Opportunity Zones Part 3: Dangers, Pitfalls and Unanswered Questions

In the last two parts of this three part series, “fun with Opportunity Zones” I discussed the many potential upsides of investing in a Qualified Opportunity Zone (QOZ). But, as with any good investment, if it seems too good to be true then it’s probably too good to be true.

In this third and final installment of the series I will discuss all the dangers, pitfalls and unanswered questions surrounding the QOZ tax incentives.

Holding Period Risk

The biggest and most obvious disincentive in regards to investing in a QOZ is the long and arbitrary holding period of ten years. As with most investments, locking in any significant amount of funds over a long period of time causes holding risk for passive investors.

Although the tax incentives in year five, year seven and year ten act as checkpoints for investors the sale of the investment in a QOZ before year ten will trigger a capital gain on any appreciation during that holding period. The ten year mark is intended as a cliff and may cause investors to hold investments longer than economically appropriate.

Lastly, the designation of all QOZs now in existence will expire on December 31, 2028. This then raises the issue of whether investors will be permitted to make a basis step-up election and exclude the gain on the sale of an interest in a Qualified Opportunity Fund (QOF) after the relevant QOZ loses its designation.

If this issue is not addressed in the final regulations then it has to be assumed that investors must sell their holdings in any and all QOFs to reap the tax savings they’ve sown. The economics of the arbitrary December 31, 2028 date is seemingly apocalyptic with many investors running to the proverbial doors looking to liquidate their holdings before the clock strikes midnight.

Tax Incentives aren’t Transferable

Another drawback in the QOZ rules is the lack of transferability of tax incentives from one fund to another fund. Assuming you want to sell your shares in one fund and reinvest in another fund you’ll potentially restart the clock on your tax incentives.

Additionally, the sale of qualified opportunity zone property (QOZP) within a QOF that wasn’t held during the required ten year holding period would presumably flow through and become taxable to the partners or be treated as a taxable gain on the corporation’s tax return.

What is unclear is whether the sale of QOZP within a QOF will reset a partner’s basis or partially disqualify a shareholder’s stock from the exclusion at the fund level.

For example, let’s say Jim is an investor in a QOF. The QOF holds partnership interest in two QOZ businesses that directly hold QOZP. One of the partnerships holds rental property and executes a 1031 exchange for another rental unit in another QOZ. Would this transfer at the lower tier level constitute a transfer of QOZP and therefore disqualify half of Jim’s interest in the QOF from the step up basis?

Unless clarified by the final regulations you would have to assume that transfers or sales at the lower tier level would impact the eligibility of tax incentives at the fund level. Otherwise, an investor could circumvent the ten year holding period requirement by rolling over gains through 1031 exchanges.

Debt Basis Rules Unclear

One of the most consequential unanswered questions surrounding the QOZ conversations is the lack of clarity on debt basis rules as they relate to the eligibility for step-up basis.

The proposed regulations make it clear that an eligible interest in a QOF must be an equity interest and not a debt instrument. Therefore, taxpayers must acquire their share of partnership interest or corporate stock with cash to be eligible for the tax deferral of capital gain or the eventual tax exclusions on the sale of the interest in the QOF.

The proposed regulations even go as far as allowing eligible equity interest to be used as collateral to secure a loan. The status as an eligible interest is therefore not impaired by using the interest as collateral whether as part of a purchase, money borrowing or otherwise.

The important unanswered question is whether financing secured by the QOF or a lower tier entity to acquire QOZP will be eligible for the step-up in basis. To understand this let’s look at an example:

John is an accountant and wants to get in on these QOZ tax breaks. He invests in some single stocks but doesn’t have substantial unrealized capital gains. He sells one of his stocks and realizes a $100 capital gain. John creates a QOF, self certificates as a QOF and reinvests the $100 into that QOF. John elects to defer the capital gain and meets all the additional requirements needed to start the ball rolling.

John has no savings or means of obtaining financing but he does have a rich uncle. The QOF signs a note securing $1 million in financing to purchase a building for $499,999 and substantially improve the building with the remaining funds. The note is an interest only loan and will be repaid in full in ten years.

After ten years John sells the property for $1.5 million, repays his uncle the $1 million he is owed and distributes the remaining $500,000 to himself. Assuming John met all the requirements he can elect to step-up the basis in his QOF interest and pay no tax on the $500,000 capital gain. Although John only put $100 of his own money into the deal he ended up with a $500,000 tax free windfall.

With this consideration, the Treasury Department could make or break the QOZ tax incentives by allowing or disallowing John from leveraging his investment. As with most large real estate deals, the properties are highly leveraged by interest only loans. Disallowing secured loans against QOZP could be the pin that deflates the QOZ in its entirety.

What Now?

If you’ve read this far then you probably feel the same way most people feel after watching the last episode of the last season of their favorite show on Netflix – confused and begging for more.

Well, that’s how we all feel as we wait for final regulations that will hopefully answer all of our questions. The clock is ticking on the QOZ tax incentives and investors need answers fast before pulling the trigger.

Once the final regulations come out make sure to check back here and I’ll have another thousand plus word article explaining everything you need to know. Until next time!

This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional tax advisor, or lawyer.