Qualified Opportunity Fund: Single-Tier vs. 2-Tier Structure

Over the past several months, I have been investigating whether I need to move from a single-tier Qualified Opportunity Fund (QOF) structure to a 2-tier QOF structure.

Please note: my discussion of tax law below should not be interpreted as legal advice. As always, you should consult your legal and/or tax advisor for advice on how this law may apply to your personal circumstances.

Under the basic Qualified Opportunity Zone (QOZ) tax statute (Internal Revenue Code Section 1400Z-2), a QOF is “any investment vehicle which is organized as a corporation or partnership for the purpose of investing in qualified opportunity zone property…,” which is defined as either:

(i) qualified opportunity zone stock;

(ii) qualified opportunity zone partnership interest, or

(iii) qualified opportunity zone business property.

My intention for my QOF was to invest in real estate, which comes under the definition of (iii) above, qualified opportunity zone business property (“QOZBP”). The CPA who I was working with indicated that setting up an LLC taxed as a partnership as my QOF entity and acquiring real estate directly from the QOF as QOZBP would work fine. This structure is what I will refer to in this article as a single-tier or direct structure.

If you are investing in real estate as your QOZ business, then you could invest in property directly from your QOF or you could form another entity below your QOF which invests in real estate. That entity is known as a qualified opportunity zone business (“QOZB”). Per the QOZ tax statute, the QOZB is a “trade or business” in which substantially all of the tangible property owned or leased by the taxpayer is QOZBP. By setting up a QOZB, the QOF is investing in either (i) qualified opportunity zone stock, or (ii) qualified opportunity zone partnership interest, as noted above. This structure is what I will refer to in this article as a 2-tier or indirect structure.

So what is the difference, you ask, between a QOF and a QOZB? If you are investing in real estate, either a QOF or a QOZB could acquire the QOZBP real estate assets. However, if you use a 2-tier structure, there are some distinct advantages:

• -- The QOF has an asset test every 6 months whereby its assets must be 90% held in QOZBP. Unless the QOF has identified QOZBP assets to acquire within 6 months of eligible gain going into the QOF, it could be challenging to satisfy the 90% asset test at the QOF level. After the first 6 months of an eligible gain contribution, cash in the QOF would be considered a “bad asset” in that it would be included in the denominator but not in the numerator for determining whether the QOF has reached the 90% threshold. The QOZ tax statute imposes a penalty for each month that the QOZBP ratio falls short of 90%.

• -- By contrast, at the QOZB level, QOZBP assets can be at a lower ratio of 70% of tangible property assets to be compliant. This provides more breathing room in the event that the QOZB has extra cash that has not been invested into QOZBP.
  Note: the QOZ tax statute and regulations provide some additional income and asset tests at the QOZB level; if you are owning and leasing QOZ real estate as your QOZB, then the 70% test is the most relevant (although the others cannot be ignored).

• -- In addition, the tax regulations provide a 31 month working capital safe harbor at the QOZB level which allows for cash designated as working capital in the QOZB to be excluded from the denominator of the 70% asset test. Most of the tax commentary that I have seen and heard on this allowance takes the position that the 31 month working capital safe harbor is only available to a QOZB and not to a QOF.
  
  
• -- If a QOF investor intends to invest in existing QOZ properties and then substantially improve them in accordance with the tax statute and regulations, then having the 31 month working capital safe harbor at the QOZB level can be beneficial indeed. It provides more time to look for an appropriate property at the front end. Once a property is acquired, the QOZB can then hold cash needed for the rehab work to occur over the following 30 months (the time allowed for substantial improvement post acquisition under the tax statute) without running afoul of the 70% asset test at the QOZB level.
  
  
• -- Note that if a QOZB is taking advantage of the 31 month working capital safe harbor, the tax regulations require a written statement that the capital is designated for the development of a trade or business in a QOZ (e.g. operating real property) as well as a reasonable written schedule showing that the working capital assets will be spent over 31 months. The QOZB also has to show that the capital was in fact spent substantially consistent with the written statement and schedule.

Based on these benefits at the QOZB level (a lower QOZBP asset threshold of 70% and a 31 month working capital safe harbor), it makes a lot of sense to start with a 2-tier indirect QOF/QOZB structure, especially if you intend to acquire older properties and substantially improve them. But what is the downside (and why did I start with a single-tier QOF structure)?

In my opinion, the main downside is the added cost and administrative overhead of a 2-tier structure. If your QOF is relatively small, e.g. husband and wife as LLC partners investing in 1-4 unit rental properties, then maintaining 2 entities instead of 1 can get a bit burdensome.

