What is a Qualified Opportunity Fund?

Opportunity Zone legislation within the Tax Cuts and Jobs Act of 2017 is a powerful tax strategy that uses tax incentives to attract long-term private investments and promote economic growth in designated urban and rural areas.

Generally, investors who experience a capital gain from a sale or exchange of a capital asset and elect to invest such capital gain into a Qualified Opportunity Fund within 180 days after the sale or exchange may be eligible for certain benefits:
  1. Ability to unlock original basis and separate it from their capital gain.
  2. Ability to defer capital gain tax liability until December 31, 2026.
  3. Ability to reduce capital gain tax liability by a total of 10% through a step-up in tax basis upon remaining invested in the Qualified Opportunity Fund for at least five years.
  4. Ability to reduce capital gain tax liability by a total of 15% through an additional step-up in tax basis upon remaining invested in the Qualified Opportunity Fund for at least seven years.
  5. Ability to eliminate capital gain tax liability on the additional capital gain realized through the investment in the Qualified Opportunity Fund upon remaining invested in the Qualified Opportunity Fund for at least ten years.
  6. Ability to support community development and make a social impact through private investment.
2019
Capital gain event occurs. Reinvest your capital gain in a Qualified Opportunity Fund.
2027
Tax payment is due (for 2026 tax year). Receive up to a 15% step-up in tax basis.
2028
Pay no capital gain tax on investment in Qualified Opportunity Fund.

Deferred payment of original capital gain tax.

who qualifies

Anyone who recognizes a capital gain for Federal income tax purposes may qualify for the tax benefits. The capital gain can be from nearly any asset (business, real estate, stocks, bonds, etc.). This includes individuals, C corporations (including regular investment companies), Real Estate Investment Trusts (REITS), partnerships, S Corporations, trusts and estates. To defer the gain realized from the sale of an appreciated asset, the investor must reinvest the gain into a Qualified Opportunity Fund within 180 days of realizing the gain. Investors can invest the original basis from the appreciated asset sale as well into the Qualified Opportunity Fund, but only the portion of the investment attributable to the gain from the appreciated asset will be eligible for the exemption from tax on future potential appreciation in the Qualified Opportunity Fund.

FAQ

-What is an Opportunity Zone?

Created under the Tax Cuts and Jobs Act of 2017, Opportunity Zones are population census tracts that meet the definition of “low-income communities” under the U.S. tax code and has been designated as a Qualified Opportunity Zone. The U.S. Treasury Department has certified nearly 9,000 census tracts as Opportunity Zones, including tracts in every state, Washington D.C., Puerto Rico, and the US Virgin Islands.

+What is a Qualified Opportunity Fund, or QOF?

A Qualified Opportunity Fund is an investment vehicle (corporation or partnership) that holds at least 90% of its assets in: (i) Qualified Opportunity Zone Business Property (includes real estate); (ii) Qualified Opportunity Zone Stock; and/or (iii) Qualified Opportunity Zone Partnership Interests.

The following provides a brief summary of each qualifying asset type:

Qualified Opportunity Zone Business Property (includes real estate):

- Tangible property used in a trade or business of the Qualified Opportunity Fund

- Acquired by the Qualified Opportunity Fund for cash or property in a taxable transaction from an unrelated party

- Either original use of the property commenced by the Qualified Opportunity Fund or the Qualified Opportunity Fund substantially improves the property by doubling its basis (less land value) within a 30-month period. This can include new development or redevelopment of existing buildings located within a Qualified Opportunity Zone

- Does not include an interest in another Qualified Opportunity Fund.

Qualified Opportunity Zone Stock

- Stock of a domestic corporation acquired by the Qualified Opportunity Fund for cash in an original issuance

- The corporation must be a Qualified Opportunity Zone Business, or QOZB, at the time of the acquisition and remain so for substantially all of the Qualified Opportunity Fund’s holding period for the stock

- The Qualified Opportunity Zone Business must have substantially all of the tangible property of the business as Qualified Opportunity Zone Business Property with at least 50% of the entity’s gross income derived from the active conduct of the business within the Qualified Opportunity Zone.

Regulations provide three new safe harbors for existing businesses:

- First, if at least 50% of the services performed, based on hours, for the QOZB by its employees and independent contractors and employees of independent contractors are performed within an OZ then the QOZB qualifies;

- A second safe harbor is the “Compensation Safe Harbor” which is met if at least 50% of the services performed for the QOZB by its employees and independent contractors and employees of independent contractors are performed in an opportunity zone, based on amounts paid for services performed;

- And the third safe harbor is the ‘Property and Management Safe Harbor” which is met if the tangible property of the QOZB that is in an opportunity zone and the management or operational functions performed for the QOZB in an opportunity zone are each necessary to generate 50% of the gross income of the trade or business.

