Opportunity Zones: Beware of the Debt Financed Distribution Trap
Since its creation under the Tax Cuts and Jobs Act (TCJA) of 2017, the Opportunity Zone (OZ) program has attracted the attention of private equity investors and fund managers as a means of raising and deploying capital into real estate projects located in designated opportunity zone census tracts. OZ fund managers may choose to utilize debt financed distributions to extract and distribute additional equity from the project as part of the overall OZ strategy, particularly as a means of providing liquidity to investors before their deferred capital gains tax obligations are recognized on December 31, 2026.
With many of the earliest OZ real estate projects either completed or stabilized, OZ fund managers have likely begun having discussions with their lenders about possible refinance transactions. Additionally, during the rising interest rate environment observed last year in 2022, refinance discussions may have accelerated as OZ fund managers attempt to lock in desirable interest rates before they possibly rise to higher levels.
Due to a uniquely worded and often overlooked provision within the OZ regulations, careful attention should be made by OZ fund managers when making debt financed distributions to their investors.
Qualifying Investment
To understand the possible implications of debt financed distributions made to OZ investors, the term “Qualifying Investment” requires explanation and understanding. In general, a Qualifying Investment is an equity investment in a Qualified Opportunity Fund (QOF) where the investor has made a deferral election with respect to capital gains invested in the QOF. In some cases, an investment is not treated as a Qualifying Investment if it is characterized (or recharacterized) as something other than a capital contribution, after applying the special rule described below. Only investors who hold Qualifying Investments in a QOF are eligible to obtain OZ tax benefits.
General Disguised Sale Rules of Section 707
Disguised sale principles are complex, but generally apply if a partner contributes non-cash property to a partnership, the partnership makes a distribution to such partner, and when viewed together, the transactions are characterized as a sale of the property to the partnership rather than a contribution and distribution. If both the contribution and distribution occur within a two-year period, they are presumed to be treated as a sale unless facts and circumstances indicate otherwise.
Special Rule Under Section 1400Z-2
The OZ regulations provide an important modification to the general disguised sale rules, whereby cash contributions to a QOF partnership are treated as non-cash property. As a result, all cash invested in a QOF partnership requires assessment under the disguised sale rules. After applying these “modified” disguised sale rules to cash contributions made to a QOF, if an amount invested in the QOF is treated as a sale, then it is not treated as a contribution to the QOF, and therefore cannot be treated as a Qualifying Investment.
The significance of this special rule is profound. If an investment in a QOF is not characterized as a contribution, the OZ investor was not eligible to make a deferral election, and as a result, capital gains intended to be deferred are subject to tax. Furthermore, the investment in the QOF is not a Qualifying Investment and is ineligible for OZ benefits – including the permanent exclusion of future gain for investments held at least ten years.
Key Takeaways
- OZ fund managers should prudently consider possible implications of debt financed distributions to their QOF investors, especially distributions made within two years of when the QOF raised capital.
- Consultation with an experienced tax and legal advisor is critical to reviewing all facts and circumstances surrounding debt financed distributions.
Brian is a Signing Director in CLA's Real Estate industry group and has more than 15 years of experience working with real estate operators, land developers, commercial real estate companies, private equity funds, and general contractors. Brian is also part of CLA's Opportunity Zone working group, and leads a team providing compliance, consulting, and advisory services to opportunity zone investors, qualified opportunity funds, and qualified opportunity zone businesses.
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