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Compliance Requirements vs. Best Practices in OZ Fund Management

Earlier this year, NES Financial EVP Reid Thomas published an article in National Real Estate Investor titled “The Three Keys to Long-Term Success in the Opportunity Zone Program.” In this piece, Reid argued that the long-term fate of the OZ program will depend on industry self-regulating to avoid the pitfalls that have plagued other well-intentioned U.S. economic development programs in the past.

Now, with the finalization of the two sets of recently published proposed regulations underway, as well as new legislation proposed that would add reporting to the OZ program, we sat with Reid to discuss current compliance requirements in OZ, the high-bar best practices that fund managers should implement, and the motivations that bind all OZ stakeholders together.

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Q: Reid, thanks for speaking with us. To start things off, insofar as they’ve been established at this point, what are the compliance requirements that OZ fund managers are beholden to?

A: To begin with, these are securities, so they need to comply with all SEC regulations. In addition to the OZ tracking and reporting requirements, Opportunity Funds must follow all the same rules as traditional private equity funds.

Beyond that, there are relatively few actual requirements. And that’s a good thing, because it makes it easier for fund managers to set up funds and for investment capital to flow. But it also has the potential for negative consequences, because it leaves the door wide open for abuses. Ultimately, those abuses could lead to a drop in investor confidence, a lack of capital flowing in, and the eventual failure of the program. So the simplicity of the regulations cuts both ways.

Here are a few of the OZ compliance requirements that do exist: First, there is a biannual reporting requirement, on June 30 and December 31, at which point the fund has to certify that 90% of the assets invested have been deployed into Opportunity Zone property.

Second, once the money is invested at the property level, the fund needs to satisfy either the “original use” test — essentially meaning that it’s a new property — or the “substantial improvement” test — which, in this context, means they must make improvements to the original building equal to its purchase value. In either case, you can’t use the invested capital all at once. So, to qualify for tax compliance, the fund has to deploy the capital down to the project level, and then the project has 31 months to actually use that capital.

There are other requirements for operating businesses in OZs — for example, they must make at least 50% of their gross income from activity within the OZ; otherwise, 50% of their wages or hours must come from revenue earned within the OZ.

These OZ compliance requirements are expected to be finalized very soon.

Q: Let’s talk about best practices. You’ve been an advocate for the OZ industry to adopt a high-bar operating standard, such as those found in other, more established financial industries. In what areas do you see a need for OZ funds to adopt best practices?

A: This is a new industry, but there’s so much that OZ fund managers can and should learn, both from private equity and other location-based economic development programs. Clearly, all stakeholders — communities, investors, OZ businesses, fund managers, legislators, etc. — want the program to succeed. Even in the absence of final regulations, these stakeholders know what a mature, responsible approach to fund management looks like, because they have examples in other successful industries. Security, transparency, and compliance built into the fund’s operations at every step — that’s what smart OZ investors are looking for.

In terms of OZ-specific best practices: investors are drawn to OZ for a number of different reasons — one of which, surely, is the tax benefits that the program can deliver. So, to think about it from an investor perspective, there are a number of things that would help an investor substantiate that they qualify for the tax deferral (and, eventually, tax forgiveness):  (1) A comprehensive audit trail, to show that the fund’s businesses or properties met certain timeline requirements. (2) Evidence that the fund actually made a “substantial improvement” to the property. (3) Tracking the dates associated with tax benefits, because there’s a basis step-up at 5 years and another at 7, with exclusion of the appreciation of the investment occurring at 10 years. Ideally, as a best practice, the investor should be able to go to their portal and print all the documents that they might want as supporting evidence for their tax return.

Q: What about stakeholders on the other side — communities and legislators? What do they want from OZ fund managers?

A: For the legislators that created the program, and for the communities it’s intended to benefit, impact tracking and reporting is going to be very important. Are OZ investments really benefiting these local communities? How many jobs are they creating? Are they changing the housing landscape, or the affordability landscape?

Although social and economic impact tracking aren’t OZ compliance requirements (yet), at NES Financial we’ve been very focused on building these capabilities into our platform. There are various approved economic algorithms that the government uses, and there’s some overlap with the models we’ve used in EB-5. The idea is that, soon, we’ll be able to collect a variety of data from publicly available sources, then compare that against the historical data for a given census tract to measure the impact of OZ investments in more or less real time.

Q: If OZ fund managers don’t set a high-bar compliance and operating standard from the outset, what do they stand to lose?

A: Well, outright failure of the program is certainly one risk if we don’t take this seriously from the beginning. If the OZ incentives don’t create the economic benefits that the architects of the program envisioned, the program will not be extended. It’ll just be allowed to expire. No one wants to see that happen.

There’s also a cost argument to be made — insource vs. outsource, now vs. later. Even if additional government requirements don’t emerge down the line, we think the best practices discussed here will be key differentiators in the marketplace — investors will want their tax reporting to be as simple as possible, and to know that their investments are making a positive social impact. Developing these capabilities in house, or retrofitting an administration platform to provide them in the future, will be more expensive than setting up a forward-looking third-party solution from the outset.

OZ fund managers should also consider the risk of investor litigation if they fail to meet certain criteria. If an OZ fund fails to do the appropriate tracking, and therefore can’t demonstrate compliance, that could easily lead to their investors losing the expected tax benefits. And that could have enormous ramifications.

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If you’d like more information about NES Financial’s purpose-built Opportunity Zone Fund Administration, please take a look through our web-based OZ resource center — or feel free to contact us at 1-800-339-1031.