Qualified Opportunity Zone Funds Explained
Qualified Opportunity Zone Funds have taken off in 2019 and are a hot topic in the private fund industry. Spencer Erickson, tax managing director, alternative investments at UMB Fund Services, defines key requirements of a qualified opportunity zone fund.
The Qualified Opportunity Zones program is a hot topic throughout the investment management community in 2019. The program is a new economic development tool, designed to encourage economic investment and job creation in distressed areas of communities, by allowing an incentive to taxpayers who reinvest capital gains in designated Qualified Opportunity Zones.
In addition to other tax reforms, Qualified Opportunity Zones (QOZs) were added to the tax code by the Tax Cuts and Jobs Act in 2017. Such QOZs were proposed by each state and certified by the IRS.
Participation in the Qualified Opportunity Zones program requires that capital is invested through a Qualified Opportunity Zone fund. There are three primary tax incentives in the Qualified Opportunity Zone program, which are outlined in the chart below:
Deferral of capital gain recognition to 12/31/2026 or date of disposition.
Re-investing capital gain proceeds into a QOZ fund within 180 days of disposition. Hold investment in the QOZ fund until 12/31/2026.
Up to 15% tax basis step-up. Receive a 10% step-up in tax basis by holding the investment in the QOZ fund for five years.
Receive an additional 5% step-up by holding the investment for an additional two years.
Tax free capital appreciation.
Receive a step-up of tax basis to market value by holding the investment in the QOZ fund for ten years.
QOZ Funds operate similarly to many existing private fund structures:
- They can be a corporation, LLC, partnership, etc.;
- They can have a single investor or multiple investors;
- They can invest in a single project or multiple projects; and
- They can focus on real estate, private equity or venture capital.
Only two additional requirements separate a QOZ fund from any other private fund:
- They elect QOZ fund status on their tax return; and
- They invest at least 90% of their capital in Qualified Opportunity Zone Property.
Investment in Qualified Opportunity Zone Property includes either a new equity investment in Qualified Opportunity Zone Businesses or direct investment in Qualified Opportunity Zone Business Property as outlined below.
Qualified Opportunity Zone Business
The investment must be new (not purchased on the secondary market), equity (not debt) in a domestic corporation or partnership. Substantially all of the business’ tangible property (owned or leased) must be Qualified Opportunity Zone Business Property (defined below). The business must generate at least 50% of its total gross income from — and deploy a substantial portion of its intangible property in — the active business conduct. Some industries are excluded: financial services, golf courses, country clubs, massage parlors, hot tub or suntan facilities, race tracks, gambling, sale of alcoholic beverages, among others.
Qualified Opportunity Zone Business Property
A Qualified Opportunity Zone Business Property must be tangible, used in a Qualified Opportunity Zone trade or business, located in a Qualified Opportunity Zone. Use of the property must originate with the fund, or the fund must substantially improve the property (double the basis of the property over 30 months). Land in a Qualified Opportunity Zone can qualify by being used in a trade or business without meeting the original use requirement, but the substantial improvement requirement applies to buildings.
To receive the tax benefits from the Qualified Opportunity Zones Program, a taxpayer must invest in a QOZ fund, the fund must invest in businesses or property, and the businesses or property must be located in an Opportunity Zone.
Interest in the space is expected to grow as fund managers and investors take advantage of the program. In the coming months, our experienced tax teams anticipate seeing significant product development and investment activity around Opportunity Zones.
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