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Qualified Opportunity Funds in a COVID-19 World—Due Diligence, Government Support, and Tiger King

by Russell Putnam

Last week Novogradac reported that investments in its 406 tracked Qualified Opportunity Funds (QOFs) had surpassed more than $10 billion. This was a 50% increase over the $6.7 billion that was reported at the beginning of January 2020. Novogradac noted that the total amount of capital raised by QOF’s was likely two or three times higher than the $10 billion amount because many QOFs do not report fundraising amounts or are not tracked at all. Just like Novogradac, our team at FactRight was seeing a significant spike in broker dealer and RIA interest in QOFs over the last six months.

And then the world got flipped upside down because of the COVID-19 pandemic. States issued stay-at-home orders, economic activity fell off a cliff, and we all fell in love with…Tiger King on Netflix.

While I too spent an inordinate amount of time pondering [spoilers ahead] what really happened to Carole Baskin’s husband and who burned down the alligator enclosure, eventually I came back to a more tolerable reality and thought, how is the COVID-19 pandemic going to impact QOFs going forward? Specifically:

  • How will current market conditions impact QOFs’ ability to raise capital?
  • What steps has the federal government taken to support QOFs and investors?
  • And what are some due diligence questions we need to be asking when evaluating a QOF in light of the pandemic?

How are current market conditions going to impact QOFs ability to raise capital?

One risk area that we assess with any real estate investment program is a sponsor’s ability to raise capital. If a program is unable to raise sufficient capital it will limit the size and number of investments the program can make, which could lead to concentration risks, and it may also cause the program to employ additional leverage, which could increase the risk profile of the offering. Capital raising concerns can be amplified with QOFs because high minimum investment amounts and capital gains requirements limit the pool of potential investors. Taking this a step further, the recent market downturn may significantly reduce the pool of capital gains that are available for investment. Novogradac noted recently that anecdotal evidence suggests that QOFs are seeing a pause in new investments since the shut-down began.

Alternatively, while the overall pool of anticipated capital gains may be less than anticipated, the selloff associated with the market downturn has likely led to unplanned capital gain recognition events, which provides investors with capital gains to reinvest. And QOFs may be the right tax-advantaged opportunity for many investors, which could allow for many QOFs to capture that demand going forward.

What steps has the Federal government taken to support QOFs and QOF investors?

  • 180-Day Reinvestment Timeline Extension—Generally, investors are able to receive QOZ tax benefits if they reinvest capital gain amounts into a QOF within 180 days of the recognition date. However, on April 9, 2020, the Treasury Department and IRS released Notice 2020-23, which extended various tax deadlines for individuals and businesses, including the timeline for investment into QOFs. With the extension, if an investor’s 180-day investment window was set to expire between April 1, 2020 and July 15, 2020, the investor will now have until July 15, 2020 to make a qualifying investment. Effectively, this extension gives investors who realized capital gains between October 5, 2019, and January 17, 2020, additional time to evaluate QOZ investment opportunities.
  • 24 Month Extension on Working Capital Safe Harbor—QOZ rules provide a working capital safe harbor that allows QOZ Businesses to characterize working capital as QOZ Business Property for up to 31 months. Treasury Regulations provide that the 31-month period may be extended for an additional 24 months if the project is located in a federally declared disaster area and the disaster delays the project. Queue Global Pandemic…Over the last month, President Trump has approved a major disaster declaration for each state. While this matter is not clearly settled, this declaration could be interpreted to allow QOFs to hold cash for up to 55 months, which could give QOFs additional time to acquire and develop their projects in compliance with QOZ timelines.
  • Other Proposed Government Measures—One of the primary tax benefits of investing in a QOF is that investors are able to delay paying tax on the initial gain invested in the QOF until December 31, 2026, at which point they would be required to pay tax on the deferred gain, or the stepped-up amount. A few weeks back, six House republicans co-sponsored a bill that would extend the deferral realization date from December 31, 2026, to December 31, 2030. The Opportunity Zone Extension Act would only apply for investments made in taxable years beginning after the date of the enactment of the legislation. If passed, the extension would provide investors with four more years of deferral and additional time to satisfy the five- and seven-year holding period requirements to take advantage of the 10% and 15% partial step-ups in basis for reinvested capital gains. This bill has not been passed by the House or the Senate; however, it does signal that members of Congress believe that QOZ investment will be critical in aiding recovery after the COVID-19 pandemic.

What are some new due diligence questions we need to ask when evaluating a QOF?

The full impact of the COVID-19 pandemic and resulting market conditions on QOFs and their respective development projects is uncertain. However, here are a few questions that we suggest asking of a product sponsor when evaluating whether a QOF program is appropriate for your client:

  • What is the anticipated impact on development timelines? There is a possibility that commercial real estate development projects could be delayed because of government ordered shut-downs, worker illness, or delays in obtaining permits and entitlements. Inspections and approvals could be delayed because local municipalities are not operating at full capacity or are not conducting required public hearings. In addition, states differ as to whether certain types of construction are allowed to proceed as an essential service.
  • How do current markets impact construction loan financing? Many of the QOFs we’ve reviewed are multi-asset funds in which construction financing has not yet been secured. We’ve heard from some QOF sponsors that market uncertainty is causing some delays in construction financing. Alternatively, the low interest rate environment may create opportunities as well. For those programs that have obtained financing, we want to ask whether management has any concerns regarding completing construction within lender required timeframes.
  • How will market conditions effect construction costs? Most of the QOF sponsors we’ve communicated with over the last few weeks have not experienced material issues with obtaining construction materials and many anticipate being able to take advantage of lower construction costs. However, it’s possible that we could see a disruption in the materials supply chain or a lack of construction labor.
  • Is the scope of identified developments projects changing? The impact of this shut-down could be particularly painful for lower income areas, including QOZs. While many of the QOZ projects we’ve reviewed are in areas with positive demographic projections, those projected trends may not quite carry the same weight that they did a few months ago and its possible that the demand for certain types of projects could change going forward. It will be interesting to see whether developers change the scope of development projects or pivot to a different asset classes all together.

And for those who are looking to pivot, might I suggest the re-development of the G.W. Exotic Animal Park in Wynnewood Oklahoma, which just happens to be located in a QOZ. Surely, a Netflix documentary chronicling QOF investors’ attempt to substantially improve the Tiger King Zoo would capture our attention for Season 2!

Russell Putnam

FactRight—Manager

russell@factright.com

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