A Guide to Becoming an Opportunity Zone Sponsor

There is a frenzy of excitement about the prospect of opportunity zone investments, but a number of investors are also considering becoming sponsors of the new fund model. While organizing a fund may seem simple, especially for experienced real estate sponsors, the opportunity zone model is actually complex. We sat down with Phil Jelsma of CGS3 to understand the process and get a guide to the process. It all starts with forming a partnership or LLC, of course.

“The steps to organizing such a fund as a Qualified Opportunity Zone Fund Sponsor appear simple, but upon closer examination are quite complex, depending upon the structure,” Jelsma, a partner at CGS3, tells GlobeSt.com. “A Qualified Opportunity Zone Fund Sponsor would typically form a partnership, an LLC or corporation for the purposes of investing in Opportunity Zone property.” In addition, the entity must include its purpose for investing in an opportunity zone property and a description of the Opportunity Zone business. “Although the proposed regulations permit existing entities to file an election to be a QOF as of the beginning of any calendar month, generally most lenders and investors will require a newly formed entity without any history associated with it,” adds Jelsma. “After forming the QOF, the QOF would need to obtain an employer identification number from the IRS.”

After this initial step, Jelsma says there are a number of other steps to become a qualified sponsor before making the first purchase. Jelsma outlines the next steps as follows:

- Elect to be a QOF: To elect QOF status, the new limited partnership or LLC needs to file Form 8996. By waiting until the first month, the sponsor receives investor equity to make the election. For example, if an entity was formed on January 1, 2019, but received its first equity on April 1, 2019, the election could be effective at the beginning of any month from January to April 2019. Generally, most investors and lenders would require proof the election has been made.

- Open a bank account for the QOF. Although many clients do not particularly care for this step, it is important the funds of the QOF be segregated. If the QOF is going to receive proceeds other than those from investors deferring gains from the sale of stock or real estate, a separate account should be established to avoid mixing gain associated with sale of deferred assets from other gains.

- Choose the right structure. The rules are different for a QOF, which owns business property directly and one, which owns property indirectly through a subsidiary limited partnership or LLC (“QOF Subsidiary”). Generally, if the QOF owns Qualified Opportunity Zone business property directly, 90% of its assets must be in the form of that property. Whereas, if it invests through a QOF Subsidiary, only 70% of the subsidiary partnership or LLC’s assets need to be Qualified Opportunity Zone business property. Thus, most sponsors will elect to operate through QOF Subsidiaries. So, if the QOF Subsidiaries are taxed as partnerships, the QOF should own majority of the QOF Subsidiary and the sponsor might own another portion directly.

These steps will prepare the fund to purchase a property in the Opportunity Zone Fund. However, once properties a property is purchased, there are a number of other steps to execute a capital plan on the property as well as to take full advantage of the tax benefits of the program. Jelsma outlines the next steps:

- Purchase Property in the Opportunity Zone Fund: If the Opportunity Zone Property is located in a state other than the owner’s home jurisdiction, the QOF Subsidiary will need to qualify to do business wherever that property is located. In acquiring a property, it must be acquired by purchase and not from a person who owns 20% or more of the QOF—related party purchases are prohibited. The basis in the property in the hands of the QOF Subsidiary cannot be determined based in whole or in part on the adjusted basis of the property from whom it was acquired. Since the QOF or QOF Subsidiary must substantially improve the property, the allocation between land and building is critical. The QOF or QOF Subsidiary must substantially improve the property, which means it must spend, within 30 months of the date of acquisition, an amount equal to at least the adjusted basis or purchase price of the building. Land value is disregarded for this purpose.

- Identify relevant testing dates: The QOF or QOF Subsidiary must satisfy either the 90% or 70% test as of two testing dates. The first is six months after the election is filed, and the second is the last day of the QOF tax year. For example, if a QOF election is filed April 1, the first testing date would be October 1, and the second testing date would be December 31. If a QOF election is filed September 1, the only testing date is December 31. In determining values, the QOF or QOF Subsidiary must use either the value shown on financial statements filed with the SEC or government agencies, the value shown on certified financial statements in accordance with GAAP or otherwise cost basis for tax purposes. Even if the QOF or QOF Subsidiary fails either the relevant 90% or 70% test on the first testing date, the Form 8996 allows an averaging to occur– which means the QOF takes the percentage at the end of the six-month period and the end of the tax year, adds them together and divides by two.

- Receive Equity in QOF: Investors must receive equity in the QOF and not debt. A contribution of services only would be a problem. The source of the equity is gains from the sale of capital assets, including stock and real estate that are invested in the QOF within 180 days after the sale transaction. If the sale were by a partnership or LLC, either can elect to invest the proceeds – or the individual partner or member – can elect to invest proceeds in the QOF within 180 days after the end of the partnership or LLC’s tax year.

- Establish a Working Capital Plan: The proposed regulations provide that a working capital plan is a written schedule for the consumption of working capital to acquire, construct or substantially improve the property. The QOF Subsidiary needs to actually deploy the capital reasonably consistent with the working capital plan, which will require coordination with both construction schedules and project budgets. Sponsors with an affiliation or ownership of a general contractor or construction company may have an advantage since they may be able to accelerate costs and development.

- Limit Non-Financial Assets: Remember no more than five percent of the assets of the QOF or QOF Subsidiary can be in non-qualified financial property, which includes debt, stock, partnership interests, options, futures, swaps and similar properties. Cash could be a problem unless it is a part of the working capital plan.

- Ensure the QOF Subsidiary LLC Satisfies the 50% of Gross Income Test: A QOF Subsidiary must prove that at least 50% of its gross income is from the active conduct of a trade or business in a Qualified Opportunity Zone. Fortunately, interest earned on the working capital reserve satisfies this requirement. This demonstrates, however, that during the construction period, when there may be little to no income generated, a sponsor will need to carefully monitor the sources of gross income of the QOF Subsidiary.

- Consider Liquidity Triggers: The investors will have a tax payment on December 31, 2026, for the gains that were reinvested in the Opportunity Zone Fund. Since the amount of the gain is the lesser of the tax that was deferred or the difference between the fair market value of the QOF and the investor’s tax basis, sponsors may need to do a valuation on December 31, 2026. Also, the statute suggests the deferred gain is treated as income with respect to a decedent. That means upon death of an investor, the gain that would be deferred until December 31, 2026, is accelerated into the decedent’s last income tax return. Sponsors will need to consider whether they will want to have liquidity triggers in their organizational documents.