Debt and financing in Opportunity Zone projects

Yes. The rule that the investment must be equity applies to the investor's money going into the Qualified Opportunity Fund (QOF), not to the project's capital stack. The statute defers gain only for an investment in a QOF, and the regulations treat only an equity interest (partnership interest or stock) as a qualifying investment.^1,11 Below that, the fund and its Qualified Opportunity Zone Business (QOZB) can take construction loans, permanent mortgages and other debt on normal commercial terms. See why Opportunity Zone investments must be equity.

• Investor-level borrowing: an investor can borrow to fund a QOF investment, and using a qualifying investment as collateral for a loan is not, by itself, an inclusion event.¹¹
• QOF-level debt: possible, but cash or loan proceeds held at the fund level count against the 90% asset test unless quickly invested.
• QOZB-level debt: the usual place for project debt. Loan proceeds held for construction can be working capital under a written plan, within the 31-month safe harbor.^9,12

In a partnership QOF, debt gives the investor basis that the deferred gain does not. An investor's basis in a qualifying investment starts at zero, because the deferred gain is not yet taxed.¹ Under IRC §752(a), an increase in a partner's share of partnership liabilities is treated as a contribution of money, and the regulations recognize that this raises the partner's basis in the QOF interest without creating a separate non-qualifying investment.^4,5

That basis does two jobs. It lets the investor deduct allocated losses, including depreciation (data center equipment often qualifies for 100% bonus depreciation), and it lets the fund distribute cash, such as refinancing proceeds, without exceeding the investor's basis.⁴ Shareholders of a corporate QOF get no basis from the corporation's debt, so neither benefit is available. This is one of the main reasons most Opportunity Zone funds are partnerships; see Opportunity Zone fund structures.

A distribution from a QOF partnership is an inclusion event to the extent it exceeds the partner's basis in the qualifying investment, and a distribution within two years of the contribution can also be tested under disguised sale principles.^3,5 An inclusion event is a transaction that reduces or ends the investor's qualifying investment and triggers tax on some or all of the deferred gain before the five-year date.^8,11

The two-year point comes from the final regulations, which apply rules modeled on the IRC §707 disguised sale rules. If a contribution and a distribution together would be treated as a sale under those rules (distributions within two years of a contribution are presumed to be part of a sale unless the facts show otherwise), part of the investor's original investment can be recharacterized as a non-qualifying investment.^3,6 Commentators note that it is a misconception that every debt-financed distribution in the first two years is prohibited: the §707 framework has exceptions for certain debt-financed distributions, but applying them is technical.²

For a corporate QOF, the analysis is different. As the regulations are generally read, a distribution paid out of earnings and profits is a dividend and does not reduce the qualifying investment, but a distribution treated as a return of basis or as gain is an inclusion event. Because the investor's basis is zero, a debt-financed distribution from a new corporate QOF with no earnings is likely to be an inclusion event; confirm the treatment with counsel. Our guide to inclusion events lists the other triggers.

Refinancing after the five-year inclusion date is usually easier, because the inclusion adds basis. The deferred gain is taxed at the earlier of a sale or five years after the investment date, and once it is included, the investor's basis in the qualifying investment increases by the amount of gain recognized.^8,10 The investor also gets the 10% step-up (30% in a Qualified Rural Opportunity Fund) before the inclusion.

That creates a common pattern: the fund refinances a stabilized property around year five and distributes cash that helps investors pay the tax on the deferred gain, using the new basis from the inclusion plus the investor's share of the new loan. The distribution must still not exceed basis. A refinancing in year two or three can work too, but it needs the disguised sale analysis above and enough §752 basis to cover the distribution.

The 10-year election is designed to cover the debt as well as the equity. After a 10-year hold, an investor can elect to treat the basis of the QOF interest as its fair market value on sale, and in a partnership fund can elect to exclude gain from the fund's or QOZB's asset sales reported on a K-1.^7,1 Practitioner summaries of the final regulations describe the partnership-interest election as stepping basis up to fair market value in a way that takes the partner's share of liabilities into account, so that debt relief on sale does not create gain in a leveraged fund.⁷ Confirm that point against the regulation text for your fund's exit plan.

Two cautions. First, the exclusion is capped: for a sale after the 30th anniversary of the investment, basis is fixed at fair market value on that anniversary.¹⁰ Second, debt-financed distributions before 10 years that caused an inclusion event are not undone by the later election. See the 10-year hold and Opportunity Zone exit strategies.

Data center projects are debt-heavy, and lenders size loans to leases and power. JLL expects data center construction to drive more than $700 billion of permanent debt originations in North America over about two and a half years.¹³ For an Opportunity Zone project, a typical stack is OZ equity in the QOZB, a construction loan during the build, and a permanent or securitized loan after the tenant takes occupancy.

• Working capital: loan proceeds held for construction must fit the QOZB's written working capital plan, and the QOZB must keep nonqualified financial property, such as idle cash outside the plan, below 5% of its assets.^12,9
• Interest and lease reserves: lenders often require reserves; hold them under the working capital plan where possible.
• Equipment financing: financing servers or other short-lived equipment adds debt that turns over faster than the 10-year hold.
• Credit support from the sponsor: a completion or carry undertaking by the sponsor is common in development lending; check how it interacts with the §752 allocation of the debt.
• Distribution covenants: lender restrictions can block the year-five tax distribution; negotiate a carve-out.

For the full picture of equity, debt and incentives in a campus, see the capital stack for an Opportunity Zone data center.