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INSIGHT: A Dozen Things You Should Know About Setting Up an Opportunity Fund

Nov. 29, 2018, 2:15 PM

By now, you have undoubtedly heard of Opportunity Zones and Qualified Opportunity Funds, a new tax-based incentive that was part of the 2017 Tax Act. While a lot of attention has gone to news about well-known investment houses, national banks, and tax-credit syndicators setting up funds, there’s no reason why a home office, closely held business, or a few family members or friends cannot take advantage of the opportunity. Whether you are going to work with one of the sophisticated players or do it on your own, here’s what you need to know, remembering that this is intended to be an overview of the rules. There are qualifiers and variations, so remember to talk to a professional about the fine details of Opportunity Zone benefits before assuming that you now know everything!

1. What are the basics?

It is estimated that there is $6.1 TRILLION of appreciated property in the US.

The Opportunity Zone provisions are intended to get taxpayers to sell some of these appreciated assets and invest the resulting gain in designated low income communities, called “opportunity zones” (we’ll call them “O-Zones”), by delaying the tax that they would otherwise pay on the sale of the asset that they sold to make the investment, and eliminating the tax on increase in value of their O-Zone investment.

To take advantage, taxpayers must invest in “Qualified Opportunity Funds” (we’ll call these “O-Funds”), and these funds must, in turn, acquire opportunity zone business assets, and hold their fund investment in accordance with specified percentages and timetables.

The law of O-Zone investing consists of two sections of the Internal Revenue Code which, in turn, refer to other tax code sections, an Internal Revenue Service website with “frequently asked questions,” some recently published “proposed regulations,” and a couple of IRS rulings. Suffice it to say that this is just barely enough to provide confidence to potential investors. Until the proposed regulations appeared, there was very little activity at all. Now, with at least some serious guidance from the government, and the promise of more regulations to come, investor interest has increased significantly. Still, the rules in the tax code can be convoluted and sufficiently incomplete that many questions continue to be unanswered, and this puts taxpayers and their advisors in the awkward position of considering whether they should try to fill in the missing tax rules with educated guesses or wait for still more guidance, even as some of the incentives (described below) may be reduced, or even lost, by delay. The bottom line is that there is currently enough guidance to provide comfort for many, but by no means all, O-Zone investments and related questions.

2. What are the Basic Incentives?

There are three basic incentives. Remember: there are qualifiers and variations, so remember to talk to a professional about the fine details of what I describe here.

Defer Tax on Capital Gains. An investor can postpone paying tax on capital gains by as much as eight years where an amount equal to this gain is invested in an O-Fund within the 180-day period that begins with the sale or exchange that generated the gain. The drawbacks: the investor gets a zero basis in its investment, and the gain is still taxable at Dec. 31, 2026, or on sale of the investment if earlier. Note that the benefits only apply to cash investments that correspond to capital gains. For example, depreciation recapture will not qualify for the favorable tax benefits.

  • Example 1: A has a basis in publicly traded stock of $1 million, which she sells for $5 million. She would normally pay a tax on this $4 million capital gain. She invests $4 million in an O-Fund, and holds that investment until at least Dec. 31, 2026. A does not have to include the gain in income until 2026.
  • Example 2: B has a basis in his coin collection of $100,000, which he sells for $400,000. B is not a dealer in coins. He would normally pay tax on this $300,000 capital gain. B invests $300,000 in an O-Fund, and holds that investment until March 2024, when he sells the investment. B includes the amount recognized in income in taxable income in 2024.

If a partnership had the capital gain, then a choice is available—the partnership can invest the gain within 180 days, the partners can invest within 180 days, or the partners can invest within the later 180 days after the partnership’s year end.

  • Example 3: C is a partner of a calendar year partnership which has a capital gain on Feb. 1, 2018. Any one of the following would be eligible for O-Zone incentives: (i) The partnership invests on or before July 30, 2018. (ii) The partnership does not invest, and C invests on or before July 30, 2018. (iii) The partnership does not invest, and C invests on or before June 28, 2018.

