What is a Qualified Opportunity Zone Fund, and How Does It Work?
Investments in Qualified Opportunity Zone funds are one of the greatest opportunities taxpayers can take advantage of to earn substantial returns and tax benefits—for the time being. Qualified Opportunity Zones are economically distressed communities designated by states and territories for certain types of investments that may be eligible for preferential tax treatment. And they allow investors to defer taxes on eligible capital gains until Dec. 31, 2026, and eliminate federal tax on future gains if an investment is held for a minimum of 10 years.
Qualified Opportunity Zone (QOZ) law was enacted in 2017 as part of the U.S. Tax Cuts and Jobs Act. As the law stands today, QOZ investments can be made until June 30, 2027. Investors are eligible to eliminate capital gains taxes on QOZ investments as late as June 2047. While attempts were made to extend the Qualified Opportunity Zone (QOZ) program in 2022, new legislation introduced in June—H.R. 3937, the Small Business Jobs Act—did not include that provision. Instead, the new legislation proposes the creation of new rural opportunity zones, increased reporting requirements for investors, and greater evaluation by the Treasury Department on QOZ investments.
Investing in Qualified Opportunity Zones can be a challenging endeavor for those who choose to go it alone rather than through a sponsor. All investments must be made through Qualified Opportunity Zone funds (more about these below). These funds require meticulous adherence to federal law by their fund sponsors. While individual investors can set up their own funds, most investors work through QOZ sponsors who assume the legal and accounting burdens.
What Investments Can a Qualified Opportunity Zone Fund Make?
The assets of a Qualified Opportunity fund, or QOF, must be composed of at least 90% Qualified Opportunity Zone property. A QOZ property is any of the following:
- A QOZ business property
- Stock in a corporation that is a QOZ business
- Interest in a partnership that is a QOZ business
A QOZ business is a trade or business in which at least 70% of the tangible property is a QOZ business property, or QOZBP. A QOZBP is a tangible property used in a trade or business of the QOZ business if:
- The property was purchased by the QOZB after Dec. 31, 2017
- The original use of the property in a QOZ starts with the QOZ business, or the QOZ business substantially improves the property, and
- Substantially all of the use of the property was in a QOZ during substantially all of the time the QOZB held the property
More details on how a QOZ business must operate:
- At least 50% of the QOZ business’s gross income must be derived from the active conduct of such business in a QOZ;
- A “substantial portion” of the intangible property of the QOZ business must be used in the QOZ business’s trade or business within a QOZ;
- And the average of the aggregate unadjusted bases of the QOZ business property attributable to “nonqualified financial property” must be less than 5%.
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Some examples of businesses eligible to be QOZ businesses are stores, restaurants, hotels, technology startups, warehouses and manufacturers. At Origin Investments, we have three Qualified Opportunity Zone Funds that invest in Class A multifamily developments in QOZs across the United States. A service provider such as a laundry, landscaper or beauty salon also is eligible. However, certain “sin” businesses, such as massage parlors, hot tub facilities, liquor stores and racetracks, are not. At this writing, software businesses or other businesses that employ workers virtually would need to perform a “substantial portion” of its intellectual property within the QOZ to qualify for tax benefits. The U.S. Treasury and the IRS are still studying how mobile workforces fit into these rules.
How is a Qualified Opportunity Fund Created and Taxed?
Unlocking the tax benefits offered by QOZs requires investing through a Qualified Opportunity Fund (QOF)—an investment vehicle organized as a corporation or partnership with the specific purpose of investing in QOZ property.
A QOF does not require an institutional sponsor. In fact, any investor can set up a QOF through a self-certification process. To certify and maintain the fund, the investor or sponsor must meet all federal requirements. Because of the complexities of QOF requirements, it is likely worthwhile for investors to use experienced sponsors with legal, accounting, underwriting and property management teams in place.
To create a QOF, fund sponsors must organize a partnership or corporation, a limited liability corporation (LLC), a regulated investment company (RIC) or a real estate investment trust (REIT) in a fund structure for the purpose of investing in QOZ property. (Learn more about the types of fund structures, and the difference between REITs and LLCs, in this article.) The corporation or partnership must file an annual federal income tax return using Form 8996 for Qualified Opportunity funds, which, among other things, certifies that the entity is organized to invest in a QOZ property.
Whether investors use a sponsor for QOZ investing or form their own funds, it is helpful to read Form 8996, which delineates the legal parameters of QOZ investing and defines QOFs, QOZ partnership interests, QOZ businesses and more.
Each state has its own QOZ and QOF reporting requirements, and investors need to follow those requirements with respect to the state’s treatment of their investment. Novogradac, a professional services firm focusing on real estate, offers a survey of each state’s personal and corporate income tax rules for QOZ investors.
An individual investor in a QOZ fund must declare their initial investment in Form 8949 of their federal income tax return.
How to Choose a QOZ Fund Manager
Investors who do not have the wherewithal to manage compliance duties on their own can turn to fund sponsors or managers who can comply with fund regulations.
However, investors should keep in mind that the 10-year holding period to qualify for QOZ tax benefits on investment proceeds requires a long-term relationship with a sponsor. Investors should be comfortable with a sponsor’s expertise and experience in not just compliance but also acquisition, financing, leasing and the ability to operate in distressed communities. These activities require an organization that has significant experience and can develop and execute strategies for economic growth in a challenging and uncertain environment.
Qualities that indicate a capable Qualified Opportunity Zone fund sponsor or manager include:
- Proven development experience. Many inexperienced operators are drawn to QOZ activity out of an interest in community development or the fees that a QOZ improvement or business activity can generate. Developing properties within a QOZ has myriad complexities and requires acquisition, finance, development and operations experience with the types of properties being targeted as fund investments.
- Substantiated leadership. To execute complex compliance requirements, a fund manager should have in-house legal counsel with extensive QOZ knowledge. An experienced management team will include seasoned and respected individuals who can provide a decade-long endeavor with the resiliency it needs. Team shortcomings could pose tax liabilities for the investor and threaten the project’s viability.
- Solid acquisition criteria. Some funds invest in single distressed communities; others focus on specific property types in various communities; and still others invest in properties in QOZs that meet their investment criteria. Regardless, all high-performing managers will have an evidence-based market selection plan with conservative growth assumptions that provide an opportunity for profit before considering tax benefits.
- Transparency. The sponsor should provide financial, legal and investor referrals, and offer documents that explain all fees. A long-term relationship should not have a hesitant or opaque start.
- Alignment of interests. Do fund sponsors invest their own money in the fund? Origin’s founding partners have made material investments alongside their QOZ Fund I, II and III investors.
Go It Alone or Find an Experienced QOZ Fund Manager?
Property values in distressed communities such as those designated as QOZs hold the promise of rising substantially with development and investment. That promise can be very enticing to a would-be investor looking to invest capital gains. Qualified Opportunity Zones can provide needed economic benefits to a community and returns for investors. But QOZ incentives exist because the gains are by no means guaranteed in the economically distressed Opportunity Zones.
At Origin, we have proven experience in creating and managing QOZ Funds, including our most recent, QOZ Fund III, which is developing a strong pipeline of deals. And we have spent years educating investors on what to look for in a QOZ fund, the ins and outs of tax reporting requirements in a QOZ fund, and the benefits of investing in a QOZ fund.
We are committed to educating our investors to ensure they make the most informed decision possible when investing in a QOZ fund. To learn more, sign up for our mailing list here, and take a deeper dive into our informative, timely articles and webinars here.