7 Common Mistakes Made By OZ Investors, With Andrew Gradman

It’s incredibly easy for Qualified Opportunity Fund managers and limited partners who invest in such funds to get tripped up by many of the novel complexities that arise from the statute and regulations dictating Opportunity Zone investing.

Andrew Gradman, a tax attorney who specializes in Opportunity Zone transactions, joins the show to discuss his recent article for California Tax Lawyer, titled “QOZ Planning When Penalties Are A Certainty.”

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Episode Highlights

  • How Andrew’s article includes 22 different suggestions to Congress, Treasury, and the IRS, designed to make the Opportunity Zones program run more smoothly, and prevent investors from having their OZ tax benefits forfeited unreasonably.
  • Why Treasury needs to issue regulations and define reasonable cause: How there may be so many non-compliant Qualified Opportunity Funds (potentially the “vast majority”) that it won’t be reasonable for the IRS to apply the penalties, because doing so would be perceived as unfair.
  • Mistake #1: Why missing your IRS Form 8996 or Form 8997 filing deadlines may mean you’re out of luck, unless you can demonstrate reasonable cause.
  • Mistake #2: Does buying a tenant out of their lease count toward substantial improvement, or merely perfecting your interest in the real property? (Treasury may take an “unhappy view” on this.)
  • Mistake #3: QOF-specific technical issues with regards to basis, debt, and depreciation, and the concept of a synthetic net operating loss.
  • Mistake #4: Not having enough liquidity to pay the tax bill that will come due for QOF investors in 2027.
  • Mistake #5: Timing issues regarding the special 180-day rule for gains recognized on a Schedule K-1.
  • Mistake #6: How to appropriately allocate purchase price to land using an appraisal, instead of relying on a property tax statement.
  • Mistake #7: Why it’s sub-optimal for Qualified Opportunity Funds to directly hold QOZ business property, instead of using a two-tier structure, wherein the QOF holds a QOZB entity that holds QOZ business property.

Today’s Guest: Andrew Gradman, Tax Attorney

Andrew Gradman on the Opportunity Zones Podcast

About The Opportunity Zones Podcast

Hosted by OpportunityDb.com founder Jimmy Atkinson, The Opportunity Zones Podcast features guest interviews from fund managers, advisors, policymakers, tax professionals, and other foremost experts in opportunity zones.

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Show Transcript

Jimmy: Welcome to The Opportunity Zones Podcast. I’m your host, Jimmy Atkinson. Joining me today on the show is Andrew Gradman, a tax attorney specializing in Opportunity Zones transactions. He recently wrote an article for “California Tax Lawyer” titled “QOZ Planning When Penalties Are A Certainty.”

We’ll be touching on that article and more during the course of today’s episode. And Andrew is joining us from Los Angeles. Andrew, welcome to the show. How are you doing?

Andrew: Great. Thanks for having me on.

Jimmy: Good. Well, today we’re going to be discussing… In part your article, you highlighted many of the common mistakes that a lot of OZ investors and OZ funds have likely made maybe without even knowing it because it’s really easy to get tripped up by so many of the complexities of both the statute and the regulations from IRS. Today on this podcast episode, I want to touch on just seven of those most common mistakes, and I’m going to quickly rattle them off.

And then, Andrew, I’m going to turn to you and see if we can get a little more color on each one of them over the course of today’s episode. So the seven most common mistakes are, number one, late filings, what to do about late filings. Number two, depreciation, how it’s treated. Number three, QOZs and liquidity. Number four, we’ll touch upon the 180-day special rule for Schedule K-1s.

Fifth mistake we’ll touch upon is allocating purchase price to land, and then six will be OZ funds operating as operating businesses. And then finally, number seven, I know this is one you really like, Andrew, is buying out tenants. So let’s go with number one here, that first most common mistake that we’re going to be touching on today, Andrew, which again is highlighted in an article that you wrote for “California Tax Lawyer” recently titled, “QOZ Planning When Penalties Are A Certainty.”

That number one most common mistake is late filings. So what can you tell us about that?

