Forming a Qualified Opportunity Fund:
The Opportunity Zone Compliant Investment Vehicle
In order to gain the tax advantages of investing in opportunity zones, investors/taxpayers must first timely invest capital gains proceeds into a qualified opportunity fund. A qualified opportunity fund, or “QOF”, can be any investment vehicle that is taxed as a corporation or partnership under U.S. tax law and is organized to invest in opportunity zone compliant projects or businesses. QOFs range from simple entities formed by individuals who have gains to invest to large complex funds organized by seasoned institutional fund sponsors – and everything in between. Most industry participants have utilized limited liability companies (that have elected to be taxed as partnerships) as the preferred vehicle, though some larger fund sponsors use limited partnerships which is typical in the private equity space.
Most individuals interested in making opportunity zone investments invest their qualifying capital gains (discussed below) into qualified opportunity funds established and managed by financial and real estate fund sponsors. However, many higher-net-worth individuals have formed their own QOFs to invest in transactions they have sourced themselves or as co-investors alongside friends, colleagues or other firms.
Before forming a qualified opportunity fund, investors must consider how the regulations impact the structuring of their fund. The first rule to consider is that qualified opportunity funds cannot invest in other qualified opportunity funds. This limitation restricts the use of hierarchal investment structures, which limits the investor’s ability to use a personally-formed QOF if he/she has not already identified one or more appropriate investment opportunities for the fund. It may be difficult for a taxpayer/investor to find suitable co-investment opportunities to invest their QOF dollars on a timely basis and they cannot simply use their own qualified opportunity fund to invest in another fund should direct investment opportunities not materialize. As has been a theme throughout this Series, the key takeaway is that meticulous planning is critical to navigating the regulations and getting the most advantage from the generous tax benefits available under the opportunity zones program.
Once a taxpayer has incurred a capital gain and a qualified opportunity fund has been formed or identified, the taxpayer must invest the gain proceeds in the QOF within 180 days after the gain is realized. In most cases identifying the 180-day investment period is straightforward, but note that there are some complexities when capital gains are incurred by a partner of a partnership as a result of transactions at the partnership level. Once a QOF has been formed and funded, there are some key compliance matters the taxpayer must pay close attention to so that the entity continues to meet the requirements of a qualified opportunity fund for the life of its investments – which can be many years – and remains eligible to get the most beneficial tax treatment. These QOF-level considerations are in addition to those regarding the structuring of an opportunity zone transaction – which is the topic of Part 5 of this Series.
Chief among the ongoing requirements of a qualified opportunity fund is that it be able to certify to the IRS annually that at least 90% of its assets are qualified opportunity zone property. This is commonly referred to as the QOF’s “90% asset test.” Qualified opportunity zone property includes: (a) direct investments in qualified opportunity zone business property, such as real or other tangible property located in an opportunity zone; and (b) investments in the equity (stock or partnership/LLC interests) of a qualified opportunity zone business, or “QOZB”, that owns qualified opportunity zone business property and otherwise meets the somewhat complex definition of a QOZB. For a variety of reasons, almost all QOFs invest their funds solely in the equity of QOZBs and not in tangible assets. In other words, QOFs do not often develop or construct projects or operate businesses in opportunity zones, but rather make passive investments in QOZBs which do those things. These concepts are discussed in more detail in Part 5 of this Series.
As noted above, a QOF’s investment in another QOF is not considered a “good” asset for purposes of the 90% asset test (because it is not tangible property in an opportunity zone nor an equity investment in a QOZB). This drives our earlier point about the structuring limitations for QOFs. Another asset which does not count towards a QOF’s 90% asset test compliance is cash (or cash equivalents or investment securities). This limitation drives the timing for a QOF to invest any cash that its owners have invested in the QOF.
A QOF needs to evaluate the percentage of its assets that are “good” assets (i.e., that meet the definition of qualified opportunity zone property) twice a year – at the end of June and December – and the average of those two percentages must be reported to the IRS by the QOF with its annual tax returns. If the QOF’s average is less than 90%, then penalties will be due. There are complexities, variables and special rules involved in determining the correct percentage of “good assets” and “bad assets” at any given time, which are beyond the scope of this note. One item worth noting, however, is that cash on the QOFs books at the testing dates will be counted as a “bad” asset for purposes of this test (other than cash funded into the QOF during the immediately preceding six months, which can be ignored) so cash needs to be invested by the QOF prior to the testing date.
For all of these reasons, investors should assess these issues with their lawyers and accountants who have expertise in this area in advance of forming or investing in a qualified opportunity fund and well in advance of each asset test date.
For a more in-depth discussion of the opportunity zone program, including the statute, proposed and final regulations, please read our Opportunity Zones Client Alerts which you can access via the following links: https://www.martinllp.net/category/opportunity-zone/
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While this Series will serve as a helpful primer on opportunity zone regulations and compliance framework, the devil is always in the details. If you are considering making an opportunity zone investment in the near future, or just want to learn more than this primer can offer, the attorneys at Martin LLP are always available to consult with you.
In the meantime, stay tuned for Part 5