Note two important things when the gain is finally recognized: First, it keeps the character it originally had; for example, short term capital gain (generally taxed at higher rates for individuals) will still be short term capital gains in the year that the gain is finally recognized. Second, there’s no guarantee that tax rates will be the same or lower in the year the gain is recognized. Accordingly, there is some risk that even though payment of the tax is delayed, it might nonetheless be subject to a higher tax rate imposed by later tax legislation.

Partial forgiveness. The investor’s basis in its investment in the O-Fund is increased from zero to 10 percent for investments held for five years, and another 5 percent for investments held for seven years, provided these dates are before Dec. 31, 2026. This effectively reduces the tax by 15 percent. Basis is also increased by the amount of gain recognized at Dec. 31, 2026. Finally, if the value of the investment decreases, the investor recognizes a smaller amount, based on the value of the investment on the recognition date.

  • Example 4: D has a gain of $4 million in November 2018 which she immediately invests in an O-Fund. She gets back a membership interest in the fund with a zero basis. If she sold that interest in 2019, she would pay tax on the full sales price. In November 2023 (five years later), her basis is stepped up to $400,000. If she sold her interest at that time, she would pay tax on the sales price less $400,000. In November 2025, her basis gets stepped up by another $200,000, and in Dec. 31, 2026, she becomes liable for tax on deferred gain, equal to $4 million (or the value of the investment, if less) less her basis of $600,000. In a typical case, this would be $4 million less $600,000, or $3.4 million. If the tax rate was 20 percent at both times, then the tax bill would have been $800,000 (20 percent of $4 million) in 2018, but it is only $680,000 (20 percent of $3.4 million) in 2026, and it is due several years later.
  • Example 5: E has a gain of $1 million in 2018, which he invests in an O-Fund. In December 2026, an appraiser values his O-Fund investment at $700,000. In his 2026 return, E recognizes a capital gain of $700,000 less $150,000 (15 percent of the original gain, reflecting the 10 percent and 5 percent basis step-ups), or $550,000. With a tax rate of 20 percent, this would lower the original tax of $200,000 (20 percent of $1 million) to $110,000 (20 percent of $550,000).

Forgiveness of additional gains. The investor’s basis in its investment is increased to fair market value for sales or transfers of the investment in the O-Fund after 10 years (until Dec. 31, 2047). Under current law, this step-up does not apply to a sale of assets owned by the Fund.

  • Example 6: F has a gain of $4 million on November 2018 which it immediately invests in an O-Fund. It gets the step-ups and pays taxes as described in the preceding slide. In December 2030, when it has a basis on $4 million in its interest in the fund, it receives an offer of $10 million for its interest. If it elects, its basis is stepped up to $10 million, so that it pays no tax on this sale. ($10 million sales price less $10 million of basis is zero).
  • Example 7: Same facts as Example 6, except that in December 2030, the O-Fund owns property with a basis of $4 million that it sells for $10 million. This generates a $6 million taxable gain, and F will have to report its share.

It is important to note one tax rule that is not affected. The O-Fund itself will be a partnership or corporation, or an LLC taxed as one or the other. The O-Fund will have all of the tax benefits and burdens of a business. If it is a partnership, it will prepare a partnership tax return, and allocate its income, losses, credits, and other tax items among its partners in accordance with its partnership agreement and applicable tax law. If it is a corporation, then it will prepare a corporate tax return and pay taxes in accordance with that. In general, electing to be an O-Fund does not affect the application of usual tax rules to the fund. Having said this, it must be noted that one area of amazing complexity is determining the basis of an investor in its investment where entity-level borrowing, or depreciation deductions are involved. Complex tax rules can be implicated where an investor is allocated losses, but is nonetheless required to have a zero basis in his, her, or its O-Fund investment, on account of the requirements of the rules I described above. This marks yet another area where the assistance of a tax professional is particularly desirable, and hopefully, the IRS will issue further clarifying guidance.

