KEY CONSIDERATIONS AND DILIGENCE ISSUES
One of the hottest new investment options being sought out by investors is the Opportunity Zone program which was created by the 2017 Tax Cuts and Jobs Act. The primary purpose of the Opportunity Zone program was to spur investment and economic revitalization in low-income communities throughout the country.
Under the Opportunity Zone program, an investor who has experienced a taxable gain from the sale of property can reinvest the gain into a “qualified opportunity fund” for a limited period of time after the sale (generally 180 days). If the gain is timely reinvested into a qualified opportunity fund, then the investor may realize significant tax benefits (e.g. temporary deferral of tax on the gain from the original sale and exclusion of tax on gains realized from the investment in the qualified opportunity fund). These tax benefits provide an attractive incentive that has peaked investor interest in the Opportunity Zone program.
There are five Opportunity Zones in Muskegon County, Michigan. Three of the Opportunity Zones are in the City of Muskegon (encompassing downtown Muskegon and the Lakeside business district), while the other two Opportunity Zones are in the City of Muskegon Heights (downtown Muskegon Heights and portions of business/industrial areas). See the following link for a graphic depiction of the Opportunity Zones in Muskegon County:
Effects of the Opportunity Zone program are already being seen in Muskegon County. Several developments in downtown Muskegon are underway or are in the works as a result of the Opportunity Zone program. More investment opportunities within these Opportunity Zones are sure to arise in the coming months and years.
As new opportunities arise, it is important that investors carefully consider each specific opportunity on its merits and undertake appropriate due diligence before making an investment.
The following are a few important items (but not an exhaustive list of items) to consider before making an investment under the Opportunity Zone program.
Make Sure You’re Investing Into A Qualified Opportunity Fund
In order for an investor to realize the tax benefits from the Opportunity Zone program, the investor’s original gain must be reinvested into a “qualified opportunity fund.” In order to be a qualified opportunity fund, the fund entity must satisfy a number of different requirements. For instance, the fund entity must be organized as a corporation or partnership (which includes LLCs). In addition, the fund entity must meet various asset tests and file required documentation with the Internal Revenue Service. Failure to satisfy the various requirements or file the required documentation may result in fines and penalties to the fund entity, and could jeopardize the investor’s ability to realize the tax benefits from the Opportunity Zone program.
As a result, it is very important that an investor undertake appropriate due diligence before completing an investment in a qualified opportunity fund. Tax professionals and legal counsel can assist in the due diligence process to ensure that the investment is in an entity that meets the requirements of a qualified opportunity fund.
Carefully Review And Understand The Fund’s Governing Documents
Perhaps the most important aspect of an Opportunity Zone investment is ensuring that the qualified opportunity fund is properly managed in compliance with all applicable laws and regulations. The governing documents should state that the purpose of the entity is to be a qualified opportunity fund within the meaning of applicable laws and regulations. Moreover, the persons responsible for managing the entity should have an affirmative obligation to ensure that the entity is managed in a manner that complies with applicable laws and regulations. Ideally, the governing documents will have processes and procedures in place which require independent verification that the entity complies with applicable laws and regulations. Self-certification by the individuals managing the fund requires a great deal of trust and is generally not recommended. The adage “trust, but verify” applies when it comes to ensuring proper management of a qualified opportunity fund.
The governing documents should also detail the terms upon which an investor may sell his or her interests in the entity. While there are important tax reasons for requiring an investor to keep his or her investment in the qualified opportunity fund for a lengthy period of time (e.g. ten or more years), it is also important that the investor be allowed to liquidate his or her investment in the qualified opportunity fund at some future time without overly burdensome restrictions on transfer. For instance, a restriction which requires the fund manager’s consent to each and every transfer of the investor’s interest in the qualified opportunity fund (even after a specified period of time) could have a chilling effect on the investor’s ability to liquidate his or her position in the fund and fully realize the tax benefits offered by the Opportunity Zone program. Any restrictions on transfer in the governing documents should strike an appropriate balance between legitimate restrictions which are designed to ensure that all investors realize the tax benefits from the Opportunity Zone program and an individual investor’s ability to liquidate his or her investment position and maximize the return on that investment.
Also, it is important to ensure that any economic terms which were advertised in a prospectus or private placement memorandum are accurately included in the qualified opportunity fund’s governing documents. For example, if investors are promised a preferred return or similar economic incentive in connection with their investment in the fund, then those returns or incentives must be affirmatively stated in the governing documents or they run the risk of being unenforceable. Conversely, investors should carefully review the governing documents to make sure there are no fees or similar charges which were not disclosed in the prospectus or private placement memorandum. In short, the governing documents should be reviewed to ensure that the economic terms that were advertised to investors match applicable provisions in the governing documents.
As a final point on the governing documents, investors should carefully inspect the terms upon which new investors may be added to the qualified opportunity fund. Preferably, the governing documents will state a total number of shares or membership interests that may be issued by the qualified opportunity fund, so that the investor’s percentage interest in the qualified opportunity fund does not become diluted by the issuance of additional shares or membership interests. However, there may be valid reasons for allowing the qualified opportunity fund to issue additional shares or membership interests (for instance, to reduce the amount of the fund’s debt by raising additional capital). At a minimum, investors should ensure that all new investors must pay at least as much per share or membership interest as the initial investors paid for their shares or membership interests. This ensures that new investors will not be able to purchase a similar position in the qualified opportunity fund at a lower price. Ideally, a specific base price per share or membership interest should be expressly stated in the fund’s governing documents.
Conduct Due Diligence On The Underlying Project Or Business
Many qualified opportunity funds are being organized to facilitate the construction of new real estate projects or as seed capital for new businesses. As a result, it is imperative that investors conduct substantial due diligence on the real estate project or businesses to which the investor’s capital will deployed.
From a real estate perspective, it is very important to review title work, surveys, environmental assessments, zoning information and municipal approvals to ensure that the real estate has no significant challenges and also that critical approvals have been obtained to ensure that the project can move forward in a timely manner. Often times, property in Opportunity Zones can be environmentally impacted, and a significant aspect of a project’s success can hinge on the Developer’s ability to obtain Brownfield tax credits or similar economic incentives. In those cases, investors will want to have legal counsel and environmental consultants confirm the extent of any environmental impacts at the property, as well as the status of any economic incentives that the developer may promote as being available in connection with development of the project.
With respect to qualified opportunity funds that will provide seed capital for a new business, it is critical for the investor to review all business plans, sources and uses of funds, existing or proposed material contracts and other information and documentation that will be essential to the new business’ success. The investor should ensure that the new business has all necessary contractual arrangements in place to carry out its short-term and long-term business plans. Litigation searches and other diligence concerning the new business’ management team should be conducted to properly vet those individuals. In short, even though the investor is not making a direct investment into the new entity, it will be important to conduct due diligence as though the investor is making a direct investment because the new business’ success will be the primary factor in determining the extent of the investor’s return on his or her investment.
We Can Help
The issues discussed above are only a handful of items that should be considered when making an investment into a qualified opportunity fund. The experienced attorneys at Gielow Groom Terpstra & McEvoy are well equipped to guide investors through the legal issues presented by Opportunity Zone investments. We work cooperatively with our client’s tax professionals and other transaction parties to complete the investment transaction in a positive manner that reduces the overall risk of the investment to our client.
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