After months of labor negotiations, in May 2019 the Baltimore Symphony Orchestra (BSO) cancelled its 2019 summer season, resulting in a lockout for the musicians. And on July 16, 2019, the National Philharmonic announced it will close due to budgetary concerns.
Earlier in 2019, the Chicago Symphony Orchestra resolved the longest musician strike in its 128-year history, which kept concerts silent in the Windy City for seven weeks. In 2016, both the Pittsburgh and Philadelphia Orchestras went on strike. In 2012, Minneapolis Orchestra musicians were locked out for 488 days, more than an entire performance season. Since 2010, Detroit, Atlanta, Indianapolis, San Francisco, Philadelphia, Fort Worth, and Pittsburgh orchestras also have been shut down, mostly due to labor disputes.
Unfortunately, it’s not unusual or even new for symphony orchestras to suffer financial woes. In 2017, The Money on ABC News published a provocative article entitled “Why no symphony in the world makes money.” The article cited research by Stanford economics professor Robert Flanagan which found that all orchestras run an operating deficit and depend upon donations or government support for their survival.
Symphony orchestras are important to their communities and to developing young talent, but they are struggling. Perhaps it’s no coincidence that the downtown areas of many cities also struggle to remain vital, as they increasingly face poverty and blighted real estate.
Qualified Opportunity Zone Funds
In Tax Cuts and Jobs Act (TCJA), Congress tried to address this issue by including tax incentives for investment in real estate in low-income areas called “Qualified Opportunity Zones” (QOZs). TCJA’s goal was to spur QOZ growth and revitalization.
Since TCJA was passed, the Department has designed more than 8,700 QOZs throughout the nation. Complying with QOZ tax requirements is complicated. Investors must engage qualified attorneys and accountants to address initial investment, as well as ongoing compliance with tax requirements, in addition to ordinary real estate development burdens. These QOZ compliance costs may not offset the tax savings for some prospective investors.
As a result, real estate sponsors have created Qualified Opportunity Zone Funds (QOZFs) where people can invest and take advantage of QOZ tax benefits in passive investments. These sponsors hire attorneys to structure QOZFs to comply with TCJA requirements. Plus, the sponsors take care of ongoing property management, development, and compliance concerns.
Tax Incentives for Qualified Opportunity Zone Fund Investments
From the investors’ perspective, QOZFs may look similar to Section 1031 exchanges, which allow investors to defer capital gains taxes from the sale of certain real estate. However, investors in QOZF have an additional benefit. There is the possibility of permanently excluding some or all of their deferred capital gains taxes.
Subject to a December 31, 2025 “expiration date,” Investors who own a QOZF for five years receive a 10% tax basis increase. That tax basis increase jumps to 15% after seven years. After ten years, a QOZF investor may be able to permanently exclude capital gains taxes from the sale of their investment.
Other Considerations for Qualified Opportunity Zone Fund Investments
QOZFs can provide other benefits for investors. Since QOZFs typically invest in several properties, they can provide investors selling a single property the ability to diversify their real estate portfolios.
Some Investors may consider QOZFs to be socially responsible investments. QOZFs pour money into areas experiencing poverty and high unemployment. QOZFs may improve living conditions and opportunities for low-income individuals. Or, depending upon the amount of gentrification, QOZF investments might displace low-income people from their homes.
Establishing a QOZF requires careful compliance with numerous tax requirements, and an error can cause loss of QOZ tax benefits. The additional tax expertise and compliance can cause higher fees and costs than investors experience in other real estate funds.
Plus, investing in low-income areas makes QOZFs high-risk investments, possibly higher risk than traditional real estate funds. In addition to the higher compliance costs, due to strict time frames for investment of QOZF money, QOZF managers may not always be able to make optimal asset investments.
Securities Regulator Interest in Qualified Opportunity Zone Funds
Tax compliance isn’t the only regulatory burden for QOZF managers. QOZFs also have drawn the attention of securities regulators. On July 15, 2019, Securities and Exchange Commission (SEC) and North American Securities Administrators Association (comprised of state securities regulators) issued a joint summary (Joint Summary) explaining how securities laws apply to QOZFs.