3. Where are the O-Zones?

For many years, the government has been designating certain census tracts as “low income communities” (or LICs). The O-Zone provisions called for each state to designate not more than 25 percent of its LICs (and, in some cases, a small fraction of census tracts that are adjacent to LICs) as opportunity zones. The designation period is now over; absent a change in law, there will be no further designations, so don’t try to plead with your governor or the IRS that a designation should be modified because your census tract was more deserving than one of the existing O-Zones. In total, there are now 8,700 O-Zones, which is about 11 percent of all census tracts. IRS Notice 2018-48 (https://www.irs.gov/pub/irs-drop/n-18-48.pdf) provides a complete list, and maps of the census tracts that have been designated as O-Zones can be found on the U.S. Community Development Financial Institutions Fund website, at https://www.cims.cdfifund.gov/preparation/?config=config_nmtc.xml.

4. What do I have to do to set up an O-Fund?

Form an Entity. First, you have to take the usual steps under local law to form a partnership, LLC, or corporation that will comply with the tax code and IRS requirements. Remember that if you choose to make your O-Fund an LLC, it must be taxed as either a partnership or a corporation, and that the partnership form requires the LLC to have more than one member, while the corporate form requires an election. Despite the word “fund,” O-Funds are merely normal business entities that are not subject to special securities law rules, unless they would otherwise apply to your offering. Otherwise, forming a family O-Fund is barely more difficult than forming a family partnership. Just to be clear, an individual cannot take advantage of the O-Zone incentives without forming an O-Fund; O-Zone activities must be conducted through an O-Fund.

Invest in Your Entity. Second, you have to make an equity investment in your Fund with an amount that is equal to (or less than) a recent capital gain, and receive back a partnership or LLC interest or stock. An important note: when I talk about LLCs in this article, I am referring to an LLC that is either taxed as a partnership, because it has two or more members, or taxed as a corporation, because it makes an election. Many of you may be familiar with “single member LLCs.” They are often used to hold title to property while limiting the liability of their single member, but unless they elect to be taxed as a corporation, they are disregarded for tax purposes. They can be used as liability-limiting, disregarded-for-tax-purposes entities with O-Zones. However, unless a single member LLC elects to be taxed as a corporation, it cannot serve as an O-Fund, and it is also not eligible to be a subsidiary entity subject to the 70 percent test I discuss in item 6, below, precisely because a non-electing single member LLC is disregarded for tax purposes. So, remember whenever you see the term “LLC” in this article, I mean an LLC that is taxed as a partnership or corporation, and not one that is disregarded.

As noted above in item 2, you generally have 180 days, including the date of the sale or exchange, to invest in your O-Fund. Currently, except for the special rule for investments by partners whose partnership had a capital gain, there are no rules permitting one person or entity to set up an O-Fund based on the capital gain of another person or entity. If two or more people each have a capital gain, it appears that they cannot form a “feeder partnership” to invest in an O-Fund. Instead, each must directly invest in an O-Fund; if they wished, they could all invest in the same O-Fund. There have been requests that the IRS modify this rule, so it could change with subsequent IRS guidance. On the other hand, the rules do allow an investor to invest in more than one O-Fund from a single capital gain, provided that the total amounts invested for all the funds do not exceed the amount of the gain.

The Entity Must Invest in O-Zone Businesses or Business Property. Third, your O-Fund must invest, either directly or indirectly, in opportunity zone business property in accordance with specified timetables. The rules here are pretty technical, and just a bit arbitrary, but we’ll discuss them below, in item 6.

5. Are O-Funds similar to ‘like-kind exchanges?’

Early on, some writers and advisors observed that the O-Zone rules bore some resemblance to like-kind exchanges. Both techniques delay the payment of taxes, but that’s where the similarity ends. For example, a like-kind exchange requires you to sell real estate and invest in other real estate. Not so with O-Funds; you can sell publicly traded stock or real estate, or even your collection of antiques (provided you’re not a dealer), and if the sale generates a capital gain, you can put up to a corresponding amount into an O-Fund that might buy a broad range of trade or business property, provided its in an O-Zone. A like-kind exchange requires you to invest the “proceeds” of the sale; with an O-Fund, the rules only require you to invest the gain. And finally, like-kind exchange requires careful tracing of the funds and often, the use of a qualified intermediary. No and no with O-Funds. An investor can literally borrow the money that it then invests in an O-Fund.

