Opportunity Zone Traps For The Unwary, With Gordon Goldie & Valerie Grunduski

Opportunity Zones have been around for about 5 years, but it’s still a relatively new tax policy. A lot of investors, fund managers, and even advisors are still getting up to speed on how to operate within the statutory and regulatory requirements.

Gordon Goldie and Valerie Grunduski from Plante Moran join the show to discuss 20+ traps that Opportunity Zone investors can fall into without the right guidance.

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Episode Highlights

  • Traps for Qualified Opportunity Fund investors, including 2026 gain recognition, deferral of tax basis, and suspended losses.
  • Traps for Qualified Opportunity Fund operators, including IRS Form 8996 and working capital safe harbor issues.
  • Traps for Qualified Opportunity Zone Business owners, including triple net leases, improvements to ineligible property, and the start-up business distinction.
  • Other Opportunity Zone traps, including cash transfers, related party restrictions, waterfall structures, debt financed distributions, and disguised sales.

Guests: Gordon Goldie & Valerie Grunduski, Plante Moran

About The Opportunity Zones & Private Equity Show

Hosted by OpportunityDb and WealthChannel founder Jimmy Atkinson, The Opportunity Zones & Private Equity Show features guest interviews from fund managers, advisors, policymakers, tax professionals, and other foremost experts in Opportunity Zones and the broader private equity landscape.

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Show Transcript

Jimmy: Welcome to the “Opportunity Zones” podcast. I’m Jimmy Atkinson. Opportunity zones are still a relatively new tax policy. A lot of investors, fund managers and even advisors are still getting up to speed even though the policy’s four or five years old now. It’s still relatively new and there are many traps for the unwary as termed by my guests joining me today from Plante Moran. Gordon Goldie is a tax partner in Plante Moran’s tax solutions group and Valerie Grunduski is tax partner in Plante Moran’s real-estate group. Gordon and Valerie, thanks for returning to the show today. It’s great to have you back.

Valerie: Thanks for having us.

Gordon: No problem, thanks.

Jimmy: So today we’re gonna dive into about a couple dozen or so of these traps for the unwary, things that investors, qualified opportunity funds and qualified opportunity zone business should be aware of. Now just a fair warning to everybody watching or listening to this podcast today. We’re gonna identify a lot of the problems. We don’t have time unfortunately to lay out all of the solutions to all of these problems. So, if you have any questions, you can reach out to Valerie or Gordon at Plante Moran if you wanna discuss solutions to these different types of traps. This is mostly meant to be a teaser, I suppose, and just kind of identify some of the problems that you should be aware of.

So, we’re gonna break today’s episode up into three different categories essentially. We’re gonna cover traps for qualified opportunity fund investors. We’ll cover traps for the qualified opportunity funds or QOFs themselves. And then we’ll also cover traps for QOZBs, the businesses that the funds invest into. So, let’s start at the top first. Let’s cover the traps for qualified opportunity fund investors. What are some of the traps that investors in QOFs should be aware of?

Valerie: Yeah, so since the incentive, obviously, is largely for the investor themselves, I think that’s probably the best place for us to start. And the first topic that we have here is one that is surprising given your point that the program’s been around for four or five years now and that’s in truly understanding what the benefits are for the investor. You know, early on we had the deferral of the original gain. There was a potential step-up in basis, that 5 or 7 years and then a step-up in basis after a 10-year hold and potentially being able to eliminate any gain and appreciation on your investment.

Somewhere along the way it seems like that the deferral of the gain until 2026 has gotten lost a little bit in the weeds. Gordon and I are often surprised that we’ve had people reach out who still believe that that original gain gets extended or goes away entirely. And so, we just wanted to level set, make sure everyone understands. You know, we love helping people use this program. We would love for more people to, you know, invest in the program. But obviously it helps to understand what the actual benefit is.

So that was just the first one. We wanted to kind of put out there as a… that’s not how it works. It would be great if it did. Unfortunately, that gain that you’re deferring does becomes due and payable with your 2026 tax return but we still think there are other great benefits beyond that. So that was the first one.

Jimmy: Yeah, yeah, absolutely. That’s a really good point to bring up. That gain is…the tax on that gain is due typically in April of 2027, I guess it would be. Unless Congress is to extend the program which there’s been some discussion but they haven’t yet. So as of now, plan on paying a tax bill in April of 2027. What other traps for the unwary, Valerie?

Valerie: Sure. Yeah. I’ll hop on the next one but I was first gonna joke, Jimmy, that I don’t know that any of us are holding our breath that too much is gonna happen in Congress this year.

Jimmy: Yeah. Very true, very true.

Valerie: But another one has to do with the treatment at, you know, a state or local tax level. So not every city, not every jurisdiction has decided to do what the federal government does. And so as an investor, you do need to pay attention to both where you are domiciled and where you pay taxes and where the investment you made is and where that pays taxes and make sure that you understand whether or not the benefit is one that is solely gonna be a federal benefit for you or if you will also get to see the benefit at a state and local level as well because unfortunately, it’s not a one size fits all across the country on that.

Jimmy: I mean, yeah. There are a handful of states that do not conform unfortunately. I think the vast majority of states either don’t have capital gains tax or they have elected to conform or maybe said more technically they have not elected to not conform because some of them automatically conform with these different tax rules by the federal government. But in any case, yeah, just be wary of where you may have tax nexus if you’re in a state that doesn’t conform to the opportunity zone policy. And California and New York I think are the 2 800-pound gorillas in the room that don’t conform and there’s a handful of others as well.