- Certain businesses are excluded, including golf courses, liquor stores, massage parlors, country clubs, tanning salons, and gambling establishments.

Qualified Opportunity Zone Partnership Interest

- Equity in a domestic partnership acquired by the Qualified Opportunity Fund for cash in an original issuance.

- Partnership must be a Qualified Opportunity Zone Business at time of acquisition and remain so for substantially all of the Qualified Opportunity Fund’s holding period of the partnership interest.

+How does a Qualified Opportunity Fund investment work?

First, investors can sell any investment and keep the original basis in that investment. It is important to note that the gain can come from any capital asset sale and is not restricted to only real estate investments.

To defer the capital gain realized from the disposition of an appreciated asset, the investor must reinvest the gains into a Qualified Opportunity Fund within 180 days of realizing those gains or, if the gains are realized within a partnership, within 180 days from the end of the partnership’s taxable year. The returned principal portion of the investment (original basis) can also be reinvested; however, only the appreciation gain portion of the original investment is eligible for the tax benefits.

+Who qualifies?

Any U.S. taxpayer who rolls over capital gains within 180 days into a Qualified Opportunity Fund or, if within a partnership, within 180 day from the end of the partnership’s taxable year. All or any portion of the capital gains may be deferred through an investment in the Qualified Opportunity Fund. These may include gains recognized as the result of a sale of a business, stock, art, property, etc. Eligible gains include both short-term and long-term capital gains, and the gains must have occurred before making the Qualified Opportunity Fund investment. It also includes Section 1231 gains, gains from real property that has been used in a trade or business and held for more than a year; however, Section 1231 gains must be netted against Section 1231 losses for that year and only the net amount is eligible to invest within 180 days of the last day of the taxable year. This netting calculation only applies to Section 1231 gains. Certain capital gains are not eligible for deferral, including:

Certain capital gains are not eligible for deferral, including:

- Capital gains recognized on a sale of property to a related party (generally 20% common ownership or certain family partnerships)

- The sold property is subject to offsetting positions that significantly diminish the investor’s risk of loss

+How much capital gains tax can an investor save by investing into a Qualified Opportunity Fund?

If an investor holds its Qualified Opportunity Fund interest for five years prior to the end of the deferment period (earlier of sale of interest or December 31, 2026), the investor will not be subject to US federal income tax on 10% of the deferred capital gain.

If an investor holds its Qualified Opportunity Fund interest for a total of seven years prior to the end of the deferment period (earlier of sale of interest December 31, 2026), the investor will not be subject to US federal income tax on an additional 5% (for a total exclusion of 15%) of the deferred gain.

If the investor holds its Qualified Opportunity Fund interest for at least 10 years, the investor generally will not be subject to US federal income tax on any additional gain recognized by the investor (in excess of the deferred gain recognized in 2026) on the disposition of its Qualified Opportunity Fund interest, provided the disposition occurs prior to 2048.

+When are deferred capital gain taxes payable?

Investors that invest capital gains into a Qualified Opportunity Fund within 180 days of recognizing the gain or, if within a partnership, within 180 day from the end of the partnership’s taxable year, will defer taxes on the capital gain until the earlier of (i) December 31, 2026 and (ii) upon disposition of their interest in the Qualified Opportunity Fund. Investors will have to recognize a portion of the deferred gains that year, but investors may benefit from the step up in basis (5 Years - 10% and 7 Years - 15%) if they reach either holding period before December 31, 2026.

+How much tax does an investor in a Qualified Opportunity Fund pay on the gains generated by the fund?

If the investor holds its Qualified Opportunity Fund interest for at least 10 years, the investor generally will not be subject to U.S. federal income tax on any additional gain recognized by the investor (in excess of the deferred gain recognized in 2026) on the disposition of its Qualified Opportunity Fund interest, provided the disposition occurs prior to 2048.

If an investor sells all of its interest in a Qualified Opportunity Fund before 10 years, the investor may elect to defer the gain from the sale of the Qualified Opportunity Fund interest by re-investing the gain in another Qualified Opportunity Fund within 180 days of the sale of the first Qualified Opportunity Fund. The investor’s interest in the new Qualified Opportunity Fund should also be eligible for the gain exclusion on future appreciation if the new Qualified Opportunity Fund interest is held for 10 years and disposed of prior to 2048.

