How To Choose A Qualified Opportunity Fund For Investing

Qualified Opportunity Zones (QOZs) are economically distressed communities where investors can benefit from tax incentives for investing in local businesses. Introduced by the 2017 Tax Cuts and Jobs Act, QOZs are designed to stimulate economic growth and job creation in these areas. Investors can defer and reduce their tax liability on eligible capital gains by investing in a Qualified Opportunity Fund (QOF). To qualify for tax deferral, capital gains must be invested in a QOF within 180 days, and the investment must be an equity interest, not a debt interest. If the investment is held for at least five years, investors can benefit from a 10% step-up in tax basis, increasing to 15% after seven years. If the investment is held for at least 10 years, investors may be able to permanently exclude gain resulting from a qualifying investment when it is sold or exchanged.

Tax benefits of investing in a Qualified Opportunity Fund

Qualified Opportunity Funds (QOFs) are investment vehicles designed to facilitate investment in "opportunity zones". These are geographic areas that have been designated as economically distressed, and they may be subject to different economic regulations than other regions.

QOFs were established as part of the 2017 Tax Cuts and Jobs Act (TCJA) to encourage investment in underfunded, low-income, and distressed communities.

Tax Deferral

Investors can defer their tax payments on prior investment gains if those gains are then invested in a QOF within 180 days after the sale. Taxes are then deferred to either the day when the QOF investment is sold or exchanged, or December 31, 2026 — whichever comes first. This deferral applies to any investment gain, such as the sale of appreciated stock or a business.

Step-up in Tax Basis

The longer a participant holds their QOF investment, the smaller their tax burden may be. If the investment is held for:

• More than five years, investors receive a 10% exclusion of the deferred gain on their investment.
• More than seven years, investors receive a 15% exclusion.

No Tax on Appreciation

If the QOF investment is held for at least 10 years, the investor does not owe federal income taxes on the fund's appreciation by the date of sale. This is achieved by adjusting the basis of the QOF investment to its fair market value on the date of the sale or exchange.

How to create a Qualified Opportunity Fund

To create a Qualified Opportunity Fund, an entity must meet the following requirements:

• File a federal income tax return as a partnership, corporation, or LLC treated as a partnership or corporation.
• Be organised for the purpose of investing in Qualified Opportunity Zone property under the laws of one of the 50 states, the District of Columbia, a U.S. possession, or a federally recognised Indian tribal government.
• Hold 90% of its assets in Qualified Opportunity Zone property.

To certify and maintain a Qualified Opportunity Fund, the entity must file Form 8996, Qualified Opportunity Fund, with the eligible partnership or corporation federal tax return annually. Form 8996 is used to certify that the corporation or partnership is organised to invest in Qualified Opportunity Zone property, report that it meets the 90% investment standard, and calculate any penalties for failing to meet this standard.

The 90% investment standard is determined by the average percentage of Qualified Opportunity Zone property held in the fund, measured on the last day of the first 6-month period of the fund's tax year and the last day of the tax year.

When reporting the disposal of equity interest by a partner or shareholder in a Qualified Opportunity Fund, Form 8996 must be completed, and each disposition must be reported on a separate Form 1099-B.

Qualified Opportunity Zone property includes Qualified Opportunity Zone stock, partnership interests, and business property. To meet the 90% investment standard, any Qualified Opportunity Zone stock or partnership interests must be held by an entity that is a Qualified Opportunity Zone business. This business must derive at least 50% of its gross income from business activities within a Qualified Opportunity Zone and satisfy one of four safe-harbour tests.

Tangible property is considered Qualified Opportunity Zone business property if it is used in a trade or business and meets the following requirements:

• Timing of acquisition: The property was acquired by purchase after December 31, 2017.
• Asset type: The property must be originally used in the Qualified Opportunity Zone or substantially improved.
• Location: The property must be located in a Qualified Opportunity Zone for substantially all of the time it is held.