Gordon, let’s bring you in. You’ve been quiet. What are the traps for the unwary investor in qualified opportunity funds?

Gordon: Yeah, I think one of the biggest things we see is that, you know, there’s a catch to deferring your gain in the statute and the regulations and that catch is that you don’t get any basis for your investment into the QOF. And so, when an investor makes the election to defer their gain…you know, let’s say they have $100,000 of gain and they invest it into a QOF. Normally when you invest $100,000 into a partnership, you get $100,000 of basis for your investment in that partnership. But the catch under the opportunity zone program is that you don’t get any basis for that $100,000 investment and/or whatever amount you’ve made the election to defer until you basically pay the tax. You know, to the extent that you made your investment, you know, before the end of 2021, you qualified for, you know, the 10% or 15% basis step-up. You get basis at the point in time when that basis step-up occurs. But for the most part, you’ve got no basis for, you know, either five years or 2026, whatever comes first.

And so, you know, that’s important to consider for a couple of reasons. One is that to the extent that there’s losses allocated to you out of the, you know, investments, then you can’t claim those losses unless you have basis. And also, to the extent that there’s distributions made to you, then as a general rule, when you receive a distribution for a partnership, it’s not taxable unless it exceeds your basis. And so, you know, for those two reasons, you need to be aware of this limitation that, you know, you don’t have basis until you pay your tax, you know, or you get the basis step-up because you could end up having losses allocated to you that get deferred and/or you could end up having distributions that become taxable. And so, you know, the loss thing…just to kinda clarify one point is, you know, that you could be deferring gains at, you know, at 20% capital gains, long-term capital gains rate and the losses might be potentially 37% losses.

And so, you know, to the extent that you’re deferring gains at 20% but don’t get basis and then, you know, have losses suspended that could’ve been used against 37% bracket income. That’s a pretty negative arbitrage there on the rate spread. And so, you know, we generally inform the, you know, investors in opportunity funds about…is that there are ways to get basis to avoid that situation from happening. It’s generally centered around how the debt of the QOZB or the QOF is structured and how it gets allocated. And so as an investor, you want to…you know, even though those are really technical issues that most investors probably would have a hard time comprehending on their own but that’s why it’s important to have advisors, you know, to consult with, is to understand, you know, how the QOZB and the QOF…you know, what type of debt they’re gonna have and how it’s gonna get allocated because to the extent that there’s debt basis allocated to the investors, then they would have basis to receive losses and distributions without negative tax consequences.

And so, it’s important to, you know, to think about that up front and to plan for it potentially and, you know, it could make a big difference in your, you know, rate of return and the effect on your taxes that if you don’t consider this trap here.

Jimmy: That’s a good one there, Gordon, for sure and that is very technical and went a little bit above my head. But that’s why we bring in the experts like you guys from time to time. So I think that wraps up, unless I’m wrong, the traps for QOF investors to be cognizant of that 2026 gain recognition and that initial deferral of capital gains eventually coming home to roost on your 2026 tax return, making sure that state and local nonconformity issues, check whether or not you have nexus in localities or states that may not conform to the federal incentive and that in the deferral of tax basis which have some problems with suspended losses or possibly taxable distributions before your basis kicks in.

Let’s move on. Unless I’m missing anything there, I think we’re ready to move on to the traps for the funds, the qualified opportunity funds and Valerie, why don’t you kick us off by talking about the IRS tax form that funds are required to file every year?

Valerie: Right. So, in order for that investor to get…to defer that gain and have the, you know, eventual step-up in basis and elimination of gain on the back end they have to have invested in a qualified opportunity fund. And in order to be deemed a qualified opportunity fund, you have to file form 8996. There’s another box that has to be checked on the return as well. But essentially stating the date in which you first want to be, you know…I guess elect to be a fund. And so that is…it’s important. If you don’t make that election, right, now that investor, when they…on their form or on their 1040 or whatever form they file, complete the 8997 to show that they have an investment in a fund, the IRS will, you know, try to match those up. And if the fund has never filed the 8996 that clearly is gonna be a problem for the investor.

And where we’ve seen this pop up a few times is especially…like, let’s say somebody sets up a fund right at the end of the year and there’s not really any activity. And so, they’re like, “Well, we don’t really have…we don’t really need to file a return because we don’t have any activity so there’s not a requirement from that perspective to file a return.” But if you don’t file the return, you’ve essentially not elected to be a fund. So that…I mean, it seems pretty basic but it’s just very important to make sure that that step is followed.

Gordon: And another problem we’ve run into also is if the QOF return, tax return for the year you made the election doesn’t get extended properly…like, maybe there’s some miscommunication between the accounting firm and the, you know, and the fund organizer. And if, you know, they…nobody extends that return, then the election has to be made, the form 8996 has to be made on a timely filed return. And so, if that initial return is not filed timely because the extension was not, you know, submitted and approved…and then we’ve also seen some situations where extensions get rejected for some reason. And so that…you know, the accountants need to pay attention to that too, is that, you know, we’ve seen extensions get rejected. And then you’ve got generally five days to fix that, you know, if there is a rejection. You know, we’ve seen, you know, various different issues there with, you know, maybe potentially an incorrect DIN or something like that.

