Treasury has issued two rounds of generally taxpayer-friendly regulations with respect to opportunity zone tax incentives and the structuring of qualified opportunity funds (QOFs). However, there still remain important issues that are keeping investors, and large amounts of money, on the sidelines. The discussion below offers some suggestions to Treasury that, if adopted, would provide fund managers and investors with needed clarity, and thereby help kick the opportunity zone (OZ) program into high gear.


When the OZ incentive was introduced as part of the 2017 Tax Cuts and Jobs Act, traditional real estate fund managers started to explore how to