Since coming into effect in January 2018, Subchapter Z of the US Tax Code—also known as the opportunity zone provisions—has enabled investors to pour billions of dollars into a broad array of businesses, from real estate development companies to tech startups. Investments in qualified opportunity funds (QOFs) offer a number of distinct tax benefits, not the least of which is reduced capital gains tax liability. But the rules governing these investments are quirky, perplexing and—in some cases—severely restrictive.
How does a qualified opportunity fund actually get qualified as a QOF? Failure to satisfy the US Department of the Treasury’s definition of a QOF can severely restrict the fund’s ability to attract capital. In this third of our series of articles on QOFs, we discuss—from a fund’s perspective—the mechanics of qualifying the fund as a qualified opportunity fund.
In order to take advantage of the many tax benefits of the opportunity zone provisions, a taxpayer must invest eligible gains in a qualified opportunity fund (QOF). This article focuses on what precisely a fund must do to qualify as a QOF. The ability of a fund to attract capital from eligible investments is critically dependent upon whether it satisfies the definition of a QOF.
Broadly, a QOF is an entity organized as a corporation (including an S corporation, REIT, RIC or REMIC) or partnership for the purpose of investing in “qualified opportunity zone property” (QOZ property) and that holds at least 90% of its assets in QOZ property (the 90% asset test). QOZ property includes “qualified opportunity zone stock” (QOZ stock), “qualified opportunity zone partnership interests” (QOZ partnership interests) and “qualified opportunity zone business property” (QOZB property). Whether a fund meets the 90% asset test is determined by calculating the average percentage of QOZ property held by the fund as measured at six-month intervals.
In practice, virtually all QOFs invest in either QOZ stock or QOZ partnership interests. QOZ stock and QOZ partnership interests are defined as stock or interests in an entity that is a “qualified opportunity zone business” (QOZB). (In a subsequent article in this series, we discuss the requirements of a QOZB.) While it is technically possible for a QOF to directly hold QOZB property in satisfaction of the 90% asset test, such an arrangement would be highly unusual, and almost certainly impractical. Thus, we do not discuss such an arrangement here.
The remaining assets of the QOF (up to 10%, by value) may be in any form, including cash, real estate, financial assets, property held for investment, unrelated business property, property located outside of a QOZ, etc.
In measuring the proportion of its assets that constitute QOZ property, the QOF computes the percentage based on the value of the assets directly held. The value of QOZ stock and QOZ partnership interests are generally determined based on cost basis without adjustment. Alternatively, if the QOF maintains financial statements in accordance with generally accepted accounting principles (GAAP), the QOF may value its assets based on its financial statements. Under either method, the QOF must consistently value all of its assets under a single method during any particular taxable year.
An entity that wishes to be treated as a QOF must certify to the IRS that it fulfills all requirements under the Opportunity Zone Provisions by filing Form 8996 for the first year in which it receives an eligible investment and each year subsequently.
Click here for the previous article in the series: How to Invest in a QOF
Click here for the next article in the series: Basics of QOF Investing: What Is a QOZB?
View all articles in the Qualified Opportunity Funds OTS Series.