And so, you know, the point is that, you know, make sure if you’ve got a fund that you want to certify and you’re not filing by the March 15th deadline, an extended deadline, that you make sure that the extension gets properly filed and approved.

Valerie: Sure. And in addition to that, you know, when we’re looking at the fund making that election on that form, they get to choose what month they want that election to be effective, right. And it might default to January because it’s the beginning of the year but obviously that kind of starts the clock on them needing to meet the various tests that, you know…there might be varying reasons to want to start that later in a year but it’s very important to make sure that the date you’re self-certifying and electing to be a QOF is before you received your first capital gain deferral dollars because again, if those timelines don’t match up, you can now cause issues for your fund investor who was, you know, planning to be able to defer that gain and have a qualified investment. I don’t know, Gordon, if you had anything else on that piece as well.

Gordon: Not necessarily really on the date there. I think that’s, you know, obviously important. But maybe going back to just the filing of the form in the first place is that there is a way to fix the form not being filed. Unfortunately, it’s expensive. And so, there’s probably been several dozen private letter rulings that have been issued by the IRS that have approved late fillings or non-filings of forms and form 8996s. And so that is unfortunately the only solution really that works and it comes along with not only a cost of having to prepare the submission but also of a filing fee that needs to get submitted to that IRS which can be close to $13,000 depending on the gross receipts of the…at the end of the submitting the form. And so unfortunately that’s the cost of missing that election and/or not making it or not extending the term timely.

Jimmy: So, make sure you file your taxes on time for your QOF.

Valerie: File them on time and correctly, hopefully, right?

Jimmy: Yeah. Do you see a lot of funds elect for a non-January effective date or do the vast majority use January?

Valerie: I mean, I’ve seen it all over the place and some of that again depends on just the timeline of when, you know, they’re planning to deploy the capital. And Gordon, I don’t know if you’ve seen anything different.

Gordon: Yeah, I think, you know, there’s a tradeoff. Like, if you use January basically you’ve…there’s this…you know, we weren’t planning to cover this but there’s this safe harbor basically that the fund has…the first testing dates is a free pass. You don’t have to invest the money. The fund doesn’t have to invest the money on its first testing date. And so, it…the date you pick to make the election could affect, you know, how long you have the free pass available for. And so, it…you know, that’s part of the reason why you don’t necessarily wanna just pick January every time. You know, if the investors didn’t put their money in until July, you’re better off putting in July than putting in January because if you put in January, you’re gonna lose your free pass earlier than you need to.

Jimmy: Yeah, that makes sense, yeah. So, then you get that free pass from July through December, I suppose, right. It’s a six-month fasting period. Right.

Valerie: So, the most important part, I guess, is that you make the date just the earliest deferred gain dollars you received to make sure that you’re matching that timeline. It doesn’t have to really be before but it most certainly should be after.

Jimmy: No, that’s a good rule of thumb. Valerie, what’s our next topic? Gordon just mentioned working capital safe harbor. I think you had a trap there as well that you wanted to cover next.

Valerie: Sure. So, we’re gonna, you know, obviously in a little bit jump into talking about qualified opportunity zone businesses and on other podcasts that you’ve had, people have discussed the two different ways to invest and that you can either just have where the qualified opportunity fund itself is holding the property or the business that is in a zone or it can be invested in a qualified opportunity zone business that is in a zone. And I’m sure you’ve had, like I said, conversations talking about all of the, I guess, kind of pros and cons between using one versus the other but we just wanted to highlight here that for those who’ve decided, “I don’t need that additional structure. I don’t wanna have to file another return or have another tier.” By having the assets held just within the qualified opportunity fund itself, you lose that benefit of that working capital safe harbor. So that working capital safe harbor in addition to that six-month free pass that Gordon was just talking about that the fund receives on the front end, a working capital safe harbor allows the qualified opportunity zone business, you know, time to make improvements or to build new.

You know, they kind of have a longer runway to actually get the work done. But unfortunately, if you’re trying to do everything right at the fund level instead of having that second tier, you do have to be careful that, you know, you are now subject to this testing every six months and you don’t have that flexibility of the working capital safe harbor plan. You need to be deploying that cash and meeting the tests along the way.

Gordon: Right. We’ve even had, you know, conversations with people who have two tier structures that for some reason think there’s a working capital safe harbor available at both the fund level and the business level. And, you know, that obviously, if it was true, would give the fund 31 months to spend the money. But unfortunately, it’s not true and the fund only has 6 to 12 months to spend the money. And so that’s, you know…why it’s on the list of traps for the unwary is just because there does seem to continue to be misconceptions about whether or not there’s a working capital safe harbor available for opportunity funds.

Jimmy: Yeah, sure. And there is at the QOZB level if you’d like to do that two-tier structure which buys you a lot more flexibility. Gordon, you had two more traps for the unwary with regards to qualified opportunity funds. Why don’t you dive into those for us, please?

Gordon: Yeah. One of them I don’t hear really anybody ever talking about and maybe it’s just a technical nuance that, you know, geeky people like me appreciate. But there’s a requirement…in order for an opportunity fund’s investment into the lower tier entity to be considered qualified opportunity zone property, there’s a requirement that investment be made directly into the qualified business solely in exchange for cash. And so, we’ve seen some situations albeit not real common but where, you know, people have either wanted to or actually had done something that would’ve violated that requirement. And so, for example, if the opportunity fund were to contribute property to the qualified business like land or a building or something, that would violate that requirement because it’s…you know, they would’ve acquired their interest in the qualified business, you know, not solely in exchange for cash, right.

