This is Chapter 4 of The Ultimate Guide to Opportunity Zone Investing
Qualified opportunity funds were created under the Investing in Opportunity Act, which was passed as part of President Trump’s Tax Cuts & Jobs Act of 2017. Per the IRS, opportunity funds self-certify, with no approval process required. These new funds provide massive tax incentives for investing capital gains in some of America’s most economically distressed communities.
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Qualified opportunity funds defined
The U.S. tax code defines a qualified opportunity fund as an investment vehicle that invests in qualified opportunity zone property. Specifically as follows:
The term “qualified opportunity fund” means any investment vehicle which is organized as a corporation or a partnership for the purpose of investing in qualified opportunity zone property (other than another qualified opportunity fund) that holds at least 90 percent of its assets in qualified opportunity zone property, determined by the average of the percentage of qualified opportunity zone property held in the fund as measured—(A) on the last day of the first 6-month period of the taxable year of the fund, and (B) on the last day of the taxable year of the fund.
Opportunity zone property can be either an opportunity zone business or opportunity zone business property. Put another way, an opportunity fund has two options:
- It can invest in opportunity zone businesses that hold tangible property located within opportunity zones.
- It can essentially become an opportunity zone business by investing directly in tangible property located within opportunity zones.
Let’s now define these two terms — qualified opportunity zone business and qualified opportunity zone business property.
Qualified opportunity zone business
An opportunity zone business can be either a corporation or partnership. In general, an opportunity zone business is a trade or business in which substantially all of the tangible property of the business qualifies as follows:
- Such property was acquired by the business by purchase after December 31, 2017.
- The original use of such property in the opportunity zone commences with the opportunity zone business, or the opportunity zone business substantially improves the property.
- During substantially all of the opportunity zone business’ holding period for such property, substantially all of the use of such property was in a qualified opportunity zone.
Furthermore, the opportunity zone business must also adhere to the following criteria:
- At least 50 percent of the total gross income of the opportunity zone business is derived from the active conduct of such business.
- A substantial portion of the intangible property of the opportunity zone business is used in the active conduct of such business.
- Less than 5 percent of the average of the aggregate unadjusted bases of the property of an opportunity zone business is attributable to nonqualified financial property.
And finally, the following types of “sin” businesses are ineligible to be deemed as a qualified opportunity zone business — private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or liquor stores.
Qualified opportunity zone business property
Opportunity zone business property is tangible property used in a trade or business of a qualified opportunity fund, so long as it meets the following three conditions:
- Such property was acquired by the qualified opportunity fund by purchase after December 31, 2017.
- The original use of such property in the opportunity zone commences with the qualified opportunity fund, or the fund substantially improves the property.
- During substantially all of the qualified opportunity fund’s holding period for such property, substantially all of the use of such property was in a qualified opportunity zone.
Tax advantages of opportunity fund investing
To encourage capital deployment to economically distressed opportunity zones, three tax advantages were created for capital gains invested in opportunity funds.
- Deferment of capital gains until December 31, 2026.
- A step-up in basis of up to 15 percent on the original gain.
- Elimination of capital gains accrued in the opportunity fund after a 10-year holding period.
Advantage #1: Deferral of capital gains until December 31, 2026
Any capital gains rolled into an opportunity fund within 180 days will be tax deferred until December 31, 2026, or the date on which the opportunity fund investment is sold, whichever is earlier.
Advantage #2: Step-up in basis of capital gains
Capital gains rolled into an opportunity fund within 180 days are eligible for a step-up in basis at year 5 and year 7. The basis of the original investment is stepped up by 10 percent after the opportunity fund investment is held for 5 years, and by an additional 5 percent if the opportunity fund is held for 7 years, so long as these milestones hit before December 31, 2026 (the date on which the original capital gain must be recognized).
If by December 31, 2026 the investor has held his opportunity fund investment for 5 or 6 years, his capital gains on the original investment is effectively reduced by 10 percent.
If by December 31, 2026 the investor has held his opportunity fund investment for 7 years or more, his capital gains on the original investment is effectively reduced by 15 percent.
The reduced capital gains tax payment would come due in April 2027.
Advantage #3: No tax owed on capital gains from opportunity fund investments
This is by far the biggest benefit of the opportunity zones program, and the #1 reason why Treasury Secretary Steven Mnuchin expects more than $100 billion in investments to flow to opportunity zones as a result of this program.
So long as an opportunity fund investment is held for at least 10 years, the basis of the investment will be adjusted to be equal to the fair market value of the investment on the date on which it is sold. In other words, there is zero capital gains tax due on any profits from the sale of an opportunity fund investment after a 10-year holding period.
Opportunity zone fund vs. Section 1031 exchange
Savvy investors are familiar with 1031 exchanges. And opportunity zones appear similar at first glance. But there are a few substantial differences, summarized below.
In a Section 1031 exchange, and investor must reinvest both the principal and capital gain within 180 days. And this transaction must be conducted through a qualified intermediary.
With an opportunity zone investment, an investor is only responsible for rolling over the capital gains within 180 days. The investor is not required to deploy the entire gain, but only the rolled over portion is eligible for tax advantages. Moreover, the principal can be used for anything. It does not need to be rolled over. And, placing an investment in an opportunity fund is much more straightforward, with no intermediary required.
Only real estate gains are eligible for 1031 like-kind exchanges. Whereas, capital gains from any type of asset sale (real estate, stocks, bonds, etc.) can qualify for investment in an opportunity fund.
A Section 1031 exchange is structured to allow for single asset swaps, usually one real estate property for another real estate property. Multiple properties can be supported, but this option usually comes with higher costs and less flexibility.
On the other hand, opportunity funds are pooled funds that can invest in multiple properties across asset classes and geographies.
Capital gains tax deferral
Capital gains tax payments on a 1031 exchange can be deferred indefinitely. With opportunity funds, capital gains of the initial investment may be deferred until December 31, 2026.
Capital gains tax reduction
With 1031 exchanges, a capital gains are reduced through a step-up in basis only upon death. With opportunity funds, the investor receives basis step-ups of 10 percent after 5 years and an additional 5 percent after 7 years, to account for a total available capital gains tax reduction of 15 percent.
Capital gains tax on final sale
With a 1031 exchange, the investor owes capital gains tax on final sale of the asset.
This may be the best benefit of an opportunity fund: zero capital gains tax is due on any appreciation of the opportunity fund investment upon sale, so long as the investment is held for at least 10 years.
Forming a Qualified Opportunity Fund
Any entity that is taxed as a corporation or partnership can self-certify as a Qualified Opportunity Fund by completing IRS Form 8996. That part is easy.
Creating the organizing documents, compliance process, and audit trail can be challenging. Visit OZ Pros to learn more about how to create an Opportunity Zone fund.