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With potential tax reforms on the horizon, investments in qualified opportunity funds can be a useful strategy to lower tax burdens with potential tax-free appreciation and deferral of capital gains.

Tax strategies

Fund Managers Can Benefit From Opportunity Zone Investments

  • Michael De Prima
  • Tony Hallada
  • Jack Rybicki
  • 1/12/2021

Key insights

  • Invest in a qualified opportunity fund (QOF) and you can potentially leverage three tax benefits: initial gain deferral, basis step-ups, and tax-free appreciation.
  • Both short- and long-term gains on carried interests can qualify for QOF benefits, which can provide fund managers with flexible tax planning options.
  • Hold QOF investments for 10 years and any appreciation can be permanently excluded from taxes.
  • While President-elect Biden has floated a long-term capital gains rate increase for individuals making more than $1 million, he views QOF investments favorably.

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The opportunity zone program has been a powerful tax planning tool for investors since its enactment in 2017. Qualifying investments are eligible for tax deferral as well as potential tax-free appreciation in value.

While this may have been an overlooked benefit in the past, private equity and other fund managers should consider the opportunity to defer gains that result from their carried interests. With the new holding period rules under Internal Revenue Code Section 1061, this deferral option may be especially beneficial. Understand the benefit of opportunity zone investments and how they could potentially lower your tax burden.

Opportunity zone investment benefits

The 2017 Tax Cuts and Jobs Act (TCJA) created opportunity zones to encourage investment in economically distressed areas through tax incentives. Since the program’s inception, investments in qualified opportunity funds (QOFs) have totaled billions of dollars. These investments offer three primary tax benefits:

  • Initial gain deferral — Capital gains invested in a QOF are deferred until December 31, 2026, unless the QOF investment is sold prior to such date.
  • Basis step-up — QOF investments held for at least five years prior to December 31, 2026 — making the deadline for such an investment December 31, 2021 — are eligible for a 10% basis step-up, which operates as a partial gain exclusion.
  • Tax-free appreciation — If you hold your QOF investment for at least 10 years, any appreciation in the value of the investment may be permanently excluded from income.

Carried interests and eligible gains

Only “eligible gains” qualify for opportunity zone benefits. This definition is broad and includes both capital and Section 1231 gains that would be recognized for federal income tax purposes before January 1, 2027.

Given the expansive definition of eligible gains, fund managers can make qualifying investments attributable to the gain on their carried interests. But it should be noted that a carried interest received in exchange for services to a QOF is a non-qualifying investment with respect to that QOF since only those gains contributed in exchange for the QOF interest can qualify for deferral.

While the taxation of carried interests has been somewhat contentious over the years, the basic rule is that they are eligible for capital gains treatment once the carry is triggered. The holding period of carried interests determines whether these gains are considered short- or long-term. Notably, the requirement for long-term capital gains treatment was extended from one to three years under Section 1061 (which was enacted as part of the TCJA). The new holding period rules may have a large impact on investments held for less than three years.

Both short- and long-term gains can be eligible for QOF purposes, which leaves possibilities for fund managers to reap the tax deferral benefits that an opportunity zone investment can generate. Consider this strategy especially if you face short-term capital gains that would be subject to higher ordinary income tax rates.

Opportunity zones under the Biden administration

Investors can likely continue to rely on opportunity zones as a tax planning strategy. President-elect Joe Biden signaled throughout his campaign that he is generally in support of opportunity zones, albeit with more transparency and disclosures to determine whether the program serves low-income communities as intended.

That said, a key feature of Biden’s proposed tax plan is to raise long-term capital gains rates (for those making over $1 million) from 20% to 39.6%. While the likelihood of his tax plan becoming law is highly uncertain at this point, it is important to consider the impact of such a rate increase on your initial gain deferral as well as the rate in effect on December 31, 2026, when the initial gains would be taxed (subject to applicable basis step-ups).

How we can help

CLA has been at the forefront of opportunity zones since their enactment. Our services include QOF outsourcing and testing, tax structuring, and all facets of fund compliance. Additionally, our private capital team helps QOFs raise their investments, while our wealth advisory team helps investors and fund managers find the right QOF for their gain rollovers. Our goal is to use an integrated approach where all aspects of your qualified investments are understood, documented, and maintained. Contact us today for more information.

Securities products, merger and acquisition services, and wealth advisory services are provided by CliftonLarsonAllen Wealth Advisors, LLC, a federally registered investment advisor and member FINRA, SIPC.

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