Andrew: So this came to my attention through a client who had this happen to them. And they told me after the deadline for filing their 8996 and 8997 that they hadn’t done so and they said, “Oh, can you help me amend my return?” And some of you in the audience are already grimacing because you know that IRS has released private letter rulings underscoring that these are what they call regulatory elections, meaning if you miss the election date, then you’ve elected not to do it.

And so you have to file a private letter ruling request and the basis for your request has to be that you had a reasonable cause for not making the filing. And that can be hard to show, meaning… You know, some people say, “Oh, that’s not hard to show.” Well, we’ll get into that because it’s often hard to show, meaning if you miss those deadlines, you could be out of luck.

And so what would be your reasonable cause? Reasonable cause would be, “I told my CPA to file form 8996 and he forgot.” The reasonable cause would be the CPA said, “I had it on my to-do list, I forgot.” But reasonable cause is never going to be something like, “Oh, I didn’t know that QOZs had a lot of requirements.”

I mean, there are people who always say to me, “I always intended to get the tax benefits. Clearly, I intended to get the tax benefits. Treasury knows this because I didn’t pay my taxes when I was supposed to. So clearly, I intended to do this.” You can’t take reasonable cause, it’s not like taffy, you can’t stretch it out that far. So in my paper, which is directed at Treasury, I beg them, I say, you know, “Hey, this isn’t a good policy. You’re going to have a lot of people who are going to be denied QOZ, either the fund will be denied or the investor will be denied simply because of a late filing and they can’t show whatever you call…”

And even if you can show reasonable cause, it’s a very extended process. So tied in with that, there’s another sort of allied mistake which I see a lot of, which is that in form 8996, that’s the form that QO funds file in, let’s say, our partnership, let’s say October, if you extend, right?

September, if you extend. That form has a line three that says, “Please certify that your operating agreement, that your organizational documents contain a promise that you’re going to be a fund.” Now, I think that’s a very common mistake that people admit that because that requirement doesn’t actually exist anywhere in the regulations or anywhere else except for line three of form 8996, which you’re not going to fill out until it’s a year too late.

And this one’s always bugged me because during the process of the proposed regulations, I had sent in a comment saying, “Hey, this is silly. Why don’t you add to the regulations a requirement so that people are on notice before it’s a year too late?” And Treasury…you know, maybe I wrote it badly, maybe I wasn’t clear because it didn’t get picked up.

I think there’s going to be a lot of these. And what further bothers me about this is there is no formal remedy. If you don’t have that language and let’s say it’s January and you were supposed to have it in December at the end of the prior year, there’s no formal remedy for that except, you know, fraud, you know, backdating a document, which I don’t encourage people to do, but if you were to survey the industry in an anonymous basis, but there are a lot of backdated operating agreements out there that add that language unit.

You know, Treasury, it’s putting people in a very difficult position for something that I perceive to be quite trivial.

Jimmy: So the operating agreement statutorily and regulatorily is not required to have that TCJA language stating that we are operating as a QOF under Section 1400Z-2, that’s not required?

Andrew: Okay. So in the code, I think you’re pointing out something smart, which is that there is a requirement that to be a fund, you have to be created for the purpose of being a fund. I think that I have… The only place that they further implement that is not in the regs but in line three of form 8996.

Jimmy: Got it.

Andrew: So other than that, there’s no expression of that requirement.

Jimmy: That’s interesting. So is your recommendation that people not check that box then on line three?

Andrew: Oh, my recommendation… I have two recommendations. My first recommendation is… Well, remember, you had me on to point out common mistakes, not common remedies to common mistakes.

Jimmy: That’s a good point.

Andrew: My job is done if I point out that someone screwed something up. If you screwed that up, I don’t know what to do. That’s why I’ve written in my article to Treasury, “You should come up with a way to fix that when people do it wrong.” Yeah, but the comment is if you’re going to form a fund now, make sure the operating…

And I say operating agreement, it says formation documents. There’s a question as to how you define formation documents. I interpret that to mean the operating agreement. I think that’s fair.

Jimmy: Right, right. Yeah, typically, I think that’s what that would be, right, or some sort of corporate resolution. Well, let’s actually stop there. That’s number one. I know we’ve got six more to go through, but first, let’s zoom out for a second because you said a couple of things that reminded me that I should ask you this first. One, who is this article addressed at? Right?

