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Setting up a closely held Opportunity Fund

The 2017 Tax Act provides a special tax incentive to encourage investing in low-income communities.  The new rule encourages taxpayers to sell their appreciated capital assets and invest an amount equal to the resulting capital gain in “Qualified Opportunity Funds” (“O-Funds”) that, in turn, invest in designated low-income communities, called “Opportunity Zones” (“O-Zones”).   Despite the use of the word “fund,” this is not something that can only be set up by a large corporate investor or needs an elaborate securities law disclosure.  It isn’t hard for a home office, closely held business, or a few family members or friends to set up a fund and make investments.

To encourage these investments, the law provides three basic tax incentives:

  • By timely investing an amount equal to the capital gain in an O-Fund, an investor can delay recognizing the gain (and paying the resulting tax) until December 31, 2026.
  • When recognized, the taxable gain will generally be reduced by 15 percent, or possibly more, if the investment has been held for seven years.
  • There will be no further tax on a sale of the O-Fund investment if it is held for ten years or more.  

Until recently, the rules were sparse on detail, and only a few taxpayers with large capital gains and an expiring opportunity to make an O-Zone investment were willing to take a chance on making investments.  However, with the recent publication of proposed regulations, the IRS has provided a sufficient, even if less than complete, framework for investors to make investments.  Still, even with this guidance, tax advisors are sometimes left to making their best judgments about what will and won’t work. 

Moreover, summarizing the O-Zone tax rules isn’t easy.  Almost every rule has one or more exceptions, and the rules are so technical that it can make for the kind of reading that exhausts even an experienced tax lawyer or accountant.  For example, many of the tax benefits are derived from adjustments to a taxpayer’s “basis” in its investment, a pretty complicated tax concept, even before we get to the more specific O-Zone rules.  Rather than give a graduate course in tax law, I’ll be describing the typical tax benefits associated with O-Zone investing.  So, as you read this summary, remember that it is just a summary.  Discussing the tax rules with your tax advisor is crucial to make sure that you get the tax breaks that you are expecting.

 A Brief Overview of the Rules.

  • No Direct Investing.  All investing must be done through an O-Fund.  Simply making an investment in your own name will not qualify for the benefits.  An O-Fund must be a partnership or a corporation, or a limited liability company (“LLC”) taxed as a partnership (because it has two or more members) or corporation (because it makes an election).  So, one of the basic requirements is that you will have to form an entity that files tax returns in order to make O-Fund investments.
  • Invest in O-Fund Within 180 Days.  Investments must be made within 180 days of the transaction that generated the capital gain.  There is a special exception for gains recognized by partnerships; either the partnership or its partners can be the investor in an O-Fund, and if it’s the partners, their 180-day period can begin far later, on the final day of the partnership’s tax year, which will often be December 31 of the year that resulted in the gain.
  • Character of the Gain.  Even after the deferral, short term capital gains (generally taxed at higher rates for individuals) will still be short term capital gains in the year that the gain is recognized, and the gain will be taxed at the then applicable tax rates.
  • Reducing the Amount of Gain.  The gain recognized in 2026 is the difference between the amount invested and the taxpayer’s basis, with a couple of exceptions.  An investor’s basis in its investment in the O-Fund starts at 0.  It is increased to 10 percent for investments held for 5 years, and another 5 percent for investments held for 7 years.  If the 5 or 7-year requirement would run beyond 2026, then that benefit is lost.  For example, investments made in O-Funds after December 31, 2019 will not qualify for the 10 percent step-up.
  • Smaller Amount Recognized.  If the investment in the O-Fund is sold before December 31, 2026, then the gain is recognized at that time, and if an investment declines in value, then the smaller value is used instead of the original amount deferred.
  • Tax Treatment of Selling Assets.  The no-tax-after-10-years rule applies to sales or transfers of the investment in the O-Fund.  Under current law, it does not apply to a sale of assets owned by the Fund.  It should be noted that many (including the original proponents of the new rules) have argued that it should apply to sales of assets, but it will take a change in law to make that happen.
  • Taxation of O-Funds.  The O-Fund itself will be a partnership or corporation, or an LLC taxed as one or the other. So, 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 its own taxes.  The O-Zone rules do not eliminate the normal tax rules that apply to partnerships, LLCs, and corporations.


Where are O-Zones?

For many years, the government has announced “low income communities” (or LICs), which are census tracts with specified high poverty rates or low median family income.  The O-Zone rules allowed each state to designate not more than 25% of its LICs, plus a few census tracts that are adjacent to LICs, as O-Zones.  In total, there are now 8,700 O-Zones, which is about 11% of all census tracts.  IRS Notice 2018-48 ( provides a complete list, and maps of the census tracts can be found in many locations, including this one maintained by the federal government: 

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

As I noted earlier, O-Funds are simply partnerships, corporations, or LLCs that are taxed as partnerships or corporations, and which elect to be treated as an O-Fund.  The IRS has posted a short, draft form for making the election.  So, the first steps, forming an entity and making an election, are easy.   

A bit harder is meeting the percentage and timing tests.  First, an investor must make an equity investment in the O-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.  As noted above, the investor generally has 180 days, including the date of the sale or exchange, to invest in an O-Fund, and the rules allow an investor to invest in multiple O-Funds, provided the total invested does not exceed the amount of the gain.  Second, your O-Fund must invest, either directly or indirectly, in opportunity zone business property in accordance with specified, highly technical, timetables.  I discuss some of those rules below.  Note that you don’t have to “trace” the funds used to make your investment; you could use the gain from a sale of stock to buy a boat, and then, a few months later, use other money to make your O-Zone investment.