  • Example 8: G owns real estate with a basis of $3 million and a fair market value of $5 million. The property is subject to a $5 million debt. He sells the real estate for $5 million, and uses the proceeds of the sale to pay off the debt. Within 180 days, G borrows $2 million, which is an amount equal to the gain on the sale of the real estate ($5 million less $3 million), and he invests this amount in an O-Fund. This investment is entitled to the favorable incentives associated with O-Zone investments.

6. A summary of the technical rules associated with O-Funds (or ‘O-Funds Involve More Math Than You Had Hoped')

Your O-Fund can either invest directly in O-Zone Business Assets, or it can invest indirectly in Qualified O-Zone Stock or Qualified O-Zone Partnership Interests. I often refer to indirect investing as investing in “subsidiary entities.” This is perhaps the primary area in which the tax code provision, and the IRS’s recent proposed regulations, are so numerical and technical that they call for a very careful reading, and more likely, a professional advisor. Moreover, some of the distinctions and computations have the potential to sound arbitrary. Here’s a quick summary, but remember this is only a summary:

Testing. There are six-month and year end testing dates to assure that 90 percent of the O-Fund’s assets are qualified opportunity zone business property. The IRS has provided somewhat complex rules for doing these calculations using cost basis or the basis reported in financial statements, depending on the particular facts. Expect there to be a lot of criticism of these rules, and don’t be surprised if they are changed before the regulations become final.

Direct and Indirect Ownership. As I noted above, an O-Zone business can be owned directly or indirectly, and the rules applicable to these two basic structures are both technical and seemingly arbitrary. I really meant it.

When it comes to direct ownership, it is necessary to add up all of the entity’s directly owned tangible assets, plus its interest in subsidiary entities, and these must exceed 90 percent of all of its assets. Any business operated at the O-Fund level needn’t be “active” to qualify, and there is no limit on the ability of an O-Fund to own financial property, other than the basic requirement that 90 percent of the entity’s assets be qualified.

With indirect ownership, each subsidiary entity is tested to assure that it passes additional tests, some of which are easier than the tests that apply to direct ownership by the O-Fund, and some of which are harder.

First, only 70 percent of the subsidiary entity’s tangible assets must qualify as enterprise zone business assets in order for the entire interest in the entity to count towards the O-Fund passing the 90 percent test. On the other hand, the subsidiary entity has other limits on its assets and the conduct of its business. In particular, no more than 5 percent of the subsidiary entity’s assets can consist of nonqualified financial property, including cash and similar liquid assets, as well as partnership interests and stock. For example, a subsidiary entity can’t, in turn, own an interest in another partnership, two-or-more member LLC, or corporation without assuring compliance with this 5 percent maximum. Most importantly, at least 50 percent of the subsidiary entity’s income must come from the conduct of an active trade or business in the O-Zone, a seemingly higher standard than the mere trade or business test that applies to direct ownership, and a “substantial portion” of the entity’s intangible property must be used in the active conduct of the business. Finally, the business cannot be certain enumerated activities, including a golf course, tanning facility or a liquor store.

  • Example 9: O-Fund H has $1 million, it invests $900,000 in a partnership, receiving back a partnership interest. Six months after the O-Fund was formed, Partnership’s assets consist of a $700,000 newly constructed building from which it runs a supermarket in an O-Zone, and a $200,000 building not in an O-Zone. So, 700/900, or 77 percent of the partnership’s assets (more than 70 percent) are good, and therefore, the entire $900,000 partnership interest qualifies. Accordingly, 900/1,000 of O-Fund H’s assets, or 90 percent, are good, and therefore, the O-Fund meets the 90 percent test.
  • Example10: O-Fund J builds a retail building in an O-Zone, and it triple net leases the property to a commercial tenant. Is this a trade or business that can be owned directly by an O-Fund, but not an active trade or business that could count favorably towards the 70 percent test if owned by a subsidiary entity? Suppose the subsidiary entity actively manages the property, is it now an active trade or business? This is a question that should be high on the IRS’s “need for guidance” list.

A Reminder About LLCs. Just in case you forgot my discussion earlier, an LLC must be taxed as a corporation or partnership in order to be a subsidiary entity that is subject to the 70 percent test. Unless it elects to be taxed as corporation, a single member LLC is disregarded for these purposes, as if the property was owned directly by that single member.