Because if you’re contributing cash and property, then it’s not solely in exchange for cash. And so, you would not be considered qualified opportunity zone property. Even if the business satisfied all other requirements of a qualified business, it would not be considered a qualified investment if the investment was not made solely in exchange for cash directly to the qualified business. And so, another situation we’ve seen is where there’s an interest in an entity contributed somehow or that, you know…or somehow somebody contributes an interest in the qualified business to the opportunity fund. So, there are other kinda nuances of, you know, situations where this could come up. Again, it’s not real common but I don’t think very many people really have this on their radar screen. So just something to keep in mind that, you know, that any investment into a lower tier entity in order to be qualified asset of the opportunity fund has to be acquired directly from that lower tier entity solely in exchange for cash.

So that’s one. Any thoughts on that, Valerie?

Valerie: No, I think you’ve covered that well, yeah.

Gordon: Okay, and then the last one. This does come up quite often, is there’s questions about how to value an investment into a lower tier entity that is not a qualified business. And so, you know, there’s often a lot of discussion amongst people, you know, because there’s this 90% test at the QOF level that, you know, some people look at as, you know, a 10% freebie that they can invest 10% of the QOF’s assets into anything they want and it doesn’t have to be qualified, you know, opportunity zone property. And so, you know, so this is kinda where this question comes in, is to the extent that an opportunity fund invests into a lower tier entity that’s not a qualified business. And, you know, they might do that intentionally kind of as a carveout to try to take advantage of that 10%. You know, how do you value that investment? And so, you know, again, I apologize if I get a little technical here but there’s really, you know, a couple of different methods you can use to value your assets for purposes of the 90% test.

One of them is the applicable financial statement method where you basically value it at whatever’s on your financial statements. But you can only use that method if you have an audited financial statement. And so that’s not used very often. And so, the more common valuation method is the alternative valuation method which basically says that you value your investments, you know, depending basically on how you acquired the asset. And so, there’s two approaches. One is if you acquire the asset by purchase or construction, then you use your unadjusted cost basis. So basically, whatever you paid for it. So, if you purchase something, you value it at what you bought it for. And generally speaking, that amount stays the same forever. And/or if you constructed it, you know, whatever you paid to construct it is what your unadjusted cost basis is and that amount stays the same forever. You know, you don’t depreciate it or anything. It’s just basically whatever your unadjusted cost basis is.

You know, and the same thing with an interest in a lower tier entity. If you purchase it, you would use whatever you paid for it to, you know…as your unadjusted cost basis. But then the question comes in…is when you make a capital contribution to a lower tier entity, is that considered a purchase? And if it’s not, then what do you need to value the asset at? And the regs are pretty clear about saying that if the capital contribution you make is to a qualified business, you know, it’s a QOZB, that it’s considered a purchase. And so therefore you use unadjusted cost basis. By the way, if it’s not considered a purchase, you have to evaluate it at fair market value. And so that’s sort of, like, the default. If you didn’t acquire something by purchasing it or constructing it, you have to use fair market value.

And so, there’s somewhat of an unanswered question. I think, you know, the safest, you know, interpretation would be that if you make a capital contribution to a lower tier entity that’s not a QOZB, that you have to use fair market value to value. Because it’s not clear that that’s a purchase. You know, the regs make it clear that a capital contribution to a QOZB is a purchase but they…it sort of insinuates that a capital contribution to a non-QOZB is not a purchase and therefore that you default to have to value it at fair market value.

And so, I’ll give you an example where that could be a problem. So, let’s say you had an opportunity fund raised a million dollars and they invest 900 grand into a QOZB by making a capital contribution and that 900 grand is their unadjusted cost basis and that stays the same forever. And then they put 100 grand into a lower tier entity that’s not a QOZB by making a capital contribution. In that scenario then they would have to value that at least under the most conservative interpretation based on its fair market value. And so, you know, on day one you would pass your 90% test but if that $100,000 investment in your lower tier entity that’s not a QOZB goes up in value, you would then fail your 90% test and be subject to penalties. And so, you know, there are potential solutions to this which, as you mentioned on the top of the show, we don’t really have time to get into but, you know, happy to talk to anybody that is in this situation, you know, regarding some of those potential solutions.

Jimmy: Yeah, that’s very intriguing. How often do you see that where a fund will intentionally invest up to 10% of its assets into non-QOZB entities kinda to take advantage of that 10% rule?

Gordon: It comes up quite often. It’s certainly not more than half but, you know, I’d say maybe, you know, couple of times out of 10. You know, we have…you know, 1 or 2 times out of 10 we might have a fund, you know, wanna talk about that.

Jimmy: That’s more than I would’ve suspected. That’s really interesting. Well, with that…

Valerie: I was just gonna say I think what’s important about everything that, you know, Gordon was just putting out there is that I think especially for smaller funds it’s easy for them to, you know, kinda get it set up. They know, “Okay, I’ve gotta keep my cash underneath this 10% threshold.” And, you know, they feel good about that 90% test. You know, once they kinda get up and running and maybe don’t think about it a lot after that. But based on what Gordon was just talking about and some other things, it is important that you are paying attention to that twice a year every year, you know, once you’ve started the fund until the fund winds down. Because obviously there are all of these little things that can happen along the way that could change whether or not you’re subject to penalties, whether or not something qualifies. So sorry, that was all after that.

