More Participants are Pairing OZ Incentive with Historic Tax Credits

With the Dec. 31 deadline to realize the maximum benefits for opportunity zone (OZ) investments nearing, interest in the OZ incentive continues to rise. Developers are continually looking for ways to make use the OZs incentive to drive investment to their projects. Among them, historic tax credit (HTC) developers are exploring ways to combine the OZs incentive with HTC investments for their often difficult to finance projects. Many HTC projects are located in OZs, which makes considering the potential to raise OZ capital a worthwhile exercise for these developers. The added benefits of the OZ incentive may increase the appeal of an HTC project located in a qualified opportunity zone for equity investors. Traditional HTC investors that have capital gains may be able to receive both HTCs and OZ benefits in a single investment, which may increase their yield and/or provide additional equity to the project. The additional OZ incentive may also assist Project developers in raising additional equity separate from HTC investment equity.

Pairing HTC and OZ – Compatibility

Qualified opportunity funds (QOFs) have largely focused on real estate investment. Novogradac’s most recent QOF survey tracked 287 funds, of which fund raising data was available for 112 funds. To date, the funds for which data is available have raised approximately $3.17 billion of OZ investment, the vast majority of which (87.2 percent) is being targeted to real estate development.

Aside from being a direct real estate play, and the fact that many HTC developments are located in OZs, other aspects of HTC projects align well for pairing with the OZ incentive. For one, HTCs require a substantial rehabilitation of a historic property, while the OZ incentive requires that existing buildings are substantially improved. In both cases, developers generally must spend more than the basis of the building to meet these similar, though not identical, tests. The timelines associated with both incentives also pair well - the HTC incentive’s relatively short period of 24 months (in a non-phased rehabilitation) to incur qualified rehabilitation expenditures that exceed the adjusted basis of the building could also satisfy the OZ requirement to substantially improve a property during a 30-month period. In addition, the proposed OZ regulations explicitly provide that the ownership and operation of real property, including leasing, qualify as the active conduct of a trade or business for qualified opportunity zone business qualification. That the landlord entity in a HTC transaction could possibly qualify as a QOF or a qualified opportunity zone business makes the pairing of the HTC and OZ incentive all the more possible.

Pairing HTC and OZ – Questions Remain

There are many compatibilities between HTCs and the OZ incentive, making it attractive to pair them. But several open questions remain. For example, while the proposed regulations permit the rental of real property as an active trade or business, they also go on to note that “merely entering into a triple-net lease” would not constitute an active trade or business. Often, HTC investment transactions are structured using a master lease, or lease pass-through, structure in which a master tenant leases the entire property under a triple-net lease. It is not clear from the proposed regulations whether this type of leasing structure would fall under the OZ definition of a “merely… a triple-net lease.” As a matter of caution, developers currently closing combined HTC and OZ transactions are finding ways to adapt the business operations or terms of the master lease to mitigate the risk of disqualification as a qualified opportunity zone business.

It is also unclear as to whether HTC projects in which the developer owned the property prior to Dec. 31, 2017 can qualify for OZ investment. The tax reform bill passed in late 2017 significantly modified the way in which HTC investors claim tax credits for properties acquired after Dec. 31, 2017, and therefore, many developers hurried to close on historic properties prior to the end of 2017. In closing before Jan. 1, 2018, developers assumed substantially higher financial risk, as many of these HTC projects had financing gaps that developers were still seeking to close. OZ equity could potentially help close these gaps.

To qualify for the OZ incentives, OZ rules require entities to hold substantially all (70 percent) of their tangible property in qualified opportunity zone business property. By definition, qualified opportunity zone business property means property acquired from an unrelated party after Dec. 31, 2017. This leads to the open question of whether the acquisition of property prior to Jan. 1, 2018 automatically disqualifies the project from being an OZ-eligible investment. Many practitioners believe that the qualified rehabilitation expenditures (QREs) should be treated as qualified opportunity zone business property separate and distinct from the non-qualifying acquired building, and therefore, if the project meets the substantially all test after taking into account the total cost of rehabilitation, the entity should qualify. The Novogradac OZ Working Group has requested further clarification of this issue, and made recommendations to Treasury that would provide for a favorable interpretation.

An ancillary question related to the qualified opportunity zone business property issue discussed above relates to related party fees paid as part of the development budget. Typically, HTC transactions include expenditures such as developer fees and construction/project management fees. These fees are often paid to parties related to the project entity. Because qualified opportunity zone business property qualification requires that property be acquired from an unrelated party, some practitioners have questioned whether the payment of these customary related party fees could somehow taint the QREs or rehabilitated building from being qualified for OZ investment. Others have argued that the sheer existence of such fees embedded into the overall development project should not disqualify the property so long as the fees are reasonable in nature and amount. Still others have offered a middle ground for consideration where the related party fees alone are treated as non-qualified property, and as long as they fall within the allowable 30 percent of ineligible tangible property, do not cause the entire building to fail as qualified opportunity zone business property.

Moving Forward

While the industry awaits final OZ guidance from Treasury, which may address these and other threshold questions, numerous HTC development projects funded in part with OZ capital are underway. These capital stacks include a myriad of transaction structures, including those where the HTC investor defers capital gain and also takes advantage of OZ incentives, and others where separate HTC and OZ investors stand side-by-side. While layering the OZ incentive into a HTC transaction may be complicated, HTC developers are no strangers to complex financing structures, and the OZ incentive offers an additional financing tool that is already attracting much needed capital into difficult projects in low-income communities.