Must be Acquired After 2017 from an Unrelated Seller. Regardless of whether the direct or indirect structure is used, only assets acquired after 2017 from at least 80 percent unrelated sellers are qualified. In other words, selling property that you owned prior to 2018 to an O-Fund (or subsidiary entity) of which you own more than 20 percent, won’t qualify for O-Zone benefits. But, see item 7, below.

Rules for New and Used Property. Already used property is generally ineligible for O-Zone benefits unless the O-Fund or subsidiary entity (as applicable) substantially improves the property. This is also discussed in greater detail in item 7, below.

7. Rehabilitation of Used Property.

Finally, to be qualified property, the use by the O-Fund or the subsidiary entity must be its first use, or if the property is already used, then within “any” 30-month period after acquisition, there must be additions to basis with respect to the property greater than the basis in the property at the start of the 30-month period. Basis in land does not count for this purpose.

  • Example 11: Fund K acquires property for $5 million, consisting of $1 million of land and $4 million of building. Within a 30-month period after acquisition, it must make capital expenditures with respect to the project that increase basis by $4 million.

The rehabilitation rule brings with it several new issues and questions:

What Does “With Respect to” Mean? Does the 30-month expenditure rule mean that the O-Fund or subsidiary entity must rehabilitate the particular property? Or can it simply upgrade the neighborhood? For example, will a playground or community center count as “with respect to” an existing, used property? So far, it seems that the IRS is interpreting this rule to apply to additions to the basis of the particular property, and not something related to it.

The IRS’s Safe Harbor. In its recent proposed regulations and revenue ruling, the IRS provided a “safe harbor”—if a property is newly constructed or rehabilitated by a subsidiary entity within a 31-month period in substantial compliance with a written plan, then any cash that the entity holds awaiting use in the new construction or rehabilitation is not nonqualified financial property. While everyone would like the IRS to be even clearer, it appears that if the project complies with this 31-month safe harbor, it will also be considered engaged in an active trade or business, even though the project is under construction, and only generating investment income.

  • Example 12: L and M form an LLC taxed as a partnership and it acquires, as its sole asset land for $1 million and an existing building on the land for $4 million. The prepare a reasonable written plan to spend $4.5 million on renovating the building over a 30-month period. They use $6.5 million of their own money to capitalize the partnership. At the same time, N forms and becomes one of the members of an O-Fund, making a $3 million capital contribution representing a $3 million capital gain. Finally, the O-Fund is admitted as a partner of L and M’s LLC, receiving a 30 percent member of the LLC in exchange for a capital contribution of $3 million. N’s investment in the O-Fund should qualify for all the favorable O-Zone incentives.

Rehabilitating Already Owned Property. Remember that the O-Zone rules only treat property that was acquired after 2017 as “eligible” under the 70 and 90 percent tests. But what if the owner now rehabilitates a pre-2018 property in 2018 or a later year? Is the rehabilitation work sufficient to make the overall project eligible? The IRS hasn’t weighed in on this point, but it seems that this should be a proper result, especially given the goal of the legislation.

  • Example 13: P has owned a used building in what is now an O-Zone since 2010. Her basis in the property is $3 million. If she contributes the land to a newly formed subsidiary entity of an O-Fund, and the entity then spends $7.5 million on rehabilitating the building within a 30-month period, it clearly passes the substantial improvement requirement. But does the subsidiary entity pass the 70 percent test? The new expenditures ($7.5 million) amount to 71 percent of the entity’s total assets, but is the subsidiary entity permitted to treat the improvements as a separate computation so that the 70 percent test can be passed?

8. Penalties and Reasonable Cause

The tax code provides that if an O-Fund fails to meet the 90 percent requirement, it is subject to a penalty at the IRS’s “underpayment rate,” currently 5 percent. And, an O-Fund can avoid this penalty if the failure is due to reasonable cause. So far, the IRS has not provided any guidance as to how this penalty or the exception will be applied. For example, can an Investor just set up an entity, call it an O-Fund, pay the penalty for a while, and then finally make investments, while simultaneously not having to pay tax on the original capital gain? It’s not clear whether this penalty was intended to cover an O-Fund that failed to qualify as such right from the start, although the tax code provision appears to read that way. Obviously, this has the potential to provide a lot of cover for investors and O-Funds that fail to meet the requirements I describe here. Suppose an O-Fund adopts a written 31-month plan, but then bad weather, a strike, or some other adverse condition delays completion of the project. It would seem that the investor should be entitled to the benefit of reasonable cause exception to owing the penalty.