And two, I guess just a point of clarification just to kind of reiterate what you said, you’re pointing out problems but you don’t necessarily have remedies to these problems yet. So I guess that kind of ties into that first question, who is this article addressed at primarily? Who are these mistakes addressed at?

Andrew: Yeah, I wrote this article as part of a competition that the California State Bar puts on called the DC Delegation, and they select some papers that then we go to DC and we present them to various staffers at relevant agencies. So the article culminates in 22 different suggestions to Congress, and Treasury, and the IRS, as to ways to make the program run more smoothly given my concern that there are a lot of arbitrary cliffs, a lot of arbitrary pitfalls in there that don’t necessarily benefit any of the stakeholders, but can lead to people losing their tax benefits unreasonably.

And the main argument is that we should look out for the penalty phase of this process. That’s why the title “QOZ Planning When Penalties Are A Certainty” because I start with the premise that there were going to be so many fund… And you can question this in the audience, you know, you don’t have to agree with me on this. But my premise is that there’s actually going to be quite a few non-compliant funds out there.

And it’s going to be so many that it’s not just going to be reasonable for Treasury, IRS to apply the penalties. It’s going to be too many. It’s going to be perceived as unfair. And so, you know, there is an exception in the… When they define the penalties in the statute, they say, “These will not apply if you can show reasonable cause.”

And so the big culminating question in my paper is Treasury needs to sit down and define, they need to issue regulations and define reasonable cause for qualified opportunity funds. Now, Congress then needs to add a similar reasonable cause provision for investors because they don’t even have reasonable cause excuse. If we can get those two things, then we can sort of maybe navigate our way out of the penalty phase which is, you know, winter is coming, you know?

Jimmy: Sure, sure. Well, let me put you on the spot here real quick, what percentage of qualified opportunity funds do you think have made some sort of mistake?

– Well, I think…

Jimmy: If I give you a hundred qualified opportunity funds, how many of them have fallen victim to one of these traps possibly unknowingly?

Andrew: Well, some traps are more fatal than others. But I think that the vast majority of all funds, even ones which are run very professionally, have made certain trivial-ish mistakes, which could comp them later. And to answer that, can we go out of order?

May I have your permission to go out of order?

Jimmy: Let’s go out of order. Sure, so maybe in IRS parlance, you use the term vast majority, maybe substantially all is the IRS, right?

Andrew: Yeah, you’re right. I was intentionally vague. Don’t test me on that.

Jimmy: Well, I won’t hold you to that. So we got through late filings. I think we were going to tackle depreciation next. Do you want to go out of order? Which one do you want to look at?

Andrew: Yeah, let me throw one out there, which is just wacky.

Jimmy: Go for it.

Andrew: So the last one on our list had to do with buying tenants out of their leases. And I think it’s probably widely held and widely accepted among professionals, among lawyers, that if you’re trying to achieve the substantial improvement test and achieve the doubling of basis, one of the valid costs you can incur is to buy tenants out of leases. And the argument becomes, “Well, look, if you look at those 263, you capitalize that into bases, clearly, you’ve got bases, and so, therefore, you’ve got doubling of bases.”

My concern is that, under the statute, you can only count costs that apply after you’ve purchased the property in question. And I would say that when you buy a tenant out of their lease, you’re further perfecting your interest in the real property. So first, you bought a fee interest with leaseholds carved out, and then you came back later and now you bought out the leaseholds.

Well, it’s the same thing as buying 20%, and then 40%, and then 60%, and then even 100%. That’s not going to count as doubling the basis of your 20% when you buy the 40%, 60%, 80% of the same property. So if that reasoning is adopted, you know, it could go either way, right? Treasury hasn’t opined on this. We don’t know what position they’re going to take. And I don’t dare say I’m right on.

So I don’t know I’m right because I’m just saying it’s a concern. This counts as a thing that’s probably pretty common out there. And if Treasury should take their unhappy view on this, then that could be a large number of unhappy funds.

Jimmy: Yeah, yeah. Very interesting. Okay. So that’s buying tenants out. And I guess that was number seven. We’ll call that number two now. Let’s move on to number three, which is depreciation.

How is depreciation treated with qualified opportunity funds and what’s the trap there?

