What Are Opportunity Funds and How Do They Work?

Opportunity Funds are investment vehicles established to channel capital into designated economically distressed areas known as Opportunity Zones. They aim to stimulate economic development and job creation in these communities by offering investors specific tax incentives. This fosters growth in underserved regions across the United States.

The Opportunity Zone Program

The framework for Opportunity Zones originated from the Tax Cuts and Jobs Act of 2017, a significant piece of legislation. These zones are census tracts that meet specific criteria, such as a poverty rate of 20% or higher, or a median family income below 80% of the surrounding area’s median. The program incentivizes long-term private investment in these areas, rather than relying solely on government funding, to spur economic growth and create employment opportunities.

States nominated eligible low-income communities, with those nominations then certified by the IRS. Thousands of communities across all 50 states, the District of Columbia, and five U.S. territories received the Qualified Opportunity Zone designation. The program directs capital to these areas to foster developments, from new businesses to real estate projects.

How Opportunity Funds Operate

A Qualified Opportunity Fund (QOF) is an investment vehicle structured as a corporation or partnership to invest in Qualified Opportunity Zone Property (QOZP). Investors contribute capital gains into these QOFs, and these funds must hold at least 90% of their assets in QOZP. This 90% asset test is a critical compliance requirement, ensuring funds deploy capital within the designated zones. The QOF self-certifies this status annually by filing Form 8996 with its federal income tax return.

Eligible investments for a QOF include Qualified Opportunity Zone Business Property (QOZBP), Qualified Opportunity Zone Stock, or Qualified Opportunity Zone Partnership Interests. QOZBP refers to tangible property used in a trade or business within an Opportunity Zone, acquired after December 31, 2017, and either originally used in the zone or substantially improved by the QOF.

When a QOF invests in a Qualified Opportunity Zone Business (QOZB), it typically acquires equity interests in that business. A QOZB must conduct substantially all of its business within an Opportunity Zone, with at least 70% of its tangible property located there. At least 50% of the QOZB’s gross income must be derived from active business within the zone, and a substantial portion of its intangible property must also be used there.

The 90% asset test for a QOF is measured semi-annually, typically on June 30th and December 31st for calendar-year funds. This continuous testing ensures compliance with investment requirements. If a QOF fails to meet this test, it may face penalties unless it can demonstrate reasonable cause for the failure. QOFs generally make investments in real estate development, infrastructure projects, or operating businesses within Opportunity Zones.

Tax Advantages of Opportunity Fund Investments

Investing capital gains into a Qualified Opportunity Fund offers several tax benefits, starting with deferral of the original capital gain. Investors can defer recognition of capital gains tax by reinvesting the gain into a QOF within 180 days of realizing the gain. This deferral lasts until the earlier of the date the QOF investment is sold or exchanged, or December 31, 2026.

A second benefit was a potential step-up in basis for the deferred capital gain investment. Historically, holding a QOF investment for at least five years increased the basis of the original deferred gain by 10%, and for seven years by an additional 5%. However, these specific basis adjustments generally ceased for new investments after December 31, 2021, meaning new investors may not qualify for them.

The most significant tax advantage is the permanent exclusion of capital gains tax on any new appreciation of the QOF investment, provided it is held for at least 10 years. If an investor maintains their investment in the QOF for this minimum 10-year period, the basis of the QOF investment is adjusted to its fair market value on the date of sale or exchange. This provision allows investors to sell their appreciated QOF interest without incurring capital gains tax on the appreciation generated within the fund.

Investor Considerations

Individuals or entities considering an investment in an Opportunity Fund should understand several key aspects. The primary requirement for accessing the tax benefits is that only capital gains are eligible for reinvestment. While an investor can contribute additional cash, only the portion derived from capital gains qualifies for the preferential tax treatment. This means the investment must originate from a recently realized capital gain, such as from the sale of stocks, real estate, or a business.

Investing in a QOF requires a long-term commitment, as the maximum tax benefits are realized only after holding the investment for at least 10 years. This extended holding period implies a degree of illiquidity, meaning investors should consider capital they will not need for a significant duration. The structure encourages sustained investment in the designated zones, aligning investor interests with the long-term development goals of the communities.

QOFs typically invest in a range of projects, including commercial and industrial real estate, housing, infrastructure, and various operating businesses within Opportunity Zones. Investors should assess how these investment types align with their overall portfolio goals and risk tolerance. The program is generally accessible to various investors, including individuals, corporations, and partnerships. However, some funds may target accredited investors, requiring specific income or net worth thresholds.