Opportunity zone funds

In short

A friend of mine sold a small company last spring and called me the same afternoon, half thrilled and half scared of the tax bill. If you are holding a large capital gain, an opportunity zone fund is one way the tax code lets a person put that gain to work in a certain kind of place. The IRS says an investor may defer the tax on that gain by putting the money into a qualified fund within the window the law sets, which is the current figure, which the official source publishes each year days. The fund must then invest in property or businesses inside areas the government has designated. Deferral means pay later, not pay never, and the rules on timing are strict. Read the official forms before you move a dollar, and sit down with a tax professional who has seen one of these before.

The whole of it

What it is

I once watched a neighbor spend an entire weekend sorting out a deal he thought was simple, only to find a rule he had never heard of. Opportunity zone funds work a bit like that. Congress created the program in the Tax Cuts and Jobs Act of 2017. The idea was to steer private money toward neighborhoods that had gone without investment for a long time.

A qualified opportunity zone is a census tract that a state governor nominated and the Treasury Department certified. A qualified opportunity fund, often called a QOF, is a corporation or partnership that must keep a set share of its assets in qualified opportunity zone property. That share is the current figure, which the official source publishes each year percent. The Internal Revenue Code lays this out in Section 1400Z-2. The IRS explains the program on its Opportunity Zones page, and it is worth reading straight from the source.

You may be a founder who just sold a business, or someone who has a gain sitting there from a big year. That gain is the thing the program speaks to. Not every dollar qualifies, though. Only a capital gain can be put into the fund. The statute speaks of gain from the sale or exchange of property, and the IRS Opportunity Zones page explains which kinds of gain qualify.

How it works

Picture the steps the way you would a road you plan to drive. First, the investor sells something and has a capital gain. Second, the investor puts that gain, all or part of it, into a QOF inside the window the law sets, which is the current figure, which the official source publishes each year days. Third, the investor reports the choice on the tax return for that year, using IRS Form 8949 and Form 8997.

Here is where the benefit comes from. The tax on the original gain is deferred. The deferral ends when the investor sells the fund interest or on a date set by law, whichever comes first. That end date matters a great deal. The IRS Opportunity Zones page explains the current rule, and the date is the current figure, which the official source publishes each year.

There was once a second benefit. A fund held for a set number of years could cut the deferred gain itself. Those step ups in basis depended on the dates, and the dates have mostly passed for new money. A person should confirm what still applies today.

There is a third benefit that still draws interest. If the investor holds the fund interest for at least the current figure, which the official source publishes each year years, the growth earned inside the fund can be tax free when sold. That means the new gain, not the old one, escapes tax. The old gain is still taxed when the deferral ends.

The fund itself has to meet a test on its assets. The test is run on a set schedule, and the fund must keep the required share of its assets in qualified property. The share is the current figure, which the official source publishes each year percent. The IRS Opportunity Zones page and Section 1400Z-2 of the Internal Revenue Code describe how the testing works and what follows when a fund falls short. The manager has to watch it closely.

The numbers, and where to find yours

Some figures change with the years, so I will not guess at them here. The deadline to invest after a sale is the current figure, which the official source publishes each year days. The share of assets a fund must hold in zone property is the current figure, which the official source publishes each year percent. The holding period for the tax free growth is the current figure, which the official source publishes each year years. The date when deferred gain comes due is the current figure, which the official source publishes each year.

Where do you find your own numbers? Start with your sale paperwork. Your closing statement or broker form will show the gain and the date of sale. Count forward from that date by the number of days in the window. Mark it on a calendar twice, because a missed date cannot be fixed. The IRS Opportunity Zones page and the instructions for Form 8997 will show the current reporting steps. The Treasury Department's Community Development Financial Institutions Fund keeps the map of designated tracts.

A worked example

Let me tell you about a founder I will call Maria Delgado. She sold her software company in March. Her share of the sale left her with a long term capital gain of $1,000,000. She had owned the stock for years, so the gain counted as long term.

Maria had a set window from the sale date to act. She picked a QOF in month four and invested the full $1,000,000. Because she put in the whole gain, the entire tax on that gain was deferred.

Now watch what the deferral does for her cash. Say the federal rate on her gain would have been 20 percent. Twenty percent of $1,000,000 is $200,000. That is the tax she did not have to send in that year. She kept the $200,000 working inside the fund instead of paying it out.

Suppose the fund grew, and after the required hold her interest was worth $1,800,000. The growth is $1,800,000 minus $1,000,000, which is $800,000. If she meets the long term holding rule, that $800,000 may be free of federal tax when she sells.

Now the part people forget. Her original gain still has to be reported when the deferral ends. Say that date arrives and her gain is still $1,000,000. At 20 percent she owes $200,000 then. She should have that money ready. Maria sets aside cash for it, so the bill does not catch her off guard. She also owes any other tax that applies to her, such as the net investment income tax, and her adviser checks that for her.

Notice the picture. She paid $200,000 later, not now. She may keep the $800,000 of growth free of tax. But the fund had to be a real one, and the deal had to hold up. That is the whole shape of it.

Where it goes wrong

I have seen smart people stumble on small things, and it is no shame. The first stumble is the clock. The investment window runs from the date of the sale, and the IRS Opportunity Zones page is the place to check whether any relief exists for a late filer. A late investment may not qualify, so the investor should plan as if no extra time will come.

The second stumble is the type of money. Only a capital gain goes into the fund. Wages, ordinary business income, and some other kinds of income do not count. A person should sort this out before wiring any funds.

The third is the fund itself. A fund that does not meet its asset test can face a penalty under the tax code, and the IRS page explains how that works. A fund that holds property that does not qualify can lose its standing. The investor should ask to see how the fund tracks the test and who checks it.

The fourth is the hold. Selling early can end the tax free growth. It can also bring the deferred gain due sooner than planned. A founder who needs cash in a few years may find the program a poor fit.

The fifth is plain risk. A fund can lose money. The tax benefit does not protect against a bad property or a weak business. The tax rules and the investment are two separate things.

Last, the rules can change. Congress has changed this program before and may again. Read the current IRS page, not an old article, and that includes this one.

Questions to answer before you leave this page

Have you counted forward from the date your sale closed by the number of days in the window, which is the current figure, which the official source publishes each year, and written the final day on a calendar? Is the money you want to invest a capital gain, or is part of it some other kind of income? Do you know the date the deferred tax comes due, and have you set aside the cash to pay it? Can you leave the money in the fund for the current figure, which the official source publishes each year years, or might you need it sooner? Has a tax professional looked at your Form 8949 and Form 8997 before you file? Has the fund shown you how it meets its asset test of the current figure, which the official source publishes each year percent, and who watches it? And if the fund loses value, are you comfortable with that, apart from any tax benefit?