Opportunity Zones: Alternative investment fund manager perspective

Opportunity Zones represent a significant investment opportunity for alternative investment fund managers (AIFMs) to defer capital gains and generate future tax-free appreciation. Fund managers offering investments in Qualified Opportunity Funds (QOFs) will have an advantage in attracting new capital as well as maintaining existing investors looking to allocate utilizing this strategy. QOFs also represent an attractive avenue for fund managers to structure their own businesses and diversify their wealth.

Background information

Opportunity Zones were initially created when the Tax Cuts and Jobs Act added Sections 1400Z-1 and 1400Z-2 to the Internal Revenue Code (the Code). These Code sections outlined significant benefits for investors who choose to reinvest capital gains into QOFs that make investments in Opportunity Zones. Opportunity Zones are census tracts that have been previously identified and located within economically distressed areas. At the time, due to the considerable uncertainty that existed, the response to the Opportunity Zone provisions was somewhat subdued. Since October 19, 2018, however, when proposed regulations were released, Opportunity Zones have generated substantial new interest, with the potential tax benefits and proposed fund launches highlighted in the press.

In order to take advantage of Opportunity Zone tax benefits, an investor must re-invest capital gains in a QOF. The capital gains can be reinvested at a fund or entity level or can be reinvested by an individual who receives a Schedule K-1 from an investment with capital gain. The capital gains can come from any asset class. For example, capital gains from trading in securities, the sale of real estate or the sale of personal property are all eligible to be reinvested in a QOF. Whether a capital gain is short-term or long-term is irrelevant. If a fund has made a 475(f) mark-to-market election, the mark-to-market income is not considered capital gain and, thus, 475(f) income is not eligible to be reinvested in a QOF. In addition, capital gains that were part of an offsetting position or straddle also are not eligible.

Capital gains that are eligible to be reinvested must be done so within 180 days. The 180 days starts on the date the capital gain was realized. For taxpayers using capital gains reported on a Schedule K-1, the 180-day period starts on December 31, 2018. It is unclear, however, whether gains reported on a Schedule K-1 can be grossed up or whether only the net capital gain reported on the Schedule K-1 is eligible to be invested.

Once the capital gains are reinvested in a QOF, the QOF must invest 90% of its assets in Opportunity Zone property or Opportunity Zone entities. Opportunity Zone property that is purchased must be significantly improved. Opportunity Zone entities must have 70% of their tangible property located within Opportunity Zones. Exceptions exist for a ramp-up period for the QOF, as well as carve outs to allow a QOF to maintain working capital balances, as long as a plan of implementation for that working capital exists. Failure to comply with QOF requirements will result in the QOF incurring tax penalties.

Assuming that eligible capital gains are reinvested in a QOF and the QOF complies with all necessary requirements, three potential tax benefits exist for investors.

  1. First, the capital gains reinvested can be deferred until the earlier of the date the investment is sold or December 31, 2026.
  2. Second, if the investment is held for more than five years, then the amount of tax due on the original capital gain is reduced by 10%. If the investment is held more than seven years, then the amount of tax due is reduced by an additional 5%, or 15% in total. The original character of the capital gain will carry over after deferral. As an example, short-term capital gains deferred will remain short-term capital gains even after a five-year deferral period.
  3. Third, gains from the disposition of a QOF are tax-free if they are held over 10 years. Mechanically, this is done by a step-up in basis in the QOF to the fair market value of the interest and must be achieved by a sale or exchange of the QOF and not the underlying assets.

For more information on the potential benefits, operations of QOFs and technical tax issues, please reference Tax Alert 2018-2119.

Investment opportunity for AIFMs

Investors and allocators are rapidly becoming aware of the value proposition related to tax deferral and the potential for large tax-free appreciation of QOFs. Investors with 2018 capital gains are already exploring the possibility of deploying those capital gains in QOFs. Offering existing investors the ability to invest in QOFs represents an attractive avenue to retain fee-generating investor capital with long-term lockups. To the extent fund managers have existing expertise in the real estate space, or expertise investing in businesses that could operate in Opportunity Zones, the ability to offer investments in a QOF may be an attractive way to expand assets under management and attract new investors. AIFMs who plan to launch a QOF may want to be pro-active in notifying their investors of capital gains as they are realized throughout the year so that investors can begin exploring the possibility of reinvesting those capital gains in the QOF.

For principals of fund managers who have large capital gains flowing through as part of incentive allocations or other investments, the ability to reinvest those gains in QOFs represents a unique opportunity to diversify their investments, defer taxes and expand their wealth over the next decade.

If a fund manager is willing to relocate all or part of a fund management business to an Opportunity Zone, then a planning opportunity could exist to save a significant amount of taxes if the intent is to exit in the future through a sale or exchange. Opportunity Zones exist in close proximity to areas with high concentrations of existing fund managers. As an example, Stamford, CT, Manhattan’s west side and Amazon’s HQ2 in Long Island City all contain Opportunity Zones. For assets other than real estate, however, open questions remain about sourcing income and assets. Further clarification is needed to determine whether a fund management business managing assets on behalf of clients across the globe with employees living in multiple geographies will be considered “within” the Opportunity Zone.

Challenges for fund managers

Opportunity Zones may bring added challenges for fund managers. Primarily, interested investors may need additional details regarding their capital gains. For example, investors may require information regarding gross gains realized by the fund, in which case fund managers can anticipate questions from investors regarding their allocable share of gross gains throughout the year. Fund managers could face multiple challenges in trying to provide capital gains information to investors:

  • Funds that employ tax allocation methodologies relying on accumulation and fill-up provisions would not be able to provide this data until the relevant period is closed; in most cases, this would be year-end.
  • Fund managers that typically release K-1s in the summer will be under increased pressure to release K-1s early so that investors can re-invest the capital gains into QOFs; this will likely also lead to increased requests for tax estimates.
  • Fund managers that release investor K-1s based on underlying investment K-1 estimates will have to review those estimates and determine whether that methodology is appropriate given the potential additional scrutiny related to the tax benefits afforded by reinvesting capital gains in QOFs.
  • Fund managers may need to develop additional reporting to track gross capital gains, as well as gains that are or have been part of an offsetting position or straddle.

These additional reporting requirements may put additional strains on investor relations and accounting departments at fund managers and their administrators. Even fund managers that do not plan to offer a QOF will still need to understand Opportunity Zones and be prepared for the increased reporting necessary to answer the questions they will begin receiving from investors.

 

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CONTACTING CAROPRESE & COMPANY

This publication is provided by Caroprese & Company as a service to its clients and colleagues.  The information and content included in this publication should not be construed as technical advice.  Questions regarding any matters discussed in this publication should be directed to Brandon Caroprese whose contact information is listed below:

Brandon Caroprese, CPA, MST

Tel. (201)-591-1783

Email. bcaroprese@caroprese.co

 

 

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