Andrew: Yeah. Depreciation and basis recovery in QO Funds is so spectacularly interesting. It’s a laboratory for every interesting thing there is in the field. When I mention it in this context, we start with what we understand that investors into QO funds, when you calculate their basis, usually, your outside basis in a partnership is going to have three major components, what you’ve invested into the fund, and then your sheriff debt, and then bases arising from operations, say income at the operational level.

And in a QO fund, Treasury reasonably says, “Look, the money you invested was never taxed so you shouldn’t get basis in that until December 31st, 2026 when the tax comes due.” So people start with a lower basis. Now, this can cause trouble in the cases in which now the only basis you’re going to get is the debt allocation.

And then let’s forget about the operational income because that’s sort of offset by operational costs. So it forces people to look to their debt. Now, there are two kinds of debt, right? Recourse and non-recourse. If the fund should have debt, which is categorized as recourse debt under, you know, 1.752-2, of course, then all the basis is going to go to the party who bears economic risk of loss, and it won’t be smoothly allocated among the partners.

So let’s start with that assumption because doesn’t always happen but let’s say that does happen. Now, in the interim, a few other bad things happen. You want to take a debt-financed distribution? Well, under the regs, you’re going to have not only gain but an inclusion event to the extent that the distribution exceeds your outside basis.

So people could have inclusion events when they’re not expecting it. And think how often we’ve promised that the 10% and the 15% step-ups would sort of manifest as sheltering gain in the year 2026. Well, again, if you didn’t have any basis of any other kind in the intervening years, and if there was depreciation at the entity level, that depreciation will be used against the 10%/15%, sucking it up, and you’re thinking, “Oh, that’s fine, I’m getting the benefit either way.”

Well, no, because you would have gotten that depreciation later, you would have gotten it later. But come 2026 when you’re expecting a 10% or a 15% haircut off the gain, for that gain, you won’t have 10% off, you something less than that. This all is on the scenario in which you have a recourse debt and the debt is not smoothly allocated among the partners.

This is something you can fix though. If you have non-recourse debt, which many, you know, knowledgeable funds are doing because that’s what we’re supposed to do, then you can have the debt allocated in accordance with the operating agreement on certain provisions. And if you have recourse debt, you can also tweak that in a more aggressive way by causing all the partners to become recourse, the guarantor.

And there are a few ways that people do this. In cases where I’m stuck with that, so in cases where you need to have a guarantee, I have… You know, I’m not recommending this, I’m not saying it’s conventionally commercially conventional, but you put something in an LLC operating agreement that says, “Notwithstanding anything to the contrary, the LLC shall not prevent liability from this debt from being borne by the members.”

It’s case by case. You got it? It’s case by case.

Jimmy: Got it.

Andrew: This is definitely an interesting concern.

Jimmy: That was somewhat of a remedy you gave us right there.

Andrew: I did. I didn’t mean to.

Jimmy: Hey, that one kind of made sense conceptually, but I’m wondering, could you very quickly walk us through an example of how that would be an issue with a real number? So let’s say you’ve got a $1 million capital gain that you put into a QOF and you’re expecting that 10% basis step-up which would essentially make that gain recognized in 2026 as 900,000, right?

So what does this do exactly?

Andrew: Okay, I’ll try to honor your numbers. Don’t hit me if I screw up your numbers.

Jimmy: That’s all right.

Andrew: So investor comes in with a million dollars of gain. Under old-fashioned partnership rules, he has a million of basis, but he doesn’t here. Then let’s say the fund or its subsidiary goes on and takes on some debt, which let’s say it’s guaranteed by general manager, by a partner, and therefore it’s recourse to that person. And so under 1.752-2 regs, the basis flows to that person.

So the starting point for our discussion is that when this individual has made his investment, he has zero outside basis. That’s starting point. Now let’s have the clock tick. The first events are let’s say he invested before 2021, so he’s got a 10% step-up. So suddenly, he does have some basis.

And now there’s depreciation, interest payments at the operational level. These will open the K-1. Are these going to be suspended for lack of outside basis which is the rule under 704(d)? No, because he has some basis, he’s got 10%. There’s actually language in the regs which seems very directly on point to achieve the outcome I’m describing.

