How Opportunity Zone Funds Directly Benefit Eligible Investors

With the passing of the Tax Cuts and Jobs Act of 2017 on December 22, 2017 a new, tax advantaged investment vehicle has emerged called Opportunity Zone Funds (OZF). OZFs were created to encourage investment in economically-distressed communities by offering investors a deferral on capital gains realized and invested in an opportunity zone fund as well as potential elimination of capital gains tax owed by Fund investors on disposition of OZF interests.

This new investment vehicle is designed specifically to encourage economic investment in low-income and/or distressed communities, as designated by state Governors. OZFs are vehicles by which taxpayers can use to invest their deferred capital gains in qualifying opportunity zones. To qualify as an OZF, the fund can be organized as a corporation or a partnership for the purpose of investing in qualified opportunity zone property and 90% of the Fund’s assets must be held in qualified opportunity zone property. Qualified opportunity zone property includes qualified opportunity zone stock, qualified opportunity zone partnership interests or qualified opportunity zone business property.

The entity in which the stock or partnership interests are acquired must have an active interest in qualified opportunity zone business property. Qualified opportunity zone business property references tangible property used in a trade or business acquired by a OZF if such property was acquired by purchase after December 31, 2017, the original use of such property in the qualified opportunity zone commences with the Fund or the Fund substantially improves the property, and the use of such property was in a qualified opportunity zone during substantially all of the Fund’s holding period for the property. The qualified opportunity zone business property will be treated as substantially improved if during the 30 month period beginning after the date of acquisition the additions to the basis of such property exceed the adjusted basis of such property at the beginning of the 30 month period .

A taxpayer is allowed to self-certify qualification as an OZF by completing a form to attach to the taxpayer’s timely filed federal income tax return for the first taxable year in which they qualify. To realize the benefits of deferral, eligible investors must invest their capital gains with the qualifying fund within 180 days of realizing the capital gains. Doing so will allow eligible investors to defer tax on the capital gains realized until the earlier of (i) the date the investment in the qualified opportunity zone fund is sold, or, (ii) 2026. If eligible investors hold the OZF interest for five or more years, the capital gains tax payable on the deferred gain is reduced by 10%. Holding the qualified interest for seven years reduces tax payable on the deferred gain by 15%. If the interest is held for 10+ years, the eligible investor may eliminate any capital gains taxes that would ordinarily be due on the disposition of the underlying investment in the OZF, assuming the investment has appreciated. Please note, the 10+ year holding period relates specifically to the fund investment. Holding the interest for 10+ years allows eligible taxpayers to reduce their original capital gain tax payable by 15% in addition to eliminating any additional capital gains realized as a result of disposing of the OZF interest itself.

The Basic Concepts of the OZF

Step 1 – A qualified opportunity zone fund is formed and certified by the Department of the Treasury by filing self-certification with the taxpayer’s federal income tax return.

Step 2 – An eligible investor, who has recently realized capital gains (within 180 days of realization) elects to invest their gains into the OZF in exchange for stock or a partnership interest. In doing so, the eligible investor is allowed deferral on the capital gains invested.

Step 3 – The OZF uses the investment to acquire qualified opportunity zone property.

Step 4 – The investor holds the interest for as long as they desire, or as is mandated by the partnership agreement.

Step 5 – If an eligible investor sells or otherwise disposes of their OZF interest before 12/31/2026, the investor will recognize the appropriate portion of deferred capital gain.

Step 6 – If the eligible investor holds their interest in the OZF through 12/31/2026, the eligible investor must then recognize the deferred capital gain. The holding periods previously noted are taken into account at this time.

Step 7 – If the eligible investor holds their interest in the OZF for at least 10 years, they are entitled to a fair market value basis step-up so that any appreciation realized in the OZF interest can be excluded from their income. The OZF directly benefits eligible investors and creates opportunity for qualifying funds to raise additional capital by offering tax deferral to eligible investors. It is important to note that the fund must meet the same criteria throughout the life of the fund’s investment period, not simply upon organization of the fund. While qualifying funds offer attractive benefits, it is important to ensure the fund structure and mechanics are appropriate to attract eligible investors and meet eligibility criteria. Once criteria is determined to have been met, funds can then educate potential investors on benefits of investing in qualified opportunity zone funds. Please consult your tax advisor to ascertain whether you may be eligible for these benefits based on your investment criteria. The HHM team is happy to answer any questions regarding OZFs and assist with entity structure, qualification and ongoing maintenance of the OZF.