Opportunity Zone Fund Legal Rules: Everything You Need to Know

Written By
Carl E. Sera, CMT
Published On
June 6, 2023

Opportunity Zones offer investors the ability to help under developed areas, as well as revitalize communities in need.

Navigating the Legal Landscape of Opportunity Zone Funds: What You Need to Know

"Opportunity Zones," a new economic development tool designed to spur investment in low-income regions, has piqued the interest of investors, developers, and company owners alike. The Opportunity Zone Program arose as part of a bipartisan effort to entice private investors to invest in low-income communities that would otherwise rely on grants or investments from non-profit organizations, federal, state, or local governments, to spur growth.

The Opportunity Zone Program attracts private capital to Opportunity Zones by extending tax benefits to investors in “Qualified Opportunity Funds,” which, in turn, invest in projects or businesses located in these zones. The incentive is not limited to real estate investments. Instead, businesses that deploy capital and operate in Opportunity Zones can benefit from this incentive.

This article briefly overviews the legal aspects of the QOZ and QOF and looks at some of the statute's requirements and proposed regulations.

A Background of the Basic Rules of Opportunity Zone Fund

Gain Deferral

Under the Opportunity Zone Program, taxpayers defer recognizing capital gains if they make an equity investment in a Qualified Opportunity Fund within 180 days of when such gains would otherwise be recognized. The initial deferral does not last forever.

Once the fund equity interest is sold, or on December 31, 2026, whichever is earlier, the investor pays tax on the lesser of (i) the deferred capital gain or (ii) the fair market value of the Qualified Opportunity zone property less its tax basis. This basis initially equals zero, but after five years, it increases by 10% of the capital gain deferred, and after seven years, it increases another 5%. As a result, taxpayers may permanently exclude up to 15% of capital gains invested in a Qualified Opportunity Fund, provided they acquire their fund interest before December 31, 2019. Unfortunately, this is no longer applicable.

After ten years, the tax basis in the Qualified Opportunity Fund investment equals its fair market value on the date it is sold, such that there is no taxable gain on the sale. Thus, taxpayers may avoid tax on any post-acquisition appreciation of the fund investment. The existing Opportunity Zone designations expire on December 31, 2028. Nevertheless, taxpayers investing in a Qualified Opportunity Fund on or before that deadline can benefit from the 10-year basis step-up until December 31, 2047.

Eligible Gain

According to the proposed regulations, the qualified gain is any gain classified as a capital gain for federal income tax purposes. Thus, the qualifying gain should include long-term capital gain, short-term capital gain, Code Section 1231 gain, and unrecaptured Code Section 1250 gain. Gains considered as ordinary income, such as depreciation recapture above straight-line depreciation under Code Sections 1245 or 1250, should not be eligible for deferral under Code Sections 1400Z-1 and 1400Z-2. Primary residences are excluded as well.

Eligible Interests

The investment must take the form of an equity stake. Preferred stock and partnership interests with unique allocations are permissible. Be aware that debt instruments do not qualify.

Eligible Taxpayers

The proposed regulations and preamble to it provide that taxpayers eligible to defer gain are any persons that may recognize capital gain, including (1) individuals; (2) C corporations, including real estate investment trusts and regulated investment companies; (3) partnerships; (4) S corporations; (5) trusts; (6) estates; and (7) certain other pass-through entities, including common trust funds, qualified settlement funds, disputed ownership funds, and other entities taxable under Section 1.468B of the Income Tax Regulations. So that you know, you must be an accredited investor to participate in an Opportunity Zone Fund investment.

Pass-Through Entities

Under the proposed regulations, partnerships can defer gain by making the election. Suppose a partnership does not make the election. In that case, each partner can elect to the extent of their distributive share of qualifying gain (provided the sale or exchange was not with a person related to the partner).

If the partnership makes the election, the 180-day period begins with the date of the sale or exchange. If the partner makes the election, the 180-day period begins on the last day of the partnership’s taxable year. A partner may, however, elect to start the 180 days on the date of the sale or exchange. These rules apply to other pass-through entities, including S corporations, trusts, and estates. Thus, owners and beneficiaries of pass-through entities have an expanded range of dates.

Subsequent Reinvestment

Taxpayers may defer gain on the sale or exchange of a QOF investment if they reinvest the proceeds in a new QOF investment within 180 days of the sale or exchange of the initial QOF investment. As you know, a complete disposition of the original QOF investment is required to reinvest the funds in a new QOF investment and obtain the benefits of continued deferral.

90% Test

Testing for the 90% requirement is done by measuring the QOF’s assets on two dates: (1) the last day of the first 6-month period of the fund’s existence as a QOF; and (2) the last day of the fund’s taxable year. According to the proposed regulations' preamble, if a calendar-year QOF chooses a month after June as its first month as a QOF, then the only testing date for the taxable year is the last day of the QOF’s taxable year.

A QOF’s failure to meet the test will result in a monthly penalty on the amount by which 90% of the QOF’s assets exceeds the amount of QOF property held by the fund. The penalty rate is the underpayment rate under Code Section 6621(a)(2) (currently 6%).

QOF Formation and Certification Mechanics

QOFs may self-certify using Form 8996, a draft instructions form on the IRS’s website. The Form 8996 must be attached to the entity's tax return, including extensions. The entity must identify the first month it wishes to be considered a QOF, which can be other than the month it is formed. The same form is expected to be used for annual compliance reporting.

According to the draft Form 8996 and instructions, the organizational documents must state that the entity's purpose is to invest in QOZP and describe the business or businesses it expects to engage (directly or indirectly).

Closing Thoughts

The Opportunity Zone program offers a compelling tax incentive for high-net-worth investors. That said, the program is not without its risks. Chief among these risks is a potential for conflicts of interest, regulatory uncertainty, and distorted pricing. While these complexities are addressable, they require a thoughtful and measured approach.

If you have an eligible gain and want to learn more about how opportunity zone funds work, please get in touch with us at Sera Capital for a complimentary 30-minute consultation.

Carl E. Sera, CMT

Carl E. Sera, CMT

Managing Principal, Sera Capital
Carl Sera is a Chartered Market Technician and the Managing Principal at Sera Capital Management, LLC. He has over 16 years of experience in the financial services industry with a focus on investment management.

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