpose of the initiative to attract investment capital to projects within and which benefit QOZs, rather than simply create attractive tax shelters.
III. True Qualified Opportunity “Funds” (i.e. multi-asset pooled investment vehicles) are now more viable.
In order to aggregate capital and maximize impact in QOZs, sponsors have been seeking a path to creating investment funds capable of investing in, holding and exiting multiple QOZBs in the same manner as a typical venture capital fund. The original Opportunity Zone statute and initial guidance left such sponsors with little guidance on to how a typical venture capital fund or other multi-asset pooled investment vehicle might be structured as a QOF. While significant questions on this subject remain and additional guidance is needed, the recently released proposed regulations provide answers to some of the issues around how such pooled investment funds might be structured, as summarized below:
QOF Window to Reinvest Sale Proceeds. It is now clear that a QOF can reinvest proceeds from the sale of a QOZB or QOZBP into new qualified assets within 12 months and still continue to satisfy the requirement that 90% of its assets are Qualified Opportunity Zone Property pending such reinvestment.
Sales of Portfolio Assets by QOF Not an “Inclusion Event”. It is now clear that where a QOF sells a QOZB or QOZBP, no “inclusion event” for investors in the QOF results. In other words, the QOF’s sale of a portfolio asset doesn’t trigger a requirement that the QOF’s investors recognize any of the capital gain originally deferred by them at the time of their investment in the QOF. Rather, an investor in a QOF will generally experience such an “inclusion event” prior to December 31, 2026 only if such investor sells or is deemed under certain rules to have sold all or part its stock or other interest in the QOF. Investors in a QOF structured as a pass-through entity may be required to recognize their attributable portion of gain resulting of the QOF’s sale of a portfolio asset which has appreciated in value, but that is separate and apart from any requirement that the investor recognize any of the capital gain originally deferred at the time of investment in the QOF.
Capital Contributions to QOFs. Venture capital and other investment funds typically accept capital commitments from investors, and investors then make capital contributions to those funds on an as-needed basis in response to capital calls by the sponsor. In a typical venture capital fund, for example, the sponsor may call capital from time to time over an “investment period” or “commitment period” of up to five years. Under current guidance, capital committed (but not contributed) by an investor to a QOF cannot be counted as invested in the QOF for purposes of the Opportunity Zone regulations. In order for an investor to enjoy the associated tax benefits, capital must actually be contributed to the QOF and the QOF must qualify as a QOF under the statute. So would seem that QOFs cannot currently accept commitments from investors, call capital as-needed, and still deliver the desired tax benefits to investors. In this way, QOFs seemingly continue to be limited in the way in which they can accept capital from investors as compared to more typical venture capital or other investment funds. However, the proposed regulations provide some flexibility for investors in a QOF to invest capital in the QOF in advance of the QOF’s investing such capital into a QOZB or QOZBP. When testing whether 90% of its assets are invested in QOZB interests or QOZBP, a QOF may disregard capital contributed to the QOF by investors up to six months prior the testing date. Accordingly, a QOF fund manager will have up to six months after receiving equity capital from investors to deploy that capital into portfolio assets.
The proposed regulations create a new expanded “working capital safe harbor” for QOZBs. Under this safe harbor, a QOZB can generally hold working capital as cash for up to 31 months without violating statutory requirements regarding the QOZB’s ownership of QOZBP, as long as there is a written designation that such working capital is planned to be used in the acquisition, construction and/or substantial improvement of tangible property in the QOZ or in the development of a trade or business in the QOZ and certain other requirements are satisfied. However, while this working capital safe harbor applies to QOZBs with respect to capital invested in them by QOFs, they don’t provide any comfort for a QOF with respect to capital invested in the QOF by its investors pending further investment by the QOF in portfolio assets.