So he gets to take his depreciation. That’s great. You know, let’s exaggerate the numbers ridiculously, and let’s say that he’s able to take all of that depreciation. All of the 10% gets consumed. That probably wouldn’t happen but let’s just say it happened.

Jimmy: All of the 100,000 gets depreciated?

Andrew: All of the 100,000. You know, that could happen with a cost segregation, with a bonus depreciation, so it could happen. So he’s so happy, “I got all depreciation.” Now, we come to the year 2026 and when the 1 million comes due, he doesn’t have that 10% basis to offset it, so he’s got the 1 million of gain. Now, you might say, “Well, that’s fine. He got his appreciation, right? So it’s the same thing.”

But think about it, if it had happened in the opposite order, then he would have had the million offset by the 10% bonus of depreciation and then he would have gotten depreciation later anyway. This is the other beautiful experiment in depreciation that is the QO zones. I like to think of them as a built-in NOL, a synthetic net operating loss.

I think I said this to your colleague, Michael, when I chatted with him. Because, you know, assuming bonus depreciation should exist in 2025, which currently isn’t set to, but imagine it will. Just imagine that. If you’re going to have a gain in 2025 and you want to be able to take some losses against it, you can invest in a QO fund, get the depreciation, defer till 2026, recognize the gain.

Now the question that all these people have is, can I use that depreciation against this future gain? I’m not going to give advice to you over this podcast on that one. It’s too complicated. That’s not what I was told to come here to talk about. But if you could, which some people can, you’ve just created a synthetic NOL, haven’t you?

It’s crazy. How does this all come up in the QOZ context? It’s crazy.

Jimmy: That’s really interesting. Yeah, a lot of unintended consequences from regulating something so complicated, I guess. Well, let’s move on to our fourth common mistake that you fear is the liquidity problem with QOZs. Describe that for us.

Andrew: I always have, especially with California clients, where we have the perfect storm of high state tax rates and nonconformity. It’s a perfect storm because I mean, certainly, you have to explain to your clients that the California tax will come due. That’s a basic requirement. But I’ll tell you from experience, it takes a lot of devotion to remind people of this because it’s not your intuition and so you got to go out of your way to say it.

And then what you find is that you have to ask them not just what your gain is going to be, but no matter what the gain is, you want to know the basis because you need to have a sense for how much cash they’re going to have left over from the sale to be able to make the payment to California. I once drew this funny graph where the question was, how much of your gain do you invest, 0% or 100%? And the optimal number, if you’re going to have liquidity issues, is somewhere in the middle because you have to pay that tax and it’s, you know, frightening when people don’t.

People go into the fund, invest the money, find out they have to pay the tax later, and then, how do they get to the money?

Jimmy: Yeah, where’s this liquidity coming from for me to pay this tax bill in 2027, right?

Andrew: Yeah. And, I mean, you know, as a quick aside, in the paper, I talk a lot about the liquidity…the lack of concern that the legislation has towards these liquidity issues. The same thing coming up in 2026. I mean, you know, God bless the proposed legislation that’s out now would defer the tax day from 26 to 28. But as the “Tax Note” article…

Jimmy: It’s now just kicking the can down the road.

Andrew: It’s kicking the can. “Tax Notes” article by Marie Sapirie observes… I mean, she wasn’t editorializing, she’s a journalist but she said, “This could be the first step towards deferring it forever. Because where are people going to come up with the money?” That’s one liquidity issue. And the others are… Okay, I’ve mentioned investing now, investing in 2026. And then just what if you have a crisis between now and the 10th year and you need some money?

It’s going to be very costly if you have to liquidate your QO fund because you’re banking on having that around for 10 years, it’s going to be very hard. So those are the liquidity concerns. That’s all I have to say about that.

Jimmy: No, those are really good concerns to keep in mind. I always tell investors when they come to me, I tell them, “Hey, make sure that you have some liquidity to pay that 2026 tax liability.” And some funds take that into account also. They’ll have some liquidity options for their investors in year five or seven or somewhere around that timeframe. But it is a concern that investors should keep in mind.

I mean, what about the 180-day rule? I think this is number five right now. So there’s a special rule if you realize a gain on the Schedule K-1, but walk us through what that rule is, and then some of the traps there.

