The Land of OZ: Targeting Investors

11 min read

Who will take advantage of the opportunities? 

Opportunity Zones are a new designation aimed at bringing business, housing, jobs and prosperity into economically challenged areas. As it turns out, though, developers have been investing in them for years; they just didn’t know it.

“We were involved with OZones before the term existed,” Gregory Reaves of Mosaic Development Partners told TCA for a story last month on revitalizing the Golaski Labs complex in Philadelphia. “Eighty percent of our projects happened to be in OZones.”

“Many of us have been in the OZone business without even knowing it,” WinnCompanies’ Lawrence Curtis stated at the NH&RA Fall Forum in Boston. “Over 40 percent of our properties would have been in OZones.”

But now, with the passage of the Tax Cuts and Jobs Act of 2017, this new tax incentive encourages the investment of capital gains from virtually any source into state-designated OZones. And this will attract a new class of investors. The questions are: Who are they? Where do these investors come from? How do you find them? And what will attract them? What’s the pitch?

One attraction, those already involved with the program agree, is the compounded advantages of the incentive. “OZones are the perfect marriage of tax mitigation strategy and real estate private equity,” declares Ricky B. Novak, co-managing partner of the Strategic Group of Companies of Atlanta that provides consulting services regarding business solutions and private equity capital. “Everything we’ve been doing is engaging with people to mitigate their tax liabilities. We started as a qualified intermediary for IRS Section 1031 (which allows the owner of investment property to sell it and buy like-kind property while deferring capital gains tax) transfer of best-in-class private real estate sponsors and expanded into federal and state tax credit programs. We deal with high-income individuals and their tax advisors, and we’ve also been in the private equity space, raising and allocating equity. It’s been to those people that we’ve directed our efforts.”

“But it’s the Wild Wild West now,” Novak warns. “There is as much misperception as there are unknowns. Every day, I get a referral from a client who’s had 1031s explained wrong to him, and [OZone investments] are much more complicated.”

As an example, he cites, “Two nationally known real estate brokers,” who labelled projects as OZone investments without understanding that to qualify, as much funding would have to go into improvement as the buildings’ existing basis. “They didn’t seem to understand the distinction between an OZone investment and an investment in an OZone. Next thing you know, their clients will look up and realize their investment doesn’t work. Our focus is on real estate, because that’s what we know: hotels, self-storage facilities, housing.” That being said, “There is still much more uncertainty with the business side than the real estate side. I would say the rules for real estate are somewhat opaque. The rules for businesses are clear as mud. We work with national accounting firms. I feel a lot better when I have five or six knowledgeable heads in the room.”

“We were very excited when we first heard about the program,” says Mary Thompson, Bank of America Merrill Lynch senior vice president in Boston. “We thought we could enhance what we were already doing in community development and affordable housing programs. And we were hopeful there might be some flexibility on what gains might be eligible, based on how the statute was written. We lobbied for a broader definition of gains, but the IRS has been clear on this narrow investment.

“We don’t have the recurring capital gains to invest. But many of our clients do, and Bank of America is thinking about how we can help them invest.”

Questions cause some hesitancy
Lingering questions are giving pause to some potential investors and their advisors. “There is a requirement that 50 percent of the growth income derives from conduct of an ‘active trader business,’ states Justin Rumer, an attorney and tax manager for the Dauby O’Connor & Zaleski accounting firm of Carmel, IN, which provides a wide range of services to the affordable housing industry. “But what level of activity rises to the level of trader business? Does management of residential buildings? What about a passive investment, like a triple-net lease?”

Can a general partner invest directly? “Some see the possibility of perceived abuse or conflict,” Rumer says. “We think it works with a partnership structure that has been in place since LIHTC came into being.”

A frequently-used example of the unknowns would be a trucking company based in an OZone, but whose services largely take place outside of the zone. Would that type of business meet the threshold? “If that’s what we’re getting caught up in, we’re missing the boat,” Rumer says. “I’m predicting that many commentators will be speaking on this.”

The fact that regulations are not fully in place remains a challenge. “It is still a moving target with IRS,” Novak notes. “The code is the skeletal system. The regs are the muscular system. The draft regs gave us the Big Picture issues.” The public comment period concluded December 31 and public hearings are slated for January 2019.

“IRS has given us a lot to work with,” Rumer agrees. “As far as the definition of capital gains, we know that depreciation recapture does not qualify. The 31-month grace period [instead of having to invest in a project within six months] is a huge step in the right direction.” He calls it a, “working capital safe harbor,” but points out, “You still need a reasonable plan and schedule to deploy the funds. It would be a misunderstanding to say that we just don’t have enough guidance [yet] to get deals done. We’ve certainly got what we need to make one-off projects work.” He concedes, however, that, “For funds invested in multiple pieces of property, there are still a lot of questions.”

“For diversified funds, we’re having to think through the various what ifs?” says Novak.

“There will be additional regs coming,” Rumer adds. “This will be an iterative project. There could be four additional tranches of proposed regulations, well into 2019.”