Based on the above, for the time being, it seems that investors must actually contribute (and can’t simply commit) all of their capital to a QOF in order to receive the related tax benefits, and that QOFs continue to have a fairly limited period of time in which they can invest capital received from investors into qualifying QOZBs or QOZBP before holding investor cash will result in a violation of the 90% test. Possibly further guidance will expand the “working capital safe harbor” discussed above to include QOFs, giving them 31 months to deploy investor capital into portfolio assets, however, existing guidance does not mention that any such expansion is under consideration. Alternatively, there are various structures which may be utilized to allow QOZs to extend their “investment period” or “commitment period” during which investor capital must be deployed.
IV. This is still a tax play for a select group of investors.
Venture capital investing has always been generally limited to wealthy and professional investors, i.e. so-called “accredited investors”. The Opportunity Zone program is further limited in its reach to those investors who actually have capital gains to invest. This has been a central hallmark of the program since its inception, and the recently proposed regulations reinforce the notion that only investors with capital gains can make QOZ investments that will be entitled to any tax benefits under this program. Thus, investors looking to invest savings from ordinary income for example, would have their investments into QOFs treated the same way as investments into any other sort of non-tax-advantaged fund or security. In addition, only equity investments into and by QOFs will qualify for the tax benefits associated with investment in a QOF – debt investments, while they can be made into a QOZB or QOZBP alongside equity investments by QOFs, will not receive any of the Opportunity Zone program’s stated benefits of tax deferral or exclusion.
In our experience successful and impactful projects involve buy-in and meaningful engagement with the communities within which these projects are being built. One avenue for such engagement and incentive alignment is co-investment in the project alongside outside investors by members of the community. Co-investment alongside QOFs by community stakeholders in the QOZ communities into which QOFs will deploy capital will likely be significantly limited, as many of the relevant stakeholders will not have available capital gains to invest into these projects within the relevant statutory time windows. Nevertheless, we expect that thoughtful project sponsors will look to gain buy-in and align incentives in various other ways. We also expect to see existing community-based mission-aligned investors with a history of investment in QOZs, such as CDFIs and investors taking advantage of other preexisting tax credit or tax investment programs, investing in QOZ projects in tandem with QOFs to crowd-in capital and maximize the effect of QOF invested capital.
V. There is more to come.
Additional Opportunity Zone regulations are expected in the coming months, and are expected to provide clarity around additional technical points, including penalties for a QOF that fails to maintain the requisite 90% of its assets in Qualified Opportunity Zone Property. Generally speaking, the recently released guidance have been encouraging and have served to bolster our confidence that further regulations and guidance should be expected to expand the number and types of businesses which may qualify as investible QOZBs, balanced against preserving the stated purpose of the Opportunity Zone legislation to benefit the economically disadvantaged communities in QOZs by targeting investment capital to those geographies.
Additional regulations are also expected with respect to the much discussed, and much anticipated Opportunity Zone information reporting requirements. Information gathering and reporting is an important component of the intentional mission-based investment approach to investing that is represented by the best expression of the Opportunity Zone program. From an impact standpoint, a significant critique flows from the basic assumption that investment automatically equals positive impact. Most sophisticated impact investors seek to measure the impact – positive or negative – that their impact investments create. By doing so, they can not only ascertain the success or failure of one specific impact mission, but can accumulate data to help structure future investments to optimize impact results on a going forward basis. Analyzing impact measurement data can also help to align incentives among stakeholders and unlock opportunities to both incentivize financial and impact performance and achieve outsized results by capturing the add-on effects of coordinating social and financial objectives. Therefore, it is encouraging that the White House Opportunity and Revitalization Council (established by Executive Order 13853), chaired by the Secretary of Housing and Urban Development and comprised of 13 different Federal agencies, is engaging with the public around collecting and assessing data relating to QOF investments, including tracking such investments by asset class, tracking QOZs that have received QOF investments, and the evaluating the impacts and outcomes of those investments in QOZs on economic indicators including job creation, poverty reduction and new business starts. These are exactly the types of indicators that impact investors look to in ascertaining impact, and QOF investors should anticipate some level of data collection and reporting.
Written by Chintan Panchal
Chintan is the head of RPCK‘s New York office and leads the firm’s impact investing practice. The views expressed here are those of the author, and should not be viewed as legal or tax advice.