9. One Fund per Property?

As noted above, the “no tax if you hold for 10 years” rule applies to a sale of an interest in the O-Fund, and not a sale of the actual business assets of the O-Fund or any subsidiary entity. With this in mind, unless and until the law is modified, it may make a lot of sense for an O-Fund to be formed to hold just one primary asset or one subsidiary entity.

  • Example 14: O-Fund Q owns five assets, two hotels, an office building, a residential building, and a supermarket. O-Fund R owns one asset, a residential building. We should anticipate that it will be easier for R to find someone willing to buy all of the interests in the O-Fund, and thereby own residential housing, than for O-Fund Q to find a buyer who wants to own five assets comprising four different businesses.

Nonetheless, many who are familiar with the O-Zone rules, including the original proponents, are holding out for a change in the rules that would provide the same tax treatment if the underlying assets were sold instead of interests in the O-Fund. And, I wouldn’t rule out the IRS issuing a letter ruling or other guidance permitting the “spin-off” or “split-up” of a single O-Fund into two or more qualifying funds, so as to facilitate a sale of one of the split-off funds that would now only have one (or a group of similar) assets.

10. What About Non-Real Estate Businesses?

Most discussions of O-Zone benefits are centered on project finance; typically, this means the construction or rehabilitation of a building located in an O-Zone. But the incentive should apply about as well to non-capital intensive businesses. Note a few considerations:

Direct Ownership Issues. Remember that an O-Fund’s investing can take two forms, direct and indirect ownership. If the O-Fund owns the business directly, then 90 percent of the O-Fund’s assets must consist of tangible property that is used in a trade or business in the O-Zone. So, if the O-Fund will have any significant intangibles, then direct ownership may not be the best form.

Indirect Ownership. If the operating business is operated through a subsidiary entity, then we fall back to the 70 percent test, applied only to tangible assets, provided a substantial portion of the intangible property of such entity is used in the active conduct of any such business. Note that a substantial portion of any intangibles acquired must be used in the active conduct of a trade or business, but that should not be a problem; central to this discussion is the operation of an active trade or business.

  • Example 15: S invests $2 million in an O-Fund. The O-Fund is going to set up and operate a “Great Hamburgers” franchise location in an O-Zone, by getting a “Great Hamburgers” franchise, including the logo and other intangibles. The cost of the franchise is $300,000, and the cost to build the location will be $1.7 million. If the O-Fund owned the Great Hamburgers franchise directly, then only 85 percent of its assets would consist of good tangibles, and the O-Fund would not qualify. On the other hand, if the O-Fund becomes a member of an LLC that owns the Great Hamburger franchise, then 100 percent of the LLC’s tangible assets ($1.7 million out of $1.7 million) are good, and it appears that the $300,000 of intangibles are entirely used in an active trade or business. So, the subsidiary entity is a good asset, meaning that the entire $2 million membership interest in the subsidiary entity would be a good asset, and the O-Fund would now pass the 90 percent test.

What about a startup business? With a startup business that is creating intangibles, as opposed to acquiring them, it may be possible to use either ownership structure, and qualify for O-Zone benefits, even with a relatively small investment.

  • Example 16: T sells his $50,000 stock portfolio with a basis of $10,000 and uses the $40,000 gain to invest in a newly formed O-Fund that uses the money to acquire desks and computers which he uses in his software business located in an O-Zone. Accordingly, 100 percent of the O-Fund’s assets consist of eligible tangible property. The O-Fund business develops a brilliant new anti-virus program. Ten years later, T sells his interest in the O-Fund for $1 billion, and pays no tax.

