Deferring Capital Gains in Qualified Opportunity Funds
December 11, 2018
The Tax Cuts and Jobs Act, passed in December 2017, contains a new federal income tax deferral mechanism: “qualified opportunity funds” (“Opportunity Zone Funds“). This Memorandum will summarize the potential tax benefits to investors and challenges to fund managers relating to Opportunity Zone Funds.
Generally, investing in an Opportunity Zone Fund potentially allows a taxpayer to (1) roll over capital gains1, (2) defer paying tax on such gains until possibly as late as 2026, (3) exclude a portion of the pre-2026 deferred gains from taxation, and (4) potentially exclude from taxation any post-ten year appreciation realized on the investment in the Opportunity Zone Fund.
Essentially, if a taxpayer: reinvests capital gains within 180 days of recognizing such gain into an Opportunity Zone Fund; makes a gain deferral election; and satisfies certain holding period requirements, it will be able to take advantage of the new rules. Opportunity Zone Funds represent a tax deferral opportunity for fund managers to defer capital gains, including short-term capital gains, from their incentive allocation.
The taxpayer can defer paying tax on the rollover gain until the earlier of December 31, 2026 or when the interests in the Opportunity Zone Fund are sold or exchanged. If the interests in the Opportunity Zone Fund are held for at least (i) 5 years but less than 7 years, 10% of the rollover gain will not be subject to tax, and (ii) 7 years, 15% of the rollover gain will not be subject to tax. By 2026, however, even if no sale or exchange takes place, a tax will be due on 85% (i.e., taking into account the 15% greater than 7 years reduction).
In addition, if the interests in the Opportunity Zone Fund are sold or exchanged after 10 years, aside from the taxes that would be payable in 2026, the taxpayer can make an election that would effectively provide for tax-free treatment with respect to any future appreciation on the interests in the Opportunity Zone Fund. If the interests in the Opportunity Zone Fund are sold or exchanged after 2026 but before being held for at least 10 years, then any appreciation on the interests in the fund will be subject to tax.
For instance, if on July 4, 2018, Ivan Investor realized $100 of capital gains, Ivan could invest $100 into an Opportunity Zone Fund by December 31, 2018 (i.e., the 180th day after July 4) and not pay tax in 2018 on the $100 of gain. If the interests in the Opportunity Zone Fund are held for 5 years but less than 7 years, Ivan would pay tax on $90 of gain when the interests in the fund are sold. If the interests in the Opportunity Zone Fund are held for at least 7 years, Ivan would pay tax on $85 when the interests in the fund are sold or December 31, 2026, whichever occurs earlier. If during the investment, the interests in the Opportunity Zone Fund appreciate to $250 (i.e., $150 of unrealized gain) and Ivan remained invested for at least 10 years, Ivan could make a subsequent election that would provide for no taxation on the sale or exchange of the interests in the Opportunity Zone Fund. Alternatively, if the Opportunity Zone Fund interests are sold after 2026 but before being held for 10 years, the $150 of unrealized appreciation will be subject to tax.
Opportunity Zone Funds may be multi-investor managed funds or single investor vehicles. It may be possible for funds to structure side-pocket investments or co-investments to take advantage of these tax benefits. In any case, the Opportunity Zone Fund must file self-certifications and comply with a 90% assets test by monitoring its portfolio to ensure that its investments continue to be eligible investments.
“Eligible Investments” include equity in certain businesses that are substantially operated in qualified opportunity zones and business property (including real estate) that is substantially used in qualified opportunity zones. Certain businesses are excluded, such as golf courses, liquor stores and spas. The map of all opportunity zones has been determined and is available at: https://www.cims.cdfifund.gov/preparation/?config=config_nmtc.xml
In sum, an Opportunity Zone Fund can provide significant tax benefits to investors, provided that the fund, its managers and investors can meet the requisite criteria.
1 Taxpayers may roll over capital gains earned on other investments. This would include general partner principals rolling over the gains attributable to the carried interest earned by a general partner from other investment funds.