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Dissecting Qualified Opportunity Funds and Sub-Funds

April 2, 2019Article
Connect Media

Coverage of the Tax Cuts and Jobs Act’s Opportunity Zone program and Qualified Opportunity Funds (QOF) has been thorough and intense. However, much of that coverage focuses on tangible investments — such as development and/or renovations of commercial real estate. Little has been discussed about another QOF investment vehicle: the sub-fund. QOFs and sub-funds are subject to specific guidelines. However, some requirements for QOFs and sub-funds differ.

A QOF might choose to invest in a sub-fund which, in turn, funnels money into Qualified Opportunity Zone (QOZ) property. QOFs and sub-funds have several things in common:

  • Both must be formed as corporations or partnerships (such as LLCs with multiple owners). Most QOFs and their sub-funds will be formed as LLCs, with multiple owners, partnership participation and pass-through taxation.
  • Both must be created in the United States, or within U.S. possessions. Regarding the latter, a QOF or sub-fund is formed in U.S. possessions only if it will invest within a designated QOZ there.
  • For both QOFs and sub-funds, tax benefits only apply if the entities acquire QOZ assets after 2017.

Additionally, if it sells interest from a sub-fund or property, the QOF is allowed a “reasonable period” to reinvest the gain. However, owners will pay taxes on that gain, unless it is re-invested in the same or different fund, or used in a 1031 exchange.

Though the QOF and sub-fund have similar requirements, confusion occurs because of different guidelines, listed below:

  • A QOF must hold 90% of its gross assets in QOZ property or sub-fund interests. The sub-fund in which that QOF invests only requires 70% its tangible assets be held in QOZ property.
  • If the QOF doesn’t meet the asset test of 90%, it pays a 5% interest penalty on the shortfall. If the sub-fund fails to meet the 70% asset test, it immediately is disqualified.
  • An entity declares itself a QOF by filing an annual Form 8996 with income taxes. That entity’s organizational charter must also specify it is doing business in an Opportunity Zone. The sub- of its tangible assets be held in QOZ property.
  • If the QOF doesn’t meet the asset test of 90%, it pays a 5% interest penalty on the shortfall. If the sub-fund fails to meet the 70% asset test, it immediately is disqualified.
  • An entity declares itself a QOF by filing an annual Form 8996 with income taxes. That entity’s organizational charter must also specify it is doing business in an Opportunity Zone. The sub-fund entity isn’t required to file a Form 8996, or to specify a purpose.
  • At least 50% of a sub-fund’s gross income must come from an active trade or business within the QOZ; QOZ working capital can count as qualifying income. QOFs are not held to that 50% rule, and can’t use working capital as qualifying income.
  • Less than 5% of a sub-fund’s assets can consist of investment/intangible property — stock, partnership interest and debt — other than QOZ working capital. This is not the case with a QOF.
  • Liquid assets can count as a sub-fund’s property, as long as a written plan and schedule are in place to meet the 100% of cost test. Again, this is not the case with QOFs.

Due diligence is required for any investment; this is especially the case for QOF and sub-fund investments. Complicating the issue is that the Opportunity Zone program is still so new. Still, the following can help protect those investing in QOFs and sub-funds:

  • Take note of the QOF’s and sub-fund’s structure and holdings. Both must pass the requirements mentioned above.
  • Though sub-funds are not required to state their purpose, their holdings must be consistent with guidance.
  • Keep an eye on the calendar; QOFs and sub-funds must pass an asset test every six months. Additionally, QOZ properties in which a QOF/sub-fund invests are required to be “substantially improved” within 30 months.
  • Work with those who know what they are doing. At Greenberg Glusker, we have staff solely dedicated to understanding guidance and rules pertaining to the Opportunity Zone program. It’s important to have access to expertise like this, to protect your investments.

While the Opportunity Zone program can provide positive benefits, it is still very new. This is especially the case for Qualified Opportunity Funds and their sub-funds. As such, an understanding about the investment and requirements is extremely important.