Administrative overhead can include filing fees to set up the entities, annual fees for using a registered agent service (if outside your home state), extra tax return and compliance fees, and time spent on maintaining corporate formalities for both entities (meeting minutes, board resolutions, business plans, bookkeeping, multiple bank accounts, etc.).

My Situation: moving from a single-tier to a 2-tier QOF structure

For my own QOF, I started out with a single-tier structure to avoid the cost and administrative overhead mentioned above. I had a game plan for deploying the eligible gain into QOZBP within the first 6 months of contributing it to the QOF and staying over the 90% threshold for the first year. My game plan focused on acquiring new construction QOZ properties built on vacant land that would qualify for “original use” under the tax rules. Since I didn’t need cash to substantially improve an older property, I paid cash for these new properties up front so that I could meet the 90% test in the first year of operation (see my blog post here on what I bought). My initial set of properties were completed and started cash flowing within 30-60 days of completion. Life was good.

Now in Year 2 of my QOF, I have realized that maintaining the 90% threshold is challenging. First, I have cash flow coming in from renting out the properties which puts pressure on that threshold. Because of the way the QOZ and partnership tax rules work, I can’t necessarily move that cash out of my QOF at this time (mainly due to basis limitations on the deferred gain). More importantly, I plan to do a cash-out refinance of my existing properties as well as contribute new eligible gain so that I can acquire more QOZBP in the future. I want to have the option of acquiring older properties and substantially improving them. As laid out above, the working capital safe harbor at the QOZB level provides more time to identify a property and rehab it without falling under the 70% QOZBP threshold.

For these reasons, I decided to move forward with setting up a new QOZB entity. After consulting with a few lawyers and CPAs, I set it up as a partnership with the QOF entity holding a 99.9% interest and our family trust holding a 0.1% interest. I took an eligible gain that I contributed to the QOF this year (and was not yet invested in QOZBP) and moved it into the QOZB so that it has the benefit of the 31 month working capital safe harbor. Now I can move forward with a cash-out refinance of my original QOF properties and move that cash into the QOZB while I shop for my next set of investments.

One note of caution that I got from my advisors: leave my existing QOZBP properties in the QOF entity. Don’t move them into the QOZB so as to avoid the risk of a deemed related party transfer that could taint those QOZBP assets and invalidate the tax benefit associated with them. Only acquire incremental QOZBP assets in the QOZB.

Based on my QOF experience to date, here is my thinking on whether to use a single-tier or a 2-tier structure:

• -- A single-tier structure can work if:
  (i) you plan on using your eligible gain to acquire a single property in your QOF; and
  (ii) you have a high probability of acquiring the property within the first 6 months of establishing your QOF; and
  (iii) you use most of your eligible gain on a property that can either qualify as “original use” in the QOZ, e.g. new construction on vacant land, or you use most of your gain toward the acquisition and substantial improvement of an existing property within the first 6 months (to satisfy the 90% asset test).
  However, once the property starts producing cash flow, you have to figure out how to get cash out so as not to fall below the 90% asset test every 6 months. An attorney and/or CPA can probably advise you on ways to get cash out while staying compliant.
• 
  
• -- A 2-tier structure is preferred if:
  (i) you plan to acquire multiple assets and you will need more than 6 months to shop for, acquire, and substantially improve (for existing property) those assets such that you will be below the 90% QOZBP threshold after the first 6 months of your QOF and beyond (unless you calculate that the associated tax penalty is manageable); and/or
  (ii) you may have future cash infusions from refinancing existing QOZBP assets or from incremental eligible gain contributions.
  
  

Key Takeaways

• -- A single-tier QOF structure is simpler and requires less administrative overhead, but a 2-tier structure provides much more flexibility for you to grow your QOF real estate investment portfolio over time.
  
  
• -- Whether you decide to go with a single-tier or a 2-tier structure, the process starts by contributing your eligible gain to a QOF.
  
  
• -- From a timing standpoint, if you have eligible gain that you need to invest quickly to meet the statutory deadline (usually 180 days from the date of realizing the gain), then start by getting your QOF entity set up and contributing your eligible gain to the QOF. You will then have 6 months to either acquire property directly from your QOF in a single-tier structure (to satisfy the 90% asset test) or move to a 2-tier structure by setting up a QOZB entity underneath your QOF and moving your eligible gain from the QOF to the QOZB.
  
  
• -- If you move to a 2-tier structure, you then have another 31 months to deploy the capital into QOZBP and substantial improvement expenditures (if applicable) provided that you put in place a written statement designating the capital for the development of a trade or business and a written schedule for expenditures over the 31 months. Then go and execute your plan substantially consistent with your written statement and schedule, and your 2-tier structure is ready to grow.