It is important to note that there is no approval process to start a Qualified Opportunity Fund. However, ongoing maintenance, including administration, compliance, and accounting, typically requires professional guidance. Initial formation and structuring by an attorney can cost at least $10,000, with ongoing compliance and accounting costing $5,000 or more annually.

Qualified Opportunity Zones and their benefits

Qualified Opportunity Zones (QOZs) are economically distressed communities that offer tax incentives for investors who invest new capital in businesses operating within them. These zones were established by the 2017 Tax Cuts and Jobs Act to encourage long-term investment in areas that need an economic boost. All 50 states, Washington, D.C., and U.S. territories have designated Qualified Opportunity Zones.

The benefits of investing in a Qualified Opportunity Zone include:

• Tax deferral: Investors can defer tax on capital gains until December 31, 2026 (generally payable in 2027), by investing in a Qualified Opportunity Fund (QOF) within 180 days of the sale of an appreciated asset.
• Tax reduction: If the investor holds the investment in the QOF for at least five years, they receive a 10% step-up in tax basis. If held for at least seven years, they get an additional 5% step-up, resulting in a total exclusion of 15% of the original deferred gain.
• Tax-free gains: If the investment in a QOF is held for at least 10 years, investors may be able to permanently exclude gain resulting from a qualifying investment when it is sold or exchanged. This means that 100% of the gains could be tax-free.

To invest in a Qualified Opportunity Zone, individuals or businesses must create their own opportunity fund or find an existing one that is accepting investment capital. A QOF must be structured as a REIT or partnership and must hold and invest at least 90% of its assets in qualified opportunity zone properties and businesses.

It is important to note that only capital gains can be invested in QOFs and that these investments may involve risks similar to other types of investments, such as market loss and liquidity risk. As with any investment, it is essential to consult with a financial advisor to determine if this opportunity aligns with your investment goals and risk tolerance.

Qualified Opportunity Fund eligibility criteria

To be eligible for tax benefits, investors must invest in a Qualified Opportunity Fund (QOF) within 180 days of making a capital gain. The QOF must be an investment vehicle that is organised as a corporation or partnership and must invest at least 90% of its assets in Qualified Opportunity Zone property. This includes Qualified Opportunity Zone stock, partnership interests, and business property.

To be eligible for tax benefits, the investment in the QOF must be a qualifying investment, which means it must be made in exchange for equity interest (not debt interest). The amount of time you hold the investment also determines the tax benefit you receive. If you hold your investment for at least five years, your basis (the amount of your investment) will increase by 10% of the deferred gain. If you hold your investment for at least seven years, your basis will increase by an additional 5% of the deferred gain. If you hold your investment for at least 10 years, you may be able to permanently exclude gain resulting from a qualifying investment when it is sold or exchanged.

To be eligible for the tax benefits, the investment must be in a Qualified Opportunity Zone, which is an economically distressed community where new investments may be eligible for preferential tax treatment. Localities qualify as Opportunity Zones if they have been nominated by a state, the District of Columbia, or a US territory, and that nomination has been certified by the Secretary of the US Treasury via their delegation of authority to the Internal Revenue Service (IRS).

Tax implications of investing in a Qualified Opportunity Fund

Investing in a Qualified Opportunity Fund can have several tax implications. Firstly, investors can defer their 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 date when the fund investment is sold or exchanged, or December 31, 2026, whichever comes first. Secondly, the longer an investor holds their fund investment, the smaller their tax burden may be. If the investment is held for more than five years, investors receive a 10% exclusion of the deferred gain. This exclusion increases to 15% if the investment is held for over seven years. Finally, if the investment is held for at least 10 years, investors may be able to permanently exclude gain resulting from a qualifying investment when it is sold or exchanged by increasing the basis of the fund investment to its fair market value.

It is important to note that the tax benefits of investing in a Qualified Opportunity Fund are subject to specific rules and regulations that may change over time. Investors should consult with investment and tax professionals before making any decisions.

Frequently asked questions