The proposed regulations permit a Qualified Opportunity Fund to sell an asset, and give the Qualified Opportunity Fund 12 months to reinvest the cash proceeds before the cash becomes a bad asset for purposes of the 90% asset test. Further, any recycling of capital into new investments does not affect an investor’s holding period in its Qualified Opportunity Fund interest and as long as the cash is reinvested within the 12-month period, it does not trigger inclusion of any of the investor’s originally deferred gain. However, any gain recognized on the sale of the underlying asset is allocated to investors per normal tax rules and Qualified Opportunity Fund investors will have to pay tax on that gain.

+What are the benefits of investing in a Qualified Opportunity Fund?

By investing in a Qualified Opportunity Fund, investors can potentially receive multiple benefits:

1. Investors obtain the opportunity to unlock their original basis and reinvest their capital gains into a tax efficient investment program

2. Investors defer capital gains upon the sale of appreciated assets until payment is due in 2027 (part of 2026 tax year)

3. Investors can receive up to a 15% step-up in tax basis when taxes are owed in 2027 as part of the 2026 tax year

4. Investors will generally have no capital gains on any profits from the fund investments after a minimum 10-year investment period

5. Investors support community development and make a social impact through their investment

+What is the timing and process for deferring gain through a Qualified Opportunity Fund investment?

Investors generally must invest in a QOF within 180 days of recognizing the eligible capital gain or, if within a partnership, within 180 day from the end of the partnership’s taxable year. Investors make the deferral election by filing a form with their U.S. federal income tax return for the year in which the deferred gain would have been recognized.

- The recognition of capital gain must occur before making the Qualified Opportunity Fund investment. An investment in a Qualified Opportunity Fund without prior recognition of a capital gain eligible to be deferred will not qualify for any of the special Qualified Opportunity Fund tax benefits, including the exclusion of gain on future appreciation.

- An “investment” in a Qualified Opportunity Fund generally means the acquisition of an equity interest in a Qualified Opportunity Fund for cash or property. A loan to a Qualified Opportunity Fund or a contractual commitment to contribute capital in the future will not qualify as an investment.

- The cash invested in a Qualified Opportunity Fund by an investor does not have to be “traceable” to any proceeds giving rise to the deferred gain. For example, an investor that recognizes a “phantom” capital gain through a partnership may defer the gain by contributing the investor’s own funds (including funds obtained through borrowing) equal to the amount of the gain to a Qualified Opportunity Fund within 180 days.

- All or any portion of a capital gain may be deferred through an investment in a Qualified Opportunity Fund. An item of capital gain may also support investments in multiple Qualified Opportunity Funds or multiple investments in a single Qualified Opportunity Fund (up to the total amount of gain) as long as the investments are made within 180 days of recognizing the eligible capital gain or, if within a partnership, within 180 day from the end of the partnership’s taxable year.

+What special timing rules apply for partnerships?

A partnership that recognizes an eligible capital gain may defer recognition of the gain for U.S. federal income tax purposes by investing such gain in a Qualified Opportunity Fund within 180 days of recognition. If a partnership does not elect to defer the gain by investing in a Qualified Opportunity Fund, the partners in the partnership may make their own deferral elections with respect to their allocable shares of the capital gain by investing in a Qualified Opportunity Fund outside the partnership. Under this scenario, the partner may treat its allocable share of the capital gain as recognized under one of the following timing rules.

- The partner may treat the capital gain as recognized on the last day of the partnership’s taxable year in which the capital gain is recognized. Thus, if a calendar year partnership recognizes a capital gain on January 1, 2018, and does not elect to defer the gain by investing in a Qualified Opportunity Fund, each partner would have until June 30, 2019 (180 days after year end 2018) to elect to defer their distributive share of the capital gain by investing in a Qualified Opportunity Fund.

- A partner may elect to treat the capital gain as recognized on the date the partnership recognizes the gain, which could facilitate an earlier investment in a Qualified Opportunity Fund.

+Can a Qualified Opportunity Fund reinvest sale proceeds?

The proposed regulations allow a QOF to sell an asset and gives the QOF 12 months to reinvest the cash proceeds before the cash becomes a bad asset for purposes of the 90% asset test. Further, any recycling of capital into new investments does not affect an investor’s holding period in its QOF interest, and as long as the cash is reinvested within the 12-month period, it does not trigger inclusion of any of the investor’s originally deferred gain. However, any gain recognized on the sale of the underlying asset is allocated to investors per normal tax rules and QOF investors will have to pay tax on that gain.

+What are the safe harbors related to working capital and Qualified Opportunity Zone Businesses holding cash?

