The lack of clarity on the rules around new opportunity zones that qualify for capital-gains tax breaks has triggered a wave of questions from investors and local leaders across the country.
On ImpactAlpha’s opportunity zone conference call last month, participants had more questions than we had time (or expertise!) to answer. We collected them up and enlisted the help of law firm Womble Bond Dickinson to find the answers.
[Editors note: Some of following questions are rather technical. For answers to more common opportunity zone questions, take spin through Womble Bond Dickinson’s helpful explainer.]
Q. Are fixed-income instruments excluded from participating in opportunity zone funding?
A. We have not reviewed the legislative history in detail. However, based on our understanding of the legislation’s intent from anecdotal conversations, we assume that the opportunity zone act was structured to spur long-term equity investments in the opportunity zones using capital gains tax breaks as an incentive, since long-term equity has been very hard to attract to these underserved communities. It is also important to note that interest income generated by fixed-income instruments (i.e., debt instruments) is treated as ordinary income and not capital gains. Therefore fixed income/debt instruments are not likely to qualify for the opportunity zone act capital-gains tax benefits.
Q. Can debt be part of a opportunity fund capital stack?
A. We are aware of efforts to propose changes to the opportunity zone act that would permit fixed-income or debt financing under the opportunity zone Act. However, we can’t predict as to whether these efforts will be successful.
Note that the opportunity zone act does not prohibit the acquisition of qualified opportunity zone property with mortgage, mezzanine or fund-level financing. Fixed-income instruments, such as CDFI promissory notes, can have a place in the capital stack of a qualified opportunity zone fund investment depending on the structure of the transaction.
Q. Can an opportunity fund invest only in equity of a business or project? Or can it also lend?
A. A qualified opportunity fund must invest at least 90% of its assets in qualified opportunity zone property, which is defined to include (i) qualified opportunity zone stock (in a qualified opportunity zone business), (ii) qualified opportunity zone partnership interest (in a qualified opportunity zone business), or (iii) qualified opportunity zone business property (used in a trade or business of the qualified opportunity fund). Given the 90% equity investment requirement, the ability for an opportunity fund to lend its capital is limited.
Q. Is public infrastructure an allowable investment for an opportunity fund?
A. The opportunity zone act does not prohibit qualified opportunity funds from investing in infrastructure projects located within qualified opportunity zones if the associated transaction is structured to comply with the requirements of the opportunity zone Act. However, government-owned infrastructure alone is probably not a permissible investment for an opportunity fund since a government cannot accept equity investments.
Q. Can investors receive an extension on the 180-day reinvestment requirement?
A. There is currently no available extension of the 180-day requirement period.
Q. How can revenue-based financing investments (for companies) align with opportunity funds?
A. We believe that revenue-based equity investment structures may be used for qualified opportunity fund investments. To achieve the capital gains tax benefits, the equity investments must be held in the qualified opportunity fund for the time periods required by the opportunity zone act. The revenue-based transaction (and the associated return of the equity investment) must be structured to comply with these time periods.
Q. Can opportunity funds invest in rural areas? For example, projects related to agriculture or sustainable land management?
A. There are rural areas designated as opportunity zones. See the interactive opportunity zone map here.
Q. Can areas adjacent to nominated census tracts qualify? Or if the fund is based in an opportunity zone, can it invest in adjacent census tracts?
A. In the opportunity zone designation process, there were provisions that enabled non-contiguous tracts to be designated as opportunity zones. The time period for that designation process has closed. However, up to 10% of opportunity zone assets may be made in non-opportunity zone locations without resulting in a failure of the opportunity fund to comply with the opportunity zone act requirements.
Q. Can an opportunity zone fund invest in a startup in the software or technology space?
A. A qualified opportunity fund must invest at least 90% of its assets in qualified opportunity zone property, which is defined to include (i) qualified opportunity zone stock (in a qualified opportunity zone business), (ii) qualified opportunity zone partnership interest (in a qualified opportunity zone business), or (iii) qualified opportunity zone business property (used in a trade or business of the qualified opportunity fund).
A qualified opportunity fund can invest in the equity of a software or technology startup that locates in a designated opportunity zone if substantially all of the tangible property owned or leased by the startup is qualified opportunity zone business property.
Q. Are there any changes anticipated to the prohibited projects section of the legislation (e.g. golf course, gambling)?
A. We are not aware of pending changes to this section of the Act. It is interesting to note that that this section of the opportunity zone Act is colloquially referred to as “ban on sin industries.” However the statutory definition of sin industries and the traditional impact industry definition of sin industries is not the same. Here is the opportunity zone act list of sin industries: private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises.
Q. How does the requirement of ‘substantially improved’ apply to direct business investment versus a real estate investment?
A. We don’t know yet. This is an area where it is expected that Treasury guidance will help us better understand how they will apply the substantial improvement test in various circumstances.
Q. Does an equity investment in a business have to be of any particular size in relationship to the business’s valuation?
A. We are not aware of any such valuation requirement.
Q. Can a project be located in both designated and eligible zones?
A. The opportunity zone act only speaks to designated opportunity zones and does not refer to “eligible zones.” We have not heard of any references to projects straddling designated opportunity zones and “eligible zones.” That said, in the opportunity zone designation process, there were provisions that enabled non-contiguous tracts to be designated as opportunity zones, to which you might be referring. The time period for that designation process has closed.
Q. California has a 13.3% tax on capital gains. Will California and other states exempt state taxes for opportunity zone investors?
A. It is not currently clear if states will provide additional tax benefits with respect to opportunity fund investments. Editor’s note: Ohio has introduced legislation that would provide a 10% state tax credit on investments greater than $250,000 in qualified Ohio opportunity funds.
Q. Can leasing a building in an opportunity zone be considered an investment?
A. No. Leasing a building located in an opportunity zone would not constitute an investment for purposes of the opportunity zone act.
Q. What happens if you refinance an investment property in an opportunity zone?
A. An investment in any qualified opportunity fund must be held for the periods specified in the opportunity zone act in order for an investor to achieve the capital gains tax deferrals and exclusions specified in the opportunity zone act. If the referenced refinance transaction does not result in a return to the investors of all or a portion of the equity investments made by those investors into the qualified opportunity fund, and the qualified opportunity fund can continue to meet the other requirements of the opportunity zone act, then we believe that a refinance transaction would be ok. Note that the opportunity zone act specifically requires Treasury to create rules to ensure that a qualified opportunity fund has a reasonable period of time to reinvest the return of capital from investments it makes in qualified opportunity zone stock and qualified opportunity zone partnership interests, and to reinvest proceeds received from the sale or disposition of qualified opportunity zone property.
Q. What if I own property in an opportunity zone? Can I sell it to an opportunity fund I own and take advantage of the program?
A. If you own property in an opportunity zone, you could sell the property to an unrelated party (as defined in the opportunity zone act) and reinvest any capital gains you achieve from that sale into a qualified opportunity fund. However, you cannot own or acquire an interest in any opportunity fund to which you are related.