LossOpportunity Zone Investing (Passive Angle)

When a QOF never breaks ground, the 90 percent test penalties come out of the investors' distribution.

Here is a loss worth studying, laid out as a 2021 case. An investor sells two assembled parcels for a gain of about $210k and goes into a QOF whose whole plan is 60 acres inside a designated tract, bought for around $2.1M, entitled for build to rent, phase one to start within twelve months. It appeals to someone who knows land and believes they are underwriting something they understand. What does not get underwritten is whether anything will actually get built, and that is the part that matters, because raw land held without improvement is not going to carry this program's requirements on its own. The qualifying property side generally turns on original use or substantial improvement of the acquired property, and how that applies to a specific asset is a question for a tax attorney, which investors in this position usually learn by paying one. What happens: phase one does not start in year one. Or year two. The sponsor keeps saying the GC number is moving and they are re-bidding. Meanwhile the fund sits on land and cash. It misses the semiannual asset testing threshold at two dates, and there is a penalty for a shortfall, which the fund pays out of fund assets, which is to say out of the investors. Nobody gets a clean number for it. A best reconstruction from the annual statements puts it somewhere between $18k and $24k of fund level penalties across those periods, on a fund where this investor's share is about 9 percent. Early 2024 the manager sells the 60 acres for about $2.35M. After carry, property taxes on raw ground for three years, the penalties, the sponsor's fees and the disposition fee, the investor gets back about $189k on $210k. And the deferred gain comes due at that point, since the fund sold and distributed. Roughly $46k federal and state for this investor. So: $21k of principal gone, $46k due, three years, and no appreciation to exclude because there was none to speak of, and a three year hold would not have qualified for the long hold treatment anyway. What to do differently: no wire until there is a signed GC contract and a permit in hand, with dates. "Entitled, phase one to start within twelve months" is a sentence rather than a schedule. And ask what the fund's plan is for holding qualifying property between acquisition and construction start, because that gap is where the penalties live.

nicole_adeyemi SS3APRO 13

Answer

priya_n21 PB2BPRO 21

You underwrote the tax wrapper and the dirt. Nobody underwrote the construction, and construction was the only thing that made the tax wrapper function. That is the whole loss in one line, and it is not a land expertise problem. You probably knew more about those 60 acres than the sponsor did. What was missing is the thing an LP cannot check from the outside, whether these people could get a shovel moving in a market where bids were climbing every quarter. A signed GMP contract and a pulled permit before wiring is exactly right, and one more question belongs next to it: the two prior projects where they went from land close to construction start, and how many months each took. If the answer is that this is their first, the twelve month schedule is a hope. The penalty piece nobody could put a clean number on is worse than the $21k. A fund that cannot tell an investor what a compliance shortfall cost, in dollars, at which testing date, has an accounting problem separate from the construction problem. That question belongs in writing before anyone wires, phrased as has this fund or any prior fund of yours failed an asset test, and what did it cost.

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priya_n21 PB2BPRO 21

3 replies

devon_pierce SS4APRO 15

The land piece is the part worth understanding precisely. Land acquired inside a zone doesn't carry the program on its own. Original use is a building concept, the substantial improvement test is measured against the basis of the building rather than the land, and the regulations specifically decline to reward land held with no real intention to improve it. A fund holding dirt has to be actively improving it to work. Which means land banking in an opportunity zone is close to a contradiction, and it still gets pitched. How that applies to a particular fund's facts is an attorney question. @nicole_adeyemi did the sponsor ever explain how they thought the holding period worked?

devon_pierce SS4APRO 15

ehernandez74 PC3BPRO 12

@priya_n21's question about prior land-close-to-construction-start timelines belongs permanently in the file on any land fund. @nicole_adeyemi the thing worth knowing is whether the operating agreement gave the manager any obligation to start construction at all, or only permission. Read closely, most of these documents turn out to be all permission. The manager may do everything and shall do almost nothing. If that is what yours says, three years of re-bidding sat fully inside the deal as signed, which is a harder thing to sit with than a sponsor who broke a promise.

ehernandez74 PC3BPRO 12

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