Unlocking Opportunity Fund Investments: A Guide To Success

Investing in opportunity funds is a way to do good for distressed communities while doing well for yourself. These funds were established as part of the 2017 Tax Cuts and Jobs Act to encourage investment in underfunded, low-income, and economically distressed areas. By investing in opportunity funds, investors can benefit from tax advantages and incentives, such as deferred and reduced taxes on capital gains. To get started, investors should consult tax and financial advisors to ensure they follow the rules and consider all potential implications.

Understanding Opportunity Funds

Opportunity funds are investment vehicles designed to encourage investment in real estate or business development in economically distressed areas known as "opportunity zones". These funds arose from the creation of opportunity zones as part of the 2017 Tax Cuts and Jobs Act (TCJA).

To be designated as an opportunity zone, a community must be nominated by the state and certified by the secretary of the U.S. Treasury via the Internal Revenue Service (IRS). Opportunity zones currently exist in all 50 U.S. states, Washington, D.C., and five U.S. territories.

An investment fund created by a corporation or partnership can become a qualified opportunity fund by filing IRS Form 8996 with their federal income tax return. Once qualified, the fund must invest at least 90% of its assets in designated opportunity zones to receive preferential tax treatment.

Opportunity funds must make "substantial improvements" to the properties they invest in. The TCJA defines this as investing an amount equal to or more than the original value of the property within 30 months of purchase. For example, if a property is purchased for $700,000, the opportunity fund has 30 months to invest at least $700,000 in improvements.

Certain types of businesses cannot be included in opportunity funds, even if they are located within opportunity zones. These include racetracks, gambling facilities, liquor stores, golf courses, country clubs, massage parlours, and suntan facilities.

Investors can defer tax payments on prior investment gains if those gains are then invested in a qualified opportunity fund within 180 days of the sale. Taxes are then deferred until either the opportunity fund investment is sold or exchanged, or December 31, 2026, whichever comes first.

The longer a participant holds their qualified opportunity fund investment, the smaller their tax burden may be. If an investment is held for more than five years, investors receive a 10% exclusion of the deferred gain. If held for over seven years, this increases to a 15% exclusion. After 10 years, the investor does not owe federal income taxes on the fund's appreciation by the date of sale.

Given that opportunity funds are relatively new, investors interested in participating should consult investment and tax professionals.

Tax Advantages of Qualified Opportunity Funds

Qualified Opportunity Funds offer several tax advantages to investors. Firstly, investors can temporarily defer taxes on eligible gains by investing in a Qualified Opportunity Fund. Eligible gains include both capital gains and qualified 1231 gains, as long as they are recognized for federal income tax purposes before January 1, 2027, and are not from a transaction with a related person. To defer taxes, investors must invest in the fund within 180 days of realizing the gain, and taxes can be deferred until either an inclusion event occurs or December 31, 2026, whichever comes first.

Secondly, the longer an investor holds their investment in a Qualified Opportunity Fund, the smaller their tax burden may be. If an investment is held for more than five years, investors receive a 10% exclusion of the deferred gain on their investment. This exclusion increases to 15% if the investment is held for more than seven years.

Finally, if an investor holds their investment in a Qualified Opportunity Fund for at least 10 years, they may be able to permanently exclude gains resulting from a qualifying investment when it is sold or exchanged. This exclusion occurs if the investor elects to increase the basis of their investment to its fair market value on the date of the sale or exchange.

How to Start Your Own Qualified Opportunity Zone Fund

Starting your own Qualified Opportunity Zone Fund (QOF) is a relatively straightforward process, but it's important to understand the requirements and ongoing maintenance of the fund. Here are the steps to start your own Qualified Opportunity Zone Fund:

Understanding the Basics:

Before starting a QOF, it's crucial to grasp the fundamental concepts. QOFs were established as part of the 2017 Tax Cuts and Jobs Act to encourage investment in economically distressed communities. These funds provide tax incentives for investors who reinvest their capital gains in designated areas. To qualify as a QOF, certain criteria must be met, including investing in "opportunity zone property" and adhering to specific tax regulations.

Forming the Entity:

To begin, you need to create the entity that will serve as the QOF. Typically, this involves setting up a partnership LLC, an S-corporation, or a C-corporation. This entity will be responsible for managing the fund and ensuring compliance with regulations. Consider seeking legal advice to ensure the entity is structured appropriately.

Filing IRS Form 8996:

To officially become a QOF, you must file IRS Form 8996 annually with your federal income tax return. This form is used to self-certify your fund as a Qualified Opportunity Zone Fund. Make sure to file this form timely, taking any applicable extensions into account.

Meeting Compliance Requirements:

QOFs must adhere to specific compliance requirements to maintain their status and receive preferential tax treatment. One of the key requirements is the 90% Asset Test, which mandates that QOFs invest at least 90% of their assets in qualified opportunity zone property. Additionally, there are rules regarding the original use or substantial improvement of the property, purchase requirements, and eligible types of businesses.

Understanding Tax Benefits:

QOFs offer significant tax advantages to investors. Investors can defer taxes on prior investment gains if they reinvest those gains into a QOF within 180 days. The longer the investment is held, the greater the tax benefits. After five years, investors receive a 10% exclusion on their deferred gains, and after seven years, they receive a 15% exclusion. If the investment is held for at least 10 years, there is no federal income tax owed on the fund's appreciation.

Ongoing Maintenance:

While starting a QOF is relatively straightforward, maintaining the fund requires ongoing professional guidance. This includes administration, compliance, and accounting services. Initial formation and structuring by an attorney can be costly, and ongoing compliance and accounting expenses can be significant. It's important to carefully consider these expenses when establishing your QOF.

Qualified Opportunity Zone Business

A Qualified Opportunity Zone Business is a trade or business wherein:

• Most of the tangible property owned or leased is located in a Qualified Opportunity Zone
• At least 50% of the business's total gross income is derived from the active conduct of a qualified business within a Qualified Opportunity Zone
• Less than 5% of the average of the aggregate unadjusted bases of the business's property is attributable to non-qualified financial property
• A substantial portion of the business's intangible property is used in the active conduct of a qualified business in a Qualified Opportunity Zone

To be a Qualified Opportunity Zone, a locality must be nominated for that designation by a state, the District of Columbia, or a U.S. territory. The nomination must then be certified by the Secretary of the U.S. Treasury via delegation of authority to the Internal Revenue Service (IRS). The purpose of Qualified Opportunity Zones is to spur economic development and job creation in distressed communities by providing tax incentives for investors who invest new capital in businesses operating in one or more Qualified Opportunity Zones.

To invest in a Qualified Opportunity Fund, which in turn invests in Qualified Opportunity Zone Businesses, you must invest the amount of a recognised eligible gain in the fund and elect to defer the tax on that gain. Eligible gains include both capital gains and qualified 1231 gains, but only if the gains are recognised for federal income tax purposes before January 1, 2027, and are not from a transaction with a related person.

Qualified Opportunity Zone Business Property

• The original use of the property in the Qualified Opportunity Zone (QOZ) must have commenced with the QOF or QOZ business, or the property was substantially improved by the QOF or QOZ business.
• During 90% of the time the QOF or QOZ business held the property, substantially all (generally at least 70%) of the property's use was in a QOZ.
• The property was purchased after December 31, 2017.

Leased property may also qualify as Qualified Opportunity Zone Business Property if the lease is a market rate lease entered into after December 31, 2017. If the parties to the lease are related, there must be no prepayment in connection with the lease that exceeds 12 months, and if the leased property was previously used in the QOZ, the business must purchase new tangible property to use in the QOZ equal in value to the leased property.

Frequently asked questions