Jimmy: No, this stuff is tricky. So again, make sure you have a proper tax advisor to help you assist with all this. Well, let’s move on to our third category which is traps for QOZB as the entity that typically sits underneath a qualified opportunity fund. Gordon, you wanted to talk about triple net leases here. I know there’s been a lot of interest from folks who are used to doing triple net leases and figuring out a way to do triple net inside of a qualified opportunity fund. Is that a go or no-go situation there?

Gordon: Yeah. You know, I think if you manage it properly, it can be done. You know, it really just depends on the definition of triple net lease. So, I guess as a starting point, as you kind of alluded to, there is a prohibition against qualified businesses having triple net leases. However, it’s…you know, there’s some de minimis rules that come into play. And so, I think there’s an example in the regs where if you’ve got a building that’s three stories and one story is leased on a triple net basis but the other two stories are not, that that’s fine. And so, you know, so that’s one, you know, consideration is the de minimis rules is that, you know, you can have triple net leases that are de minimis in the big scheme of things to your business. But if you’ve got a… you know, let’s say a one tenant building, you know, that’s a situation where you…you know, the de minimis rule’s not gonna come into play and you have to make sure that that lease with that one tenant is not gonna be a triple net lease and/or at least the majority of your leases are not triple net leases.

And so, then it gets into the definition of, “Well, what is a triple net lease?” So, you know, what’s important to point out here is that it’s really more based upon who’s responsible to pay for the costs, things like maintenance, repairs and things like that. I’m sorry. Who’s responsible to hire somebody to, you know, to do those things? And so as opposed to who’s responsible to pay for it. So, you can have a triple net lease economically in an opportunity zone business meaning that it’s fine if the tenant, you know, reimburses the landlord for the common area maintenance and other things like that. But the landlord has to be the one engaging, you know, the company to do the repairs and the maintenance, you know, and/or other significant services. The landlord can’t pass all of that stuff onto the tenant because if all the landlord is doing is just clipping coupons with rent every month and the tenant is out there engaging somebody to do the repairs and the maintenance and all that stuff, then that’s what’s considered a true triple net lease where it would be, you know…that could invalidate your QOZB.

But if the landlord is hiring those people and getting reimbursed on the tenant, that’s okay. So, a lot of people would…

Jimmy: Is the issue essentially, Gordon, that it has to walk and talk a little bit like an active trader business essentially?

Gordon: Yeah, exactly. The qualified business has to be doing more than just collecting a rent check every month. And so, to the extent that they’re responsible to go out and engage somebody to do repairs and engage somebody to do maintenance, then that’s more like an active business and therefore it would be eligible. But if they’re contractually, like, delegating those responsibilities to the tenant, then it would be considered more like, you know, clipping coupon investment, like, almost investing in bonds, you know, or something like that. And those are clearly ineligible. And so, it’s really trying to distinguish, you know, how actively they’re involved in managing, you know, the business.

Jimmy: Right, right. Well, what else do you have for us, Gordon? Traps for QOZBs.

Gordon: Yeah. So, another one that is somewhat surprising but it’s just the way things are unfortunately. I say surprising because it’s, I would argue, inconsistent with the intent of Congress in putting this statute together, is that if you’ve got a qualified business that owns property that’s considered ineligible for some reason, either…maybe for example they owned it before the opportunity zone legislation came into play because in order to be opportunity zone property, it has to be acquired from an unrelated party after December 31, 2017. And so, you know, if you’ve got a business that owned property before that date, then it’s considered ineligible property. And as I mentioned, it has to be acquired from an unrelated party. And so, another situation we see is where a business acquired property from related party after December 31, 2017 or maybe where it…it also has to be acquired by purchase too. And so maybe it could be that the property got contributed by a partner.

So those are probably the three most common situations we see. Either they owned it at December 31 already, they acquired it from a related party or it got contributed as a capital contribution. The IRS is very clear that any improvements that you make to an ineligible building are also considered ineligible and they state that in the preamble to the regulations. And so, there’s probably a distinction here because I think most people would view that as being interpreted differently in a situation where the ineligible property is just vacant land. So, if, you know, somebody owned vacant land on December 31, 2017, I think most people would view that…if you build a building on that vacant land, that’s eligible because it’s distinguishable. It’s a building versus land. But if you owned a building on December 31, 2017 or you acquired it from a related party or whatever and you make improvements to that building, the IRS says that that is…any improvements that you make to that building are ineligible.

And so, you know, we see a lot of that with, say, historic buildings that are, you know, that are, you know, ineligible for some reason that, you know, people would wanna rehab them and place them back into service but unfortunately any improvements that you make to that building are considered ineligible. And that’s important because, you know, you could potentially still pass the 70% test if you could count the improvements as eligible. I mean, the math’s a little harder than the typical, you know…you’ve gotta double your basis. I think it turns out to be more like 2.4 times, you know, in order to pass the 70% test but at least you had a million-dollar asset that you spent 2.4 times improving, you would pass the 70% test if you were allowed to count those improvements as eligible property. But the IRS says, “No, no. Those are not eligible property and therefore, you have to be a qualified business.”