It should be noted that whether T should run his business through an O-Fund or a subsidiary entity will depend on numerous secondary factors. For example, will the software development business be considered an active trade or business? If not, then direct ownership will be desirable. Will there be any intangibles used in the business that might exceed the 10 percent ineligible assets allowed for a direct ownership structure? If so, a subsidiary entity will be desirable. Plainly, this is a fact pattern where careful study is required to assure that the best method is used.

11. Benefits for Developers of Projects

While the O-Zone provisions are most associated with getting a tax break for an investor, they seem to apply quite well to service providers too.

  • Example 17: U is the developer of a business in an O-Zone. U is putting up $100,000, corresponding to a recent $100,000 capital gain, in exchange for a 10 percent interest in the O-Fund. Other investors are putting up $900,000 for the other 90 percent of the interests. When U sells his interest 12 years later, Q qualifies for the basis step-up and doesn’t pay tax on the sale.
  • Example 18: V is the developer of a business in an O-Zone. V is contributing $50,000, corresponding to a recent $50,000 capital gain, in exchange for a 1 percent interest in the operating income of the O-Fund that will “flip” and a 30 percent interest in the O-Fund’s income (if any) from capital transactions, and W contributes $1 million in exchange for a 99 percent interest in operating income and a 70 percent interest in income from capital transactions. The O-Fund operating agreement provides that any liquidation of the O-Fund must be made in accordance with the member’s capital accounts, meaning that V will only get $50,000, and W will get $1 million, if the fund was liquidated with no appreciation in the O-Fund’s assets. You may recognize this as a typical “promote” intended to give V capital gain treatment when the property is ultimately sold. In an O-Zone, after a more than 10-year holding period, it would seem that V should qualify for the further benefit of not paying tax because the gain arises in an O-Zone.

12. Timing Considerations and the Need for a Smart Advisor

Owing to the technical timing rules that put severe burdens on the investor and the O-Fund to make their respective investments speedily, it seems that the optimal strategy is for an investor to find a potential project or business first, and then sell property to generate a capital gain and start the clock running. Consistent with this process, a home office that plans to make O-Zone investments would be well advised to have an advisor that can find suitable investments. In particular, it must be remembered that unlike tax credit investments, where the credit provides a kind of subsidy that insulates the investor from a loss in value when it makes certain investments (e.g., in affordable housing, historic buildings, renewable, and new markets). Accordingly, investing in O-Funds calls for a true expectation that the investment will at least hold its value if not appreciate, in order to justify the investment in the first place.

  • Example 19: X plans to open a new location in an O-Zone. It has a written plan to build this new location in 31 months. If X has capital gain property that it can sell and make a corresponding investment in an O-Fund this can be an excellent resource.
  • Example 20: Y has a large stock portfolio and it hires an advisor to find it O-Zone investments. Rather than selling some of its stock and giving the advisor a limited amount of time to find investments, the advisor endeavors to find suitable investments, and when it does, Y sells some of its stock and makes the investment.
  • Example 21: Z has a modest portfolio. It wants to sell $250,000 of stock in which it has a $50,000 basis and delay payment of the tax (approximately $40,000) on the $200,000 gain. It finds a risky $200,000 investment, which it plans to make using an O-Fund so as to delay, and potentially reduce, the payment of the $40,000 tax until it pays its 2026 tax liability. Z should carefully weigh the benefit of this delay in paying tax with the potential risk of losing $160,000 (i.e., the $200,000 of gain being invested less the $40,000 of tax that would be paid currently).

Obviously, there is a great deal to digest here, and it may take a while for the marketplace to absorb the rules and potential tax consequences. But with good advisors, both as to the technical rules and the choice of investments, the power of this new incentive to both change many low income communities for the better and also reduce the tax liability of many investors cannot be denied.

Forrest David Milder is a partner in the law firm, Nixon Peabody, LLP, where he specializes in the tax aspects of tax-equity investing. He is a frequent speaker and author on tax-equity topics, including the Bloomberg Tax Management Portfolio, “Rehabilitation Tax Credit and Low-Income Housing Tax Credit.” He is a past chair of the American Bar Association’s Forum on Affordable Housing and Community Development and the MIT Enterprise Forum of Cambridge. He can be reached at 617-345-1055.