One of the requirements applicable to QOZBs is a 5% limit on cash and financial property. It would be hard to manage construction and redevelopment with this limitation. However, there is a safe harbor in the legislation related to the cash needed to improve the property. A QOZB can hold a reasonable amount of working capital for up to 31 months if it meets the following requirements:

- First, there needs to be a written plan on how to spend the working capital;

- Second, there needs to be a schedule for the expenditures;

- Finally, the QOZB needs to substantially follow the written plan and schedule

The regulations give some additional flexibility to the time limits if there are delays in government actions such as permitting or other entitlements.

+Can I invest more than my capital gain into a Qualified Opportunity Fund and receive similar tax benefits?

There is no restriction on the amount that may be invested into a Qualified Opportunity Fund; however, only the capital gain portion of the investment will receive the tax benefits. The additional invested funds will be accounted for as a separate investment in the Qualified Opportunity Fund and will be subject to U.S. federal tax policies.

+Can I rollover a gain from one Qualified Opportunity Fund to another?

Yes, if an investor sells all of its interest in a Qualified Opportunity Fund before 10 years, the gain will not be excluded from income as a general matter; however, the investor may elect to defer the gain from the sale of the Qualified Opportunity Fund interest by re-investing the gain in another Qualified Opportunity Fund within 180 days of the sale of the first Qualified Opportunity Fund. The investor’s interest in the new Qualified Opportunity Fund should also be eligible for the gain exclusion on future appreciation if the new Qualified Opportunity Fund interest is held for 10 years and disposed of prior to 2048.

+Can investors receive a return of their deferred capital gains/equity by debt-financed distributions?

The proposed regulations specifically approve partnership debt-financed distributions so long as the distribution does not exceed the investor’s basis, as increased by the investor’s share of the debt, in its QOF. This removes some of the concern that investors’ equity would remain completely tied up for 10 years. Depending on how the debt is allocated, an investor should be able to receive a distribution of refinancing proceeds to the extent of the investor’s share of the debt, plus any basis credit the investor receives pursuant to the 5-year, 7-year, and 2026 basis adjustments.

+What happens to an investment if the investor passes away prior to selling his or her interest in the Qualified Opportunity Fund?

Investments made into a Qualified Opportunity Fund do not receive a stepped-up basis at death. The recipient of the Qualified Opportunity Fund interest has the obligation to pay the deferred taxes in 2026 (or earlier if the recipient disposes of the Qualified Opportunity Fund interest prior to 2026). However, it is not all bad for the recipient since the recipient receives the 10-year benefit of the investment. In other words, if the recipient holds the interest in the Qualified Opportunity Fund for at least 10 years from the original investment, the original investment made into the QOF grows tax-free.

+Can an investment in a Qualified Opportunity Fund be gifted?

Transferring a QOF interest by gift (other than a grantor trust disregarded from the transferor) is considered to be a disposition of the property and ends the deferral. The beneficiary does not get the 10-year benefits upon the beneficiary’s subsequent disposition.

+What type of benefits does an Opportunity Zone have on the community?

While much of the talk regarding opportunity zones revolves around the tax benefits, its main purpose is to transform and uplift neighborhoods by injecting private capital to spur economic development and improve quality of life.

+What are other possible tax consequences of investing in a Qualified Opportunity Fund?

Operating income generated by the fund (e.g., rental income from real estate) generally will be taxed according to ordinary U.S. tax rules based on the Qualified Opportunity Fund structure. For instance, if the Qualified Opportunity Fund is structured as a partnership, rental income from underlying investments will be reported to investors on their Schedule K-1s and included in their taxable income.

Qualified Opportunity Fund investors are generally required to take a zero basis in their fund interest for which the deferral election is in effect. An investor’s basis generally will be increased by the amount of gain recognized at the end of the deferral period in 2026, in addition to any other basis increase under ordinary U.S. tax rules.

The zero basis could reduce the ability of an investor in a Qualified Opportunity Fund structed as a partnership to utilize net losses generated by the Qualified Opportunity Fund during the deferral period because an investor in a partnership generally may not deduct losses in excess of its basis in the partnership interest. The zero basis could also increase the likelihood that an investor may recognize gains from Qualified Opportunity Fund distributions in excess of its basis, including return of capital distributions from a Qualified Opportunity Fund organized as a corporation or REIT.

+Will there be any depreciation recapture at the end of the investment in the Qualified Opportunity Fund?
The zero-basis rule and the subsequent basis step-ups have raised numerous questions about depreciation. Treasury remains silent so far on whether there will be any recapture at ultimate exit when a QOF investor makes a fair market value basis step-up election.

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