Issues to Consider in Making a Qualified Opportunity Zone Investment
story by Jack Muench, Willcox, Buyck & Williams, P.A.
This is the first part of a two-part article that explains investing in qualified opportunity zones, its opportunities, and its restrictions. The first part of this article, presented below, deals with critical non-tax issues for potential Opportunity Zone investors. The second part will present an overview of the Internal Revenue Code and Treasury regulations that form the basis for the tax savings.
In late 2017, Congress passed the Tax Cuts and Jobs Act. That legislation contained Internal Revenue Code Section 1400Z, which provides income tax advantages for persons who invest indirectly in property located in Opportunity Zones.
Investments in qualified opportunity funds are generally intended to encourage investments to start small businesses, to develop abandoned properties, or to provide low-income housing in economically distressed communities. Internal Revenue Code Section 1400Z allows the deferral and, in some cases, the negation, of capital gains tax. In order to achieve these tax benefits, an investor must invest in either Qualified Opportunity Zone stock or in a Qualified Opportunity Zone partnership interest.
From a non-tax perspective, an investor must examine the structural and operational risks inherent in any investment venture. This is especially true where, as here, the investment term required to achieve the tax benefits is between five and ten years.
A Qualified Opportunity Zone investor will become a shareholder in a corporation, a partner in a partnership or a member in an LLC. Regardless of the entity type, the typical investor will have relatively little say in management or critical decisions. These decisions include the following, all of which should receive careful attention in making such an investment.
1. Capital Calls.
Some entities require that the general partner/CEO/manager will have the ability in certain instances to call for additional capital past the original amount invested. It is critical for the investor to understand what these instances are and to make sure that she can protect herself against an untoward capital call if at all possible. Preferably, a capital call cannot occur without a vote of a substantial percentage of the investors. Investors should be aware that, even if it takes a substantial vote, once the requisites for the capital calls have been met, an investor will generally have a fairly short period of time to contribute the additional capital. Typically, if he or she does not, there are penalties for not contributing, which can include a substantial diminution or even a forfeiture of the original investment. Identify up front whether capital calls will be required and seek to limit them as much as possible.
2. Management Bonuses.
In many deals, an incentive for management performance is a “flip” in the management interest. Typically, the flip will allow the general partner’s interest in profits to be significantly increased after the investors have received a minimum return on their invested capital. Investors must analyze their proposed shareholder/partnership agreements carefully in order to ascertain that the flip cannot be achieved merely by insignificant sales of entity assets or the passage of time.
3. Replacing Management.
Continuity of management is critical to the success of any enterprise. In some instances, however, management acts in a fashion such that removal is required. Hence, removal provisions should be carefully analyzed to require that, in the event of behavior such as fraud, theft, or a material breach of the partnership agreement (or the partnership’s loan documents with its lender) swift and certain removal and replacement are addressed.
4. Conflicts of Interest.
Management expertise is critical to the success of any enterprise. This signifies that the manager of your investment project may well be the manager of other, and even competing, projects. Entity documentation must be carefully analyzed to ascertain the degree to which conflicts of interest are permitted and minimized.
5. Investment Liquidity.
It must be recognized that an Opportunity Zone investment is not the same as buying a share of stock in IBM. Indeed, due to federal and state security laws, an investor will almost certainly find her investment to be very difficult to sell. In this regard, an investor would like to see a partnership agreement provision allowing for a forced sale (a “put”) from the investor to the partnership. While a “put” is desirable from the investor’s standpoint, its very existence will require the entity to maintain a pool of money (which may make the desired tax benefits unavailable). Further, exercising the “put” may result in financial strain to the entity.
6. Lender Issues.
Real estate investment projects typically require a loan. Since at least 2008, lenders have become increasingly sophisticated in ascertaining that their loans will not go into foreclosure. Thus, loan agreements may require a significant equity-to-debt ratio and may prohibit the replacement of management without lender approval, at least of the replacement manager. Loan agreements may also seek to require management and, in some cases, investors to sign a personal guaranty of some or all of the loan. A potential investor must be aware of the particulars any loan documentation in place or likely to be put in place during the term of the project.
There are significant non-tax issues that arise in Qualified Opportunity Zone investments. These issues must be analyzed before a potential investor becomes enamored of potential income tax savings.
248 West Evans Street | Florence, SC | 843.662.3258
2050 Corporate Centre’ Drive, Suite 230 | Myrtle Beach, SC | 843.650.6777