Everywhere you look, there’s another opportunity zone fund. What are these things and why are they suddenly so popular?
The tax savings
It’s all about taxes, specifically capital gain taxes. Added to the Internal Revenue Code by the 2017 Tax Act, new section 1400Z-2 allows investors to reduce their capital gain taxes in four increasingly-generous levels:
Level one savings
If you sell property (including property sold through a partnership or limited liability company) and recognize a capital gain, then you don’t have to pay tax right away on the gain to the extent you invest in a “qualified opportunity zone fund,” or QOZF, within 180 days. Instead, the gain is deferred until the earlier of (i) the date you sell your interest in the QOZF, or (ii) December 31, 2026.
For example, you bought stock two years ago for $1,000, and sell it during 2018 for $1,100, recognizing a $100 capital gain. If you invest $75 in a QOZF within 180 days, you pay tax in 2018 only on $25 of the gain. You pay tax on the $75 on the earlier of the date you sell your interest in the QOZF or 12/31/2026.
It gets better.
Level two savings
If you hold your investment in the QOZF for at least five years, you get to increase your tax basis in the QOZF by 10% of the gain you deferred, further reducing your tax bill.
Example: In the example above, if you hold your investment in the QOZF for at least five years, you get to increase your tax basis by 10% of $75, or $7.50.
Level three savings
If you hold your investment in the QOZF for at least seven years, you get to increase your tax basis in the QOZF by another 5% of the gain you deferred.
Level four savings
If you hold your investment in the QOZF for 10 years, you pay no capital gain tax on the appreciation in the QOZF.
Example: If, in the original example, you invested $75 in the QOZF and sold it after 10 years for $195 (10% appreciation per year, compounded), you would pay no tax on the $120 of appreciation.
What if the value of the QOZF goes down?
If you lose money on the QOZF, then your tax on the original capital gain also goes down.
Example: You sell appreciated stock for a $100 profit, and invest $75 in a QOZF. Three years later, you sell your interest in the QOZF for $50 (I’m assuming your tax basis in the QOZF hasn’t changed). You pay tax on only $50 of capital gain, not the whole $75.
Thus, it’s heads-you-win, tails-the-government-loses.
What’s a Qualified Opportunity Zone Fund?
A qualified opportunity zone fund means a corporation or partnership that holds 90% of its assets in any mix of the following assets:
- Stock of a corporation that is a “qualified opportunity zone business.”
- An interest in a partnership that is a “qualified opportunity zone business.”
- “Qualified opportunity zone property.”
A “qualified opportunity zone business” is a business substantially all of the assets of which are qualified opportunity zone property.”
”Qualified opportunity zone property” means property that is:
- Located in a “qualified opportunity zone”;
- Used by the QOZF in a trade or business; and either:
- The property is brand new (g., ground-up construction); or
- Within 30 months, the QOZF or the qualified opportunity zone business spends at least as much to renovated the property as it paid to buy it.
Boiled down version: A qualified opportunity zone fund means a fund that, directly or indirectly, owns new or substantially renovated business assets in a qualified opportunity zone.
Only new businesses or assets count
In figuring out whether a fund is a qualified opportunity zone fund, you take into account only property acquired after 12/31/2017.
Does it matter where the capital gain came from?
No. The capital gain you’re deferring could come from the sale of appreciated stock, the sale of real estate, the sale of artwork, or anywhere else.
An alternative to a like-kind exchange
Under section 1031 of the Internal Revenue Code, the owner of appreciated real estate (only real estate) can defer paying tax on sale by exchanging the real estate for different real estate. In fact, a whole industry has grown up around these so-called “like-kind exchanges.”
For as long as it lasts, the QOZF provides a simpler and possibly better alternative.
What is a Qualified Opportunity Zone?
A “qualified opportunity zone” means a low-income area that has been nominated as such by the Governor of a state and approved by the U.S. Treasury. A list is of current qualified opportunity zones is available here.
No massage parlors
In a crippling blow to my own business plans, a “qualified opportunity zone business” does not include massage parlors or hot tub facilities. Nor does it include golf courses, country clubs, suntan facilities, racetracks or other facilities used for gambling, or liquor stores.
Can I use a limited liability company?
Section 1400Z-2 itself defines “qualified opportunity zone fund” as a “corporation or partnership.” However, section 7701(a)(2) of the Internal Revenue Code defines “partnership” follows:
The term “partnership” includes a syndicate, group, pool, joint venture, or other unincorporated organization, through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of this title, a trust or estate or a corporation; and the term “partner” includes a member in such a syndicate, group, pool, joint venture, or organization.
Based on that definition, a limited liability company should work.
What if I invest more in a QOZF?
Suppose you sell appreciated stock for a $100 capital gain, and within six months invested $150 in a QOZF. The favorable tax rules apply only to two-thirds of your investment. The other one-third is just a regular investment.
Who can form a Qualified Opportunity Zone Fund?
Anyone, literally. If you sell appreciated stock and want to defer or avoid tax on all or part of the gain, you can form your own QOZF.
Conversely, large companies, including large investment managers and large real estate developers, have already formed QOZFs, taking advantage of the tax benefits and the media buzz to raise capital.
Investment Company Act limits
When Congress enacted the tax benefits for qualified opportunity zone funds, it could have created an exception to the investment company rules at the same time, making the funds even more appealing and effective. But it didn’t.
Consequently, and perhaps paradoxically, larger QOZFs — those with more than 100 investors — will have to own property directly, or take controlling interests in other businesses, to avoid being treated as investment companies. They will not be allowed to hold minority, non-controlling interests in businesses owned by others, such as, say, the residents of the qualified opportunity zone.
How can I raise capital for my QOZF?
You can raise capital using any method you like, including Title II Crowdfunding (Rule 506(c)), Title III Crowdfunding (Regulation CF), Title IV Crowdfunding (Regulation A), or Rule 506(b).
Qualified opportunity zone funds are about saving taxes, specifically capital gain taxes. They make less sense for non-accredited investors who, by definition, earn less money and pay tax at lower rates. Consequently, we will probably see fewer QOZFs using Title III or Regulation A to raise capital, and many using Rule 506(b).
More rules to come
The Internal Revenue Service hasn’t yet issued guidance on the details of this complicated legislation. Expect complicated regulations and at least a few surprises.
Waiting for the other shoe to drop
How long will it take before a QOZF is sold using tokens?
This post originally appeared on Mark Roderick’s blog, and reposted with his permission.