As the billions of dollars that have already poured into Opportunity Zone Funds attest, there is no shortage of investor interest in the Opportunity Zones program. However, lingering misconceptions about how the program works may reduce success for some investors, according to Chicago-based law firm Ginsberg Jacobs LLC, which is helping individuals, corporations and partnerships set up Opportunity Zone Funds.

Created by the Tax Cuts and Jobs Act of 2017, the program offers a path for investors to deploy unrealized capital gains – estimated at nearly $6 trillion – into any of the 8,700 census tracts designated as Opportunity Zones in exchange for deferred or reduced taxes.

“It is a great program that should pull capital into under-invested areas,” said Darryl Jacobs, co-founder of Ginsberg Jacobs. “In Chicago, for example, it’s expected to spread investment beyond downtown, completing the evolution of former industrial hubs like the Kinzie Corridor while lifting neighborhoods on the South and West sides, where there’s a higher concentration of qualifying census tracts.

“Both Opportunity Zones and areas adjacent to them stand to benefit,” he added. “But to get the most out of the program, investors must do their due diligence. Deals still must pencil out. Investors also need to make sure they understand the program’s rules, or they may fail to get the hoped-for tax deferrals or breaks, or, even worse, face penalties.”

Here are five misconceptions about the program, followed by explanations of how it actually works:

1) All capital gains qualify. Capital gains from real estate, stock and other assets treated as gains for the purposes of federal income tax may be invested in a Qualified Opportunity Fund (QOF), which the IRS defines as “an investment vehicle that is set up as either a partnership or corporation for investing in eligible property that is located in a Qualified Opportunity Zone.” But the gains must arise from a sale between Dec. 22, 2017, and Dec. 31, 2026, and be invested within a QOF within 180 days of the gain recognition date, Jacobs said. Under proposed regulations, gains allocated to partners by partnerships are recognized by the partner on the last day of the partnership’s tax year.

Further, the investor cannot use a gain earned by selling a property to a related person. Sales to a spouse, child or other relative, or a trust set up to benefit such people, would not qualify, nor would a sale to a corporation if the seller owns 20 percent or more of its shares.

“If you own a property in the Opportunity Zone, you can sell it to anyone, but not all buyers will be eligible for the tax advantages,” said Jacobs. “If the seller retains an indirect interest in the real estate through the acquiring venture, they would only see the tax benefits if they own less than 20 percent of that purchasing entity – a rule intended to maintain the integrity of the program.”

2) Capital gains can be deployed at any time before 2027. After investors put money in the QOF, the fund must deploy at least 90 percent of its assets in eligible property by the earlier of Dec. 31 of the year in which the QOF is formed or the date that is six months after the date on which the fund is designated as a QOF. A failure to satisfy these requirements will result in a penalty.

“You have 180 days from the day you recognize your gains to invest in a fund; then the fund may have as much as six additional months before it must invest the money,” said Jacobs. However, for those who need more time, he offered this tip: “People also can form their own closely held fund without third-party investors, which can buy them up to another six months.”

3) All money in a QOF has to be invested in the Opportunity Zone. In fact, as little as 63 percent of the fund must be invested in qualifying assets, depending on how it is structured. Under the guidelines, a QOF must have more than 90 percent of its assets invested in a property or business within the Opportunity Zone. Through the so-called 70-30 rule, included in IRS guidelines released in October, a business qualifies if “substantially all” – defined as 70 percent – of its property is located within zone boundaries. Thus, if a QOF invests 90 percent of its funds into a qualifying business rather than directly in property, the qualifying business needs only 70 percent to be in qualifying assets. This means the aggregate amount required to be invested in eligible property would only be 63 percent.

“After the initial tax year, the IRS will measure this twice a year – on June 30 and Dec. 31 – and if you fall below the required amount, there will be a penalty,” said Jacobs. “As long as the minimum requirements are met, the balance of the fund can be invested anywhere.”

4) Any existing building in an Opportunity Zone qualifies. Properties must be newly constructed or “significantly rehabbed” within 31 months – and by “significantly rehabbed,” the IRS means the renovation must be equal to the cost of the property itself (but not the underlying land). The property can be commercial or residential but can’t be a “sin property,” such as a liquor store or massage parlor. Certain other property types, such as golf courses, racetracks and other gambling facilities, also do not qualify for special treatment.

“If a QOF invests directly in a property, the proposed regulations appear to say it must make improvements immediately and does not get 31 months,” said Jacobs. “So, that makes it impractical to buy property directly, and in truth, a QOF should not be investing directly in property anyway, as that carries liabilities. Instead, it’s better for the fund to invest in partnerships that are based in the Opportunity Zone and able to purchase property there.”

5) Investors pay no taxes on capital gains after 10 years. Assuming the investor makes an investment in a QOF prior to Dec. 31, 2019, he or she is allowed to defer paying taxes on the original capital gain (that is, the money invested into the QOF) until the earlier of divestiture or Dec. 31, 2026. If the investor holds the investment for five years, the basis is increased by 10 percent – in other words, he or she would pay tax on 90 percent of the original gain rather than 100 percent. If the investor holds the investment for seven years, the basis step-up rises to 15 percent, meaning the investor would pay tax on just 85 percent of the original gain. However, since the original gains are taxed no later than Dec. 31, 2026, an investor needs to invest gains no later than Dec. 31, 2019, to get the maximum tax benefit.

In addition, the investor does not have to pay any capital gains tax on appreciation from the QOF investment if it is held for 10 years.

“The longer an investment is held, the more tax benefits the investor reaps,” said Jacobs. “And if they’re willing to commit a decade or more to a particular project, they are rewarded for the risk they take in the form of tax-free gains – but only if that project is successful.”

About Ginsberg Jacobs LLC:
Ginsberg Jacobs LLC is a Chicago-based law firm that provides comprehensive legal solutions in the areas of real estate, finance, taxation, tax credits, litigation, corporate, and trusts and estates planning. Informed by the team’s experience working at larger law firms, Ginsberg Jacobs’ small-by-design approach delivers highly personalized service across multiple disciplines and geographies, including Alaska and Hawaii, using alternative-fee arrangements to eliminate unnecessary overhead. The firm represents both public and private entities, including some of the country’s most prolific lenders, developers, investors and businesses ranging from Fortune 500 companies to high-growth startups.