Andrew: Yeah, this one could be more simple, but I’m going to shock some folks. So I always like to say you have 180 days from the date of the sale or the date of the deemed sale. And so the deemed sale could be a later date arising in case you have, say, 1231 property or an installment sale or a K-1. And in the case of the K-1, they actually let you choose from any of three dates, the date on which the underlying entity sold its property, or December 31st of the end of that year, assuming calendar year taxpayers, or the date the K-1 is due, which is, you know, assuming calendar year, March 15th of the following year.

The concern I think people don’t perceive is that in their minds, they imagine a one continuous investment period. Starting from the date you sell the property, let’s say, January 1st, 2021, the underlying partnership sold some property. Unreflectively, you think, “Okay, then I have from that date until 180 days after the K-1 date, which gives me like 560 days to make my investment.”

And that’s not the case. You have to choose one of these dates and you could imagine mutually exclusive investment periods where people invest in an earlier period and re-invest in a later period and then someone tells them, “Well, you have to choose which of those is going to be an actual investment.” And it’s such a simple issue but I’ve seen it enough times.

My recommendation to Treasury is to let people just choose their own 180-day date. They don’t have to elect it, just let them… As long as all the investments they make fall within the 180 days, and the ones they identify on form 8997, yeah, or form 8949, let them do that. I think that’s the easiest low-hanging fruit.

Treasury’s got to accept that. How could they not agree with that? That’s so easy.

Jimmy: That seems to make sense. So just to recap, you have a sale on January 1, 2021. Technically, you have until September 11th of 2022, right, to place that gain into an OZ fund, but you can’t use that entire 500 and whatever day period. You have to kind of pick either…you’re treating January 1 as the start date, or you’re treating December 31 as the start date, or you’re treating March 15th of 2022 as the start date, that being the due date for the partnerships tax returns, right?

So you have to pick one and then you got to make all your investments within that 180-day period. That makes sense. Okay, okay. And your remedy there seems to make sense as well. All right. So let’s move on to…I think we’re on number six now, allocating purchase price to land. What’s the trap there, Andrew?

Andrew: Yeah. So in a non-QOZ setting, you buy land and building or you always got to allocate between land and building. And historically, we want to allocate to the building to get the depreciation. Your audience is familiar with most of this. In the QOZ setting, there’s an opposite force because you want to minimize your obligations to substantially improve that building.

And it’s measured by purchase basis, cost basis. So the opposite force is, “Now let’s allocate basis to land so we get this equilibrium where you choose the lowest.” What we would want to do if we were God or if we could pay the appraiser sufficiently a large bribe is we would want to have it be as little as possible basis in the building to honor our substantial improvement needs, but no less than that because then we want to depreciate the rest.

Now, my concern is what people do in California, at least, and this may be true in other states as well when they have property tax documents, which purport to give them a valuation of the property. And I see people cherry-pick with these. So if the property tax document is favorable and they don’t get an appraisal and they say, “I’ll stick with that.”

Or conversely, if it’s unfavorable, they do get an appraisal. And my comment to that is, you know, sometimes these property tax documents are probative, meaningful, sometimes they’re not and there are ways to tell. So according to the California Property Tax treaties, which I’ve cited in the paper, sometimes they look at comparables.

If you’re in a neighborhood where the land is all similar, the state appraiser will look at and look at the land of the other properties, and then will sort of benchmark the valuation he’s using. And in those cases, you have a probative property tax statement. And that is almost as…you know, that is a data point which the IRS could look to and take very seriously.

And in those cases, you do too. You can always get another appraisal, but that doesn’t immunize you against a good or a bad property tax data. In other cases, you can look at the property tax data and compare it to the comparables and you will see that the appraisal wasn’t thoughtful. And that also happens, unfortunately, and, you know, probably happens more often than not, but you can throw these things out the window, but then if you want to rely on them, you know, you do so at your own risk too.

So the bottom line, I think, it’s not news to anyone that you really should get an appraisal to do the allocation between land and building. And the caution is out there for people who think that they cannot do that and rely on a property tax document. That’s dangerous.