The Joint Summary states QOZFs “must comply with all applicable regulations of the SEC and the securities regulators in the states where they are doing business, in addition to other applicable regulations, such as those of the … IRS …. This includes … complying with the registration and anti-fraud provisions of federal and state securities laws. The Joint Summary also notes that some QOZFs must be registered as investment companies.
Why Qualified Opportunity Zone Funds are Securities
Like most other real estate funds, QOZFs are investment contracts under federal securities laws. The US Supreme Court first defined “investment contract” under the Securities Act of 1933 in SEC v. W.J. Howey Co.
Decided in 1946, Howey involved the sale of the orange groves with the optional management agreement. Since most investors had no idea how to manage an orange grove and simply wanted a passive investment, nearly all purchased the management contract.
In Howey, the Supreme Court developed the investment contract test, which is still in use today. A business transaction (or real estate fund) is an investment contract if:
1. There is an investment of money (or other assets).
2. The investment is in a common enterprise (usually a pooling of assets).
3. There is an expectation of a profit.
4. The profit comes from the efforts of a promoter or a third party.
QOZFs will almost always meet the first two criteria for an investment contract. Except in the rare instance where a single investor creates and owns the entire QOZF, people will be investing money together in a pooling of assets.
The only reason to invest in a QOZF is tax savings. Profit, under the Howey test refers to investments in which financial gain (including tax savings) is a major goal of the investment. This contrasts with the situation, for instance, where a person buys a co-op to live in or where a group of physicians buy a medical office building so they can have a place for their medical offices.
Since QOZF investors depend upon the expertise of the fund sponsor and professional property management for the investment’s success, QOZFs will meet the last criteria (reliance on the efforts of a third party). Only in the unusual circumstances where real estate professionals establish and self-manage their own fund comprised of their own money might a QOZF not be a security.
Securities Law Exemptions Available for Qualified Opportunity Zone Funds
QOZFs always will be subject to anti-fraud provisions in state and federal securities laws. Fortunately, there are exemptions on which QOZFs can rely so they need not register with the SEC or qualify with state regulatory agencies.
Like most real estate securities, QOZFs often are sold under the exemption in Rule 506(b) of Regulation D. Rule 506(b) prohibits general advertising relating to the offering and general solicitation of investors. Some real estate securities, including QOZFs, are sold in advertised offerings under Rule 506(c) of Regulation D.
Both Rule 506(b) and 506(c) enable real estate fund sponsors to be nimble. Both allow securities to be sold without prior SEC or state securities regulator review or approval. And both preempt state qualification requirements. Sponsors need to file only minimal post-sale paperwork on Form D with the SEC and state securities commissions.
Best practices require a private placement memorandum. However, Rule 506 offerings do not dictate the manner of disclosure as long as all material facts are disclosed and as long as the offerings are sold only to accredited investors (generally investors with a net worth over $1 million, not including their residence, or an annual income over $200,000, or $300,000 for two spouses). Rule 506(c) requires specific steps to verify accredited status. Rule 506(b) allows investor self-certification.
Fund sponsors should be aware that Rule 506 exemptions are only from registration of the securities offering. Sales of QOZFs must be made by licensed broker-dealers unless there is an exemption. Plus, some QOZFs must register as investment companies.
Tax Savings to Help Struggling Orchestras and Low-Income Areas
Struggling orchestras and QOZs both count tax laws as a major benefactor. People who donate to keep orchestras solvent are motivated at least in part by the income tax deduction for charitable donations. With TCJA, QOZs needing community rejuvenation can lure investors with the promise of tax deferral and exclusion of capital gains from income taxes.
To qualify as a tax-exempt charitable organization, orchestras must meet and maintain certain requirements and file an annual report. That burden usually is not difficult for an orchestra.
QOZs are designated by the government. But QOZFs are subject to significant up front structuring and ongoing management requirements.
Tax savings is a powerful motivator. Yet, the charitable donation deduction may not be sufficient incentive for many orchestras to get the funds they need to survive. QOZFs appear to be popular with investors. However, only time will tell whether QOZFs will spur the growth Congress hoped for when it passed TCJA.
This series draws from Elizabeth Whitman’s background in and passion for classical music to illustrate creative solutions for legal challenges experienced by businesses and real estate investors.