Among the greatest uncertainties at this point is the ability to recycle capital within the ten-year compliance term. In other words, as long as the initially invested funds stay within a designated OZone for the ten years required to avoid capital gains taxes, can they be reinvested from one project to the next? “This is the most important issue,” Novak states.

“In my mind, if the goal of the program is to drive investments into these zones, why should IRS or Congress care, as long as you have a building or business operating there?” Rumer asks. “We think it is going to be allowed, but we don’t yet have those rules.”

“To the extent that the final regulations do not permit recycling assets, there are five or six ways we can get the sponsor out of the deal, but the sponsor has to go along with it,” Novak says. “The main thing is, just make sure the fund doesn’t sell assets during the ten years.”

The Social Impact Pitch
“The program dovetails with social impact questions,” Rumer says. “The potential investors we’re talking to are very concerned that the social impact is met. And since those in the workforce housing category are generally eliminated from LIHTC, perhaps this can fill the gap by keeping rents a little bit lower.”

“I really want to see this take off,” Novak states. “We have a glaring lack of affordable housing and a hard time with mixed-income projects and creating jobs. Of our clients, a small percentage will make their decisions based on [social impact]. But these days, you expect market-rate return even if you’re doing some good. The vast majority of our clients don’t want to lose money – preservation of capital is most important. Social good is secondary.”

The White House Steps In
On December 12, 2018, President Trump signed an executive order to facilitate OZone development that he said would provide “massive incentives” to “draw investment into neglected and underserved communities of America so that all Americans, regardless of ZIP code, have access to the American dream.”

The order creates a White House Opportunity and Revitalization Council, led by HUD Secretary Dr. Ben Carson, that will involve 13 federal agencies to help streamline applications to qualify as OZones and to promote federal grants, loan guarantees, infrastructure spending and crime prevention programs. “With the creation of today’s council, the resources of the whole federal government will be leveraged to rebuild low-income and impoverished neighborhoods that have been ignored by Washington in years past,” the president said.

How, or if, the executive order encourages new high-net-worth investors into OZones, or whether it will favor certain zones or geographical area over others, remains to be seen.

Investor Recruitment Strategies
“If you wanted the Super Bowl to come to your city, what would you do?” asks John W. Gahan III, a partner in the Boston office of the Sullivan & Worcester law firm, focusing on real estate transactions and tax credits, and one of this year’s NH&RA Vision awardees. In response to that rhetorical challenge, Gahan offers a prescription for encouraging OZone projects and investors:

“You would start an advertising campaign focused around the question, ‘Why here?’ It should be the same with OZones. Let’s look at it from several perspectives:

“First, the OZone specifics – advertising about a specific zone. Brag about previous successes in that zone. Emphasize projects already on the drawing board, if not shovel-ready. Working with schools, institutions and community stakeholders within that zone. Invite visits to the sites and stage forums with local leaders.

“Reach out to high-net-worth individuals in the area who have money to invest and may wish to do good in the community.

“Second, on a state level, create a website showing where the OZones are. Go to governors and see if state laws on capital gains are in parallel with the federal program. Engage state leaders and stakeholders to try to get this accomplished, so the OZone investment will be that much more attractive.

“Seek out those responsible for the state’s Qualified Application Plan [QAP] for LIHTC and those for Historic Tax Credits and try to get them to create an OZone benefit.

“Stress infrastructure improvements and try to mix and match different types of projects within the zone.

“Look at census tracts contiguous to OZones, which may already be places where there is improvement and social movement within the area. Potentially, it’s not going to take much more investment to expand the progress into the OZone if, ‘It’s already happening here.’

“The overview is, get your ‘stuff’ together in making your pitch. In an ideal world, the OZone investment is the last money in. But you don’t want to present it to the potential investor that way, because then he or she can drive a harder bargain. Make them understand that this is called an OZone for a reason—because it is a good investment opportunity—and that you can complete the project, development or business with or without that investment, but this is a place the investor wants to be involved. How would they feel if they passed up an opportunity to be involved in an area where the next Amazon is coming? Make it clear, ‘This is where you want to put your money.’”

“Once you tell your clients about it, the program sells itself,” Rumer says. “But there is still a lot on us as practitioners to educate. On the LIHTC side, we need to kind of get creative in how we can identify capital gains and put them together [with appropriate projects]. We have to get syndicators to position their properties and bring them to their investors. For the most part, the OZone piece will be value-added, but you can’t count on it as an incentive. I see it as closing gaps in the financing.”

“We’re not seeing much incentive for LIHTC deals,” Novak observes. “And we haven’t done anything in New Markets, but it makes sense on the surface.” However, he does foresee, “a great opportunity to incorporate other tax incentives with these programs. Historic marries well with OZones. We love the idea of layering and lowering the risk. There’s a very good play there.”

“We are not recruiting investors now,” says Thompson. “What we are hoping to do is play a role in this type of investment. We really want this program to be successful and we would really like it to work for us. So, we will continue to monitor developments and see how we can participate. We won’t close the book.”

Story Contacts:
John W. Gahan III,
Ricky Novak,
Justin Rumer,
Mary Thompson,