And like I said, you know, that seems contrary to the intent of Congress to encourage taxpayers to make investments in the opportunity zones. And, you know, the reason the IRS gave for why they take that position is they said it’s too hard to track which I think is a bit of a joke. But maybe at some point they might reconsider their opinion on this but, you know, we try to steer people away from taking that issue head on because you don’t wanna be…yeah.

Jimmy: That is too bad that that type of improvement wouldn’t qualify. Valerie, you were gonna chime in, I think.

Valerie: I was just gonna say especially when the program first came out and we were, you know, trying to explain this to groups. There were a lot of people who were upset because they were excited to find out that they had property that was in an opportunity zone census tract, right. And they were like, “Oh, I’ve got this great project that I can do with this property.” And so, they were upset to find out that the way it is written, it kinda felt like they were being left out. Now getting to the comment you made at the top of the program, we have some ideas on ways that, you know, you could still make opportunity zones work for that property but it’s not as beneficial and it’s not as all-in as it would be if the IRS hadn’t taken that position.

Jimmy: Right. Right. Well, now Valerie a few minutes ago covered working capital safe harbor at the QOF level and applying it to a QOZB. Gordon, you had some more thoughts on working capital safe harbor.

Gordon: Yeah, really the trap is really more from a documentation standpoint that, you know…I think too many people think that you’re just by right allowed to have a working capital safe harbor where you have 31 months to spend the money. But there’s three requirements that you have to meet in order to be entitled to that 31-month period. And if you don’t meet those requirements, then you aren’t eligible for the 31-month period. And so that’s the trap, is to be aware of the fact that there are requirements in order to be qualified for the safe harbor. And they’re generally related to documentation. So, you have to have a written plan that shows, you know, how you’re expecting to spend that money and when you’re expecting to spend the money. So, you also have to have written schedule that shows when you’re expecting to spend the money. And then you basically have to comply with the, you know, with the schedule.

And so, you know, there are some rules related to amending plans although it’s a little unclear. You know, that’s another potential trap is when and if you’re allowed to amend a working capital safe harbor plan. But, you know, the first kinda point related to, you know, traps on the working capital safe harbor is just to be aware that there’s a requirement that you have, you know, documentation that shows that there…you know, contemporaneous with when you started the plans. So basically, when you receive the money, you should have a written plan in place and a written schedule showing, you know, how and when you’re expecting to spend that money. And so that’s the first prong. And then the other is that there’s been several updates, I guess I’ll call it, to the regulations since they were finalized. And one of the updates introduced a concept of startup businesses with respect to the working capital safe harbor plans. So that was not a requirement or that was not a concept that was built into the original final regulations. It was one that the IRS came up with as…I think it was a correction to the regulations.

And so, there is a distinction between startup businesses in terms of how the working capital safe harbor works. And so that’s another trap that we see people getting caught up in partly because they, you know, they remember the rules that were adopted when the initial regulations were finalized and maybe might not be aware of the fact that the IRS has changed the rules since then to introduce the startup business concept. But I think that one of the biggest distinctions there is that the working capital safe harbor period…sometimes you can have stacked two different working capital safe harbor periods on top of each other. So, if you, you know, have a second infusion of cash, you can have, you know, overlapping or, you know, sequential 31-month periods. But that’s only available for startup businesses. And so, if you’re not a startup business, you don’t have the ability to stack the working capital periods on top of each other or overlap them.

And so, you know, that’s a potential trap that people might think they have the ability to stack them but they don’t if they’re not a startup business. And then there’s also a presumption that during the working capital safe harbor period that you satisfy the 70% test. And it’s also…that’s another distinction here for startup businesses. So that’s only true for startup businesses. So, if you’re not a startup business, then you don’t have the presumption that you automatically pass the 70% test during the working capital safe harbor period. So, you actually have to pass the 70% test during the startup period. So those are important traps for people to be aware of too if they have businesses that are not startup businesses.

Jimmy: Yeah, and of course that begs the question what is a startup business. How is that defined? We don’t need to get into that right now. We also didn’t even touch upon the fact that the IRS changed the working capital safe harbor periods during the COVID pandemic because they were declared disaster emergencies across the country and I think those may have changed once or twice. But suffice to say we don’t need to cover that right now but there’s a lot more nuance to working capital safe harbor plans that you should be aware of. But anyway, let’s move on to our next topic because I don’t wanna draw this out for too much longer.

Valerie: Yes.

Jimmy: But Valerie, I’m gonna turn to you here with this next one. So, opportunity zones obviously are a place-based tax policy and the different geographies that are eligible to receive this type of investment are census tracts that have been designated as qualified opportunity zones. But those census tracts are bounded to the 2010 census map. Just a couple of years ago we got a new map reflective of the 2020 census and some of the boundaries changed a little bit. Some of the census tracts actually changed on the map. What are the implications of that, Valerie?

Valerie: Right. So, it’s really, you know, just making sure that you’re paying attention to the right year’s census tracts when you’re looking, especially for somebody who’s purchasing property, you know, now. If you’re doing it based on the 2020 census tract, you might not be in an eligible property. So, this one was kind of a quick hitter. Just make sure that you’re looking at the right years of census tract data which most of the tracking tools that are out there, you can specify which year census you want to search by. So just making sure that where your property is, is actually in an eligible opportunity zone census tract because obviously it will be disappointing to find out later that it wasn’t. So just wanted to make sure people are being cognizant of making sure they’re looking at the right year for that.