Here’s Just a Bit of the Technical Rules. 

Ongoing compliance with the O-Zone rules is where the “heavy lifting” begins.  The rules are deep in computations, and the tax rules impose requirements that may seem arbitrary.  Much of this is due to the significantly different rules that apply when an O-Fund acquires O-Zone business assets directly as compared to investing indirectly by acquiring Qualified O-Zone Stock or Qualified O-Zone Partnership Interests, with these “subsidiary entities” running the O-Zone business.  In general, it can really matter whether an investment is made directly or through another entity, and this makes it extremely difficult to have rules of thumb or best practices. 

A few observations –

  • The Ninety Percent Test.  First, no matter which structure is chosen, 90 percent of an O-Fund’s assets must be in certain “good” assets, and this is tested at the 6-month point and year-end of each taxable year.
  • Good Direct Investments.  The following are good assets --  
    • Tangible assets used in a trade or business that are either new or substantially improved (more on that below) and acquired from an at least 80 percent unrelated person, after 2017.
    • O-Zone Stock and O-Zone Partnership Interests, also discussed in greater detail, below.
  • Ten Percent Other Investments.  The following are “other” investments, and must be limited to no more than ten percent of the O-Fund’s assets –
    • Everything Else.

    The other investments can be just about anything, provided they are kept below ten percent of total assets.

  • Subsidiary Entities.  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, an easier rule -- only 70 percent of a subsidiary’s tangible assets have to be either new or substantially improved, and acquired from an at least 80 percent unrelated person after 2017.

    But here are tougher rules -- no more than 5 percent of the subsidiary entity’s assets can consist of something called “nonqualified financial property, essentially cash and similar liquid assets, as well as partnership interests and stock.  And, certain so-called “sin businesses” like liquor stores and tanning parlors, are prohibited altogether.  Finally, 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. 

    Here’s the important distinction from direct investing – so long as a subsidiary entity passes the relevant tests, the entire interest in the entity counts as a good asset.  In other words, even though a O-Fund can directly own just ten percent non-qualifying assets, it can own a subsidiary entity that has thirty percent non-qualifying tangible assets, and an indefinite amount of certain kinds of intangibles.  For example, using a subsidiary partnership or corporation, an O-Fund can indirectly own a business with significant intangibles, e.g., a franchise or goodwill, that it could not own directly under the 90 percent test that applies to direct ownership.  It can also indirectly own a business that fails other tests – for example, it could have up to 30 percent unimproved, used tangible assets, or tangibles located outside the O-Zone.  On the other hand, a subsidiary entity can only have five percent of its assets in the form of cash, which is less than the ten percent other assets permitted for an O-Fund, if held directly.  But don’t miss one last distinction between the two possible structures, perhaps the most arbitrary of all – an O-Fund’s directly owned assets must be used in a “trade or business,” while a subsidiary entity must be engaged in an “active trade or business.”  At this time, it’s not clear whether certain traditionally passive businesses, e.g., triple-net leasing, can be conducted by a subsidiary entity and still be eligible for favorable O-Zone benefits.

  • Substantial Improvement.  I noted earlier that used property must be substantially improved.  This requires the owner to make “additions to basis” within any 30-month period after acquisition greater than the basis in the property at the start of the 30-month period.  Basis in land does not count for this purpose.  The IRS has gone one step farther on this rule, and provides 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, and the entity will generally be considered engaged in an active trade or business during the construction or rehabilitation.  The safe harbor can be particularly important to project development, for example, allowing a 31-month window to construct or rehabilitate a building.

Penalties and Reasonable Cause.

The Code provides a relatively low cost solution when an O-Fund fails to meet the 90 percent requirement.  The Fund is subject to a penalty at the IRS’s “underpayment rate,” currently 5 percent, on the shortfall.  An O-Fund can avoid this penalty if the failure is due to reasonable cause.  At this time, we don’t know whether investors can simply “do their best” to comply with the rules and thereby avoid the penalty, even if the O-Fund never had sufficient good assets to meet the 90 percent requirement, but the Code provision certainly appears to call for this favorable treatment. 

A Few Final Observations.

As I noted earlier, the O-Zone rules are so technical that it isn’t possible to describe them in anything that is both short and understandable.  So, in lieu of many more pages of discussion, here are a few more highlights –

  • Developers.  The O-Zone rules can also be used by developers.  Remember that like a third-party investor, a developer has to invest an amount equal to a recent capital gain.  Having done that, it should be possible to structure an O-Fund that gives the investor a preferred interest in the O-Fund and the developer a larger share of the back-end.
  • The Ten Year Rule.  As I noted earlier, there has been a significant outcry about the no-tax-after-ten-years rule only applying to sales of interests in O-Funds (and not the underlying assets).  Don’t be amazed if this rule gets amended sometime in the next ten years.  Unless and until that happens, it may be desirable for O-Funds to have a limited number of similar assets so as to facilitate a sale of interests in the entity down the road.  An O-Fund with many different assets will benefit from diversification, but it may have trouble finding a buyer at the entity level.
  • Be Sure to have a Plan.  With the two primary benefits of O-Zone investing being a delay in the payment of current tax and the elimination of tax on gains associated with very long term investing, it is important to make smart investments.   For some investors, this means just getting a delay in payment of tax and preserving capital; for others, it means taking a risk and trying for a non-taxable “home run” from the future sale of a significantly appreciated investment of the next brilliant start-up.  Be sure to have a plan and a team for implementing your strategy.  Depending on an investor’s current assets, it will generally make sense to find an O-Zone investment, and then sell assets to generate a capital gain.


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