What real estate investors need to know about qualified opportunity funds

The Tax Cuts and Jobs Act of 2017 provides for significant tax and economic benefits for investors, real estate developers and fund sponsors in the form of the Opportunity Zones program. Designed to spur long-term growth and economic development in economically distressed neighborhoods through tax incentives, the Opportunity Zones program has become a very hot topic, as have qualified opportunity funds (QOFs), the instruments to invest in these zones.

Significant uncertainties remain, however. The Treasury Department and IRS have proposed regulations and a revenue ruling that address many of the as-yet-unanswered questions. President Donald Trump has also signed an executive order that establishes the White House Opportunity and Revitalization Council, whose mission will be to engage with all levels of government to revitalize urban and economically distressed communities located in qualified opportunity zones (QOZs).

In the meantime, though, investors can still get involved and start taking advantage of the benefits the Opportunity Zones program offers. To that end, here is an overview of the benefits to investors and what is required of a QOF.

Investor benefits and requirements

Any capital gain from the sale or exchange of property by a taxpayer to an unrelated party that is invested in a QOF within 180 days of the sale of such property is excluded from gross income until the earlier of either the date the investment in the QOF is sold or Dec. 31, 2026. Eligible investors include individuals, corporations (including regulated investment companies and real estate investment trusts), partnerships, trusts and estates.

If a taxpayer invests capital gains from the sale or exchange of property with an unrelated person in a QOF within the 180-day period beginning on the date of the sale or exchange, the investor can elect to defer the gain from the sale or exchange. The law provides that only capital gain reinvested into the QOF is entitled to the QOF benefits, not the total proceeds, which is different than the tax deferral rules for like-kind exchanges under IRC Sec. 1031. The gain deferred can be any capital gain, including short-term capital gains, long-term capital gains, capital gain from the sale of collectibles, and net IRC Sec. 1231 gain and gains from sales of securities.

The benefits stack up the longer a taxpayer is invested in a QOF. An investor’s basis in the QOF is initially zero but will be increased by 10% of the deferred gain if the investment is held for five years by Dec. 31, 2026 and an additional 5% of the deferred gain if the investment is held for seven years by Dec. 31, 2026. That means if a gain on the sale of property is reinvested in a QOF within the required time frame, investors may be able to decrease the taxable portion of the originally deferred gain by 15% if the investment is held seven years or more by Dec. 31, 2026.

At the investor’s election, an investor can exclude any post-acquisition capital gains on an investment in a QOF if the investment in the QOF has been held for 10 or more years. This is arguably the biggest benefit of investing in QOFs. It’s important to note, however, that when an investor invests both the capital gain and additional amounts into a QOF, the investment will be treated as two separate investments, of which only the capital gain portion will be eligible for the 10-year capital gain exclusion (and related five- and seven-year basis increases).

QOF requirements

One of the main requirements for a QOF is that at least 90% of its assets must be QOZ property. QOFs will need to consider the business plan — i.e., into what assets to deploy capital — as well as how to properly apply the testing requirements. Failure to maintain the 90% asset test will result in penalties that need to be considered by funds. Although failure to maintain the required amount of qualified assets will not prevent the fund from achieving the tax benefits provided to QOFs, significant penalties may apply that will damage investor returns.

Funds can be structured as either indirect (two-tier) investments or direct (single-tier) investments. The proposed regulations imply that there is an advantage for indirect investments over direct investments. In an indirect investment, the lower-tier entity can have as little as 63% of QOZ business property in order to pass the 90% asset testing, as opposed to a single-tier structure, which requires 90% of its assets to be QOZ business property. Comments have been requested by the Treasury in regard to this topic; therefore, it is imperative that any updates are closely monitored to ensure a two-tier structure will still work in the future.