Real Estate Horizons

The new Opportunity Zone program

By Babak Nikravesh

The new Opportunity Zone program offers investors significant tax incentives to invest in economically distressed areas within the United States and its territories.

Investors can defer federal income tax on their gains by rolling over capital gains into vehicles known as Qualified Opportunity Funds (QOFs), with the added benefit that a portion of such gains can be permanently excluded from tax, and future appreciation in the value of a QOF can potentially escape U.S. federal income tax altogether. This new investment regime is intended to tap into an estimated US$6 trillion in unrealized capital gains, and according to government officials is expected to generate US$100 billion in private capital targeting opportunities in these areas.

Investments eligible for preferential treatment under the OZ program are investments made in QOFs which must, through the activities they conduct or investments they make, have a substantial geographic and economic nexus with designated opportunity zones. Significantly, QOFs need not be structured as typical investment funds; indeed, a better way to think about QOFs may be as holding companies. Indeed, perhaps the most significant way in which QOFs differ from a traditional investment fund is the requirement that an investor dispose of QOF interests to secure the most meaningful of the available tax incentives— the permanent exclusion from tax of gain following a 10 year hold. Given this requirement, fund sponsors may seek to impose transfer restrictions and drag rights in order to facilitate a group sale of QOF interests.

Significantly, even non-U.S. investors that may enjoy some form of U.S. tax exemption may still benefit. Many such investors may be sitting on unrealized gains that, upon sale, would be treated as income effectively connected with a U.S. trade or business (ECI). Such gains are eligible for the deferral and income exclusion benefits of this regime. Moreover, future appreciation in the value of the QOF can be fully exempt from U.S. income tax upon a subsequent sale of QOF interests, even if such gains may otherwise be ECI. This is a surprising development, and provides an unusual (and unique) opportunity for non-U.S. investors to make ECI-generating investments and avoid U.S. federal income tax.