Jimmy: Yeah, certainly is. Well, let’s move on to the seventh and final trap or a common mistake that you see funds making and investors making. This one concerns qualified opportunity funds as operating businesses. What’s the concern there, Andrew?

Andrew: Yeah. Every once in a while, you see people who have their qualified opportunity funds without QOZ businesses underneath them. And I think in our community of professionals, some people are okay with it and modestly okay. I am very much against it. And the only occasion I would, sort of, bless that is if we had one of these cases where you’re buying a completed property, a certificate of occupancy situation where it’s completed and you buy it and you’ve got no more improvements to do.

Other than that, never.

Jimmy: So in that case, something very simple like that, you can have the qualified opportunity fund directly hold the qualified opportunity zone property? Is that right?

Andrew: Yeah, because the statute does permit the funds to hold QOZ business property, and the case I’m giving is where, you know, someone else built a new property and before it’s placed in service, they sell it to you and all you have to do is like put in one brick, and then, I don’t know, whatever you do, and then you call a county, get the certificate. That’s fine for a QO fund.

Here is why…

Jimmy: I think where you’re going is you typically would like to see a two-tier structure where the QOF holds the QOZB, which then holds the QOZB…

Andrew: Oh, I apologize. Yeah, that’s the background you’re trying to elicit. Yeah, what you should do is your QO fund should own a QOZ business. And here’s, sort of, the reason. So in this statute, they allow for reasonable working capital for the subsidiary business, QOZBs, but not for the funds themselves.

And Treasury just took that and they ran with it. And they created this whole token-esque, you know, mythology of different rules that apply. And so at the QOZ business level, they allow you to hold a non-qualified financial property like cash in excess of 5% if you do so for the 31 months or up to 62 months working capital safe harbor.

And that comes with a slew of extra benefits. Any income from that working capital will count towards the 50% test. Any intangible property I bought during that period will count towards the 40% test. The entity will be treated as meeting the 70% requirement during that interval, the requirement of 70% of tangible property, the QOZ business property, all of these, you get all these freebies at the QOZ business level, making it possible to not screw up and have a footfall and no penalties when you don’t deserve them.

There was a recent article in the NovoGradac edition of the QOZ edition where they point out that it’s not perfect. There are a few gaps still left in there, but for all intents and purposes, it’s almost perfect. But at the QO fund level, we don’t have these. So we have a hobbled working capital safe harbor, meaning the newly invested funds can be held for one testing date as cash, and then after that, they got to be used.

And then the other thing is, what happens if… Allow me to refresh my… You know, at the QOZ business level, I told you that they had a special rule that gets you around the 70% tangible property test for tangible property. They don’t have an equivalent one for funds.

What they say is that you can get a pass for tangible property which is undergoing the substantial improvement process during the 30-month substantial improvement period. And I apologize for stumbling over my words here. My problem with this is that when you analyze it, it’s not workable.

I’ll just say it very quickly. It’s very unhelpful. And I can think of so many cases where people would seek to use that safe harbor and fail it. And so, therefore, it’s just never ever use the QO fund, is my opinion. Other people may disagree with me, this is my opinion.

Jimmy: Yeah, yeah. The two-tier structure, I think, just gives you a lot more flexibility in almost every case. Well, Andrew, I think we’ve kind of run out of time here today on today’s episode. I know that your article goes into much more detail on all these points, and I think it covers an additional approximately a dozen or so other common traps, so we’ll be sure to link to that article in our show notes for today’s episode.

And our listeners and viewers out there can find the show notes for today’s episode at opportunitydb.com/podcast. There, you’ll find links to all of the resources that Andrew and I discussed on today’s show and we’ll be sure to link to his article as well. Andrew, pleasure speaking to you today. Before you go, can you tell our listeners and viewers where they can go to learn more about you and the services you provide?

Andrew: My website is www.gradmantax.com. I’m a transactional tax lawyer. So if you don’t know what a transactional tax lawyer is, you probably don’t need one. I usually work with other lawyers and I’m brought in to do the tax aspects of deals.

Jimmy: Fantastic, gradmantax.com. Please do visit that. And again, we’ll have show notes and we’ll link to that on the show notes page at opportunitydb.com/podcast. Andrew, thanks for joining me today. It’s been a pleasure.

Andrew: Likewise. Thank you.