Gordon: Yeah, and just to be clear on that. So, if the census tract expanded for example or merged maybe, you could be in a census tract that is on the list of eligible census tracts but actually not be eligible for opportunity zone benefits because your property is in a portion of the census tract that wasn’t in the census tract in 2010 and therefore, you’re not eligible for any benefits. You’re only eligible if you’re in the portion that was, you know, actually in the census tract in 2010, if that makes any sense.

Valerie: Right. Yep.

Jimmy: That does make sense and I would encourage my listeners and viewers…a quick plug here. We have a mapping tool at Opportunity DB. You can find it at opportunitydb.com/map. And our map is locked into the 2010 census. So, you’ll know if you plug in an address or you wanna zoom in and around on the map, you can see for sure whether or not the area is shaded blue which means it’s an opportunity zone on our mapping tool or not. So, with that, Valerie, I think we’ve got one more trap for QOZBs and it deals with IRS form 8996 again which I know QOFs are supposed to file but do you see QOZBs file them and is there a problem with QOZBs filing them?

Valerie: Yes, there is. So, this one I will admit obviously doesn’t happen a lot, hopefully. And we’ve seen it on a couple of clients that we’ve inherited, right. So, you know, if somebody had already set up the QOZB, set up their QOF and then we kind of see them down the road and just based on maybe just misinterpretation of what they were supposed to do, they filed the form 8996 for both the qualified opportunity fund and the qualified opportunity zone business. And the regulations make it clear that a fund cannot invest in another fund. So essentially, right, this QOZB has now made an election to be treated as a fund which kind of foils the whole thing up. This one unfortunately I don’t think it’s as clear…the late filing for a QOF, obviously Gordon reference to that. You know, you could do a private letter ruling which while it’s expensive is at least a solution. Unless I’m wrong, Gordon, I don’t think we have an easy solution. We have some thoughts on what may or may not work but I don’t think we yet that’s a solution for what happens if you accidentally certify a QOZB as a fund.

Gordon: Right, yeah. It’s not really clear. Part of the problem is that there is, you know…there’s no guidance from the IRS and there’s an… you know, as best we can tell, this has happened a fair amount because the IRS issued an announcement a couple of months ago saying QOZBs should not file form 8996. So, like, I don’t think they would’ve done that if they hadn’t been seeing a fair number of those forms being filed. But at this point, they haven’t really provided any guidance as to how to fix that situation. So, you know, like Valerie said, we’ve got some thoughts that we suggest people kinda follow in that situation but there’s not a 100% certainty that, you know, our recommended strategy’s actually gonna work. But hopefully at some point we’ll get some guidance from the IRS on that.

Jimmy: Yeah, hopefully sooner rather than later. And just one note from me. I did cover that topic extensively with Kirk Walton on a podcast episode that I recorded with Kirk last year. I’ll be sure to link to that episode in the show notes for today’s episode if anybody wants to dive into that topic further. We went over a lot of the numbers. And that’s a little bit old now because we were using numbers from 2020 and 2021, I believe. Not anything new from 2022. But still kinda a good overview of that particular topic of QOZBs wrongly filing the form that’s intended for QOFs and then making it look like QOFs had investments into other QOFs. But that kinda covers our top three topics, traps for the unwary for the investors, for qualified opportunity funds and for qualified opportunity zone businesses. We’ve got a handful of other traps, just kind of a grab-bag of other traps that opportunity zone stakeholders should be aware of. Gordon, do you wanna walk through these last remaining topics?

Gordon: Yeah, yeah. So again, it’s a bit kinda jumping around here because they are just miscellaneous potpourri type traps to be aware of. One we see quite often is that cash doesn’t flow consistent with the way the structure is intended. So, you know, people like to take shortcuts. And so, you know, for example, you know, instead of putting the money into a QOF and then the QOF putting it into the QOZB, can I just put it right into the QOZB and then just record it as if it went into the QOF and then the QOZB? So that sort of thing. And so, you know, or, you know, even more like, “Can I just, you know, transfer money directly to the seller of the property, you know, from my personal account and not have it go through the QOF and the QOZB?” You know, we see that sort of situation. Both, you know, people asking us before they do that or don’t do that and/or sometimes they just do it, you know. And so, you know, I would recommend people, you know, try that as much as possible, have cashflow consistent with the way the structure’s intended. That will absolutely mitigate any risk that you have that, you know, the IRS might blow up, you know, all of your, you know, benefits. It’s not worth…

Jimmy: You wanna create that paper trail, right?

Valerie: Yes.

Gordon: Exactly. Yes.

Jimmy: Yes. Yeah.

Valerie: Yeah, and a couple extra seconds of moving cash around is easier than having to deal with the whole thing being work on the back end.

Gordon: Yeah. And unfortunately, my understanding is it does take some time to get bank accounts set up sometimes. And so, you do have to plan ahead.

Valerie: Is working, Gordon.

Gordon: Right. Yes. Yeah. Yeah, with the whole know your customer roles and stuff. It’s, like, you’ve gotta plan ahead and make sure each of the entities have a bank account. And so that’s maybe one of the things, you know, to avoid putting yourself in this situation because sometimes you get to closing and it’s like, “Well, I can’t move the money the way I want to because I have to close it and I don’t have a bank account.” And so, you know, think about that ahead of time. So that’s, you know, maybe another on this one.

We also have, you know…people on occasion, you know, forget basically that there’s limitations to the number of tiers of entities you can have in these structures. Basically, the most you can have is the taxpayer that have the gain, an opportunity fund and a qualified business. I mean, if you’ve got more tiers than that, you’ve probably got a problem somewhere. And so, unless it’s a disregarded entity. You can have more tiers than that if there’s disregarded entities involved but basically, you know, if you’ve got more tiers than that and there’s no disregarded entities, then you’ve got a problem and it’s probably something you need to, you know, consult with somebody on how to fix or how to avoid that issue. So that’s kind of a quick hitter like Valerie mentioned the other one.

We also see, you know…and this is a way more broader topic than I’m gonna get into but related party transactions are also a problem. There’s generally only two places where the related party rules come into play. One is when you generate the gain that you’re investing in the opportunity fund. It can’t be from a sale to a related party. The other is when the opportunity fund or the qualified business is acquiring an asset. You know, if the asset’s required from a related party, then it’s not a qualified asset. And so that’s generally speaking, you know, where this first kinda trap comes in, is when you’re acquiring assets from, you know, potentially a related party. And what’s not obvious is that that could include things like…and people think about buying a building from a related party but it can also include services. So, for example, if you have a related party construction company that you engage to build your building or to make improvements to your building, that’s arguably a related party transaction and the cost associated with that would arguably be ineligible.

And so again there’s kinda solutions and workarounds to that but just being aware of the fact that when you’re engaging a related party to perform services that end up getting capitalized as part of a tangible property, that that is arguably an ineligible asset and being conscious of the fact that you’ve only got 30% of your, you know, of your tangible assets can be ineligible. And so, you need to make sure that whatever you do, you keep those related party services and such below the 30% threshold. So, you know, that’s something we see fairly frequently. You know, particularly in what I’d call captive, you know, opportunity funds where, you know, somebody, a developer has their own capital gains and they’re investing into their own project and that sort of thing. So that’s something to be conscious of.

And the other one is maybe a little bit more broader but I don’t hear a lot of discussion about this, is that, you know, as most people know, the threshold for being related in this is 20%. So, to the extent there’s common ownership that’s, you know, more than 20%, then that’s considered a related party. But what’s not really clear is how do you determine whether somebody’s more than a 20% partner when you’ve got a partnership that has a complicated waterfall? So, and most of these deals have partnerships with complicated waterfalls. And so, I don’t hear much, any discussion about that. And so, you can’t just look at bottom line profit sharing and say, “Well, the bottom-line profit sharing is 20% or less. Therefore, we’re not a related party.” You know, when you’ve got complicated waterfalls. And so, I don’t know that there’s a definitive answer to this, unfortunately but it’s something to be aware of is that, you know, don’t just kind of, you know, on the surface look at, you know, some bottom-line profit-sharing ratios and make a conclusion as to whether somebody’s related or not.

You really need to dig into more of the details on, you know, who really is gonna be getting, you know, profits and how much are they gonna be getting and does that potentially create exposure that somebody’s related when you might not have otherwise thought that they are or vice versa. So, you know, that’s a trap, is people just not really appreciating that. It’s not quite as simple determining who’s a 20% partner or not than you might think.

Jimmy: Hard to know if you’re dealing with a related party or not in some cases. That’s interesting. I think you’ve got just a couple more traps for us.

Gordon: Right. Just really one more and I think most people know about this or a lot of people do. But there’s a provision that…I guess in the regulations they call it a disguised sale. And so obviously you wanna avoid that. It sounds bad, right. But so, the regulations basically say if there’s a debt finance distribution that occurs within two years of making your contribution or capital contribution to a QOF where you basically get money back from the QOF within two years and the money that you got back came from a debt financing, then that’s basically treated as if you never made the investment in the first place. And so, you know, just being conscious of that, that you wanna avoid having any sort of distribution going out to a QOF investor that was debt financed within two years of when the money came in. And so, you know, it’s easy enough to make sure that you wait, you know, more than two years because, you know, 25 months is fine but 23 months is a problem.

And so, you know, just being aware of that requirement and the restriction so that you can avoid that trap is important.

Jimmy: Well, Valerie and Gordon, this has been great. You know, on its surface, investing in opportunity zones is pretty simple. It’s a pretty simple concept. You know, defer capital gains by rolling them over into a qualified opportunity fund that invests its capital into qualified opportunity zone businesses which puts its dollars to work in economically downtrodden communities. But, you know, when you dive in and look at the subtle nuances here and there, there are quite a few traps for all of the different levels of that structure. The investor, the fund and that bottom tier QOZB as well. Really appreciate both of you sharing your insights on opportunity zones today and traps for the unwary. Before we go, where can our audience of high-net-worth investors and advisors go to learn more about you and the services that you offer at Plante Moran?

Valerie: Sure. So www.plantemoran.com\opportunityzones is where you can find all of the opportunity zone content that we’ve pushed out. And then, Jimmy, I’m sure you’ll be sharing our email addresses as well if anyone would like to contact us directly.

Jimmy: I will indeed. I’ll be able to share those on our show notes page available at opportunitydb.com/podcast. I’ll have all the links to all of the resources that Valerie and Gordon and I discussed on today’s show. And also, please be sure to subscribe to us on YouTube or your favorite podcast listening platform to always get the latest episodes. Gordon and Valerie, again, thank you so much for joining me today. Really enlightening.

Valerie: Thank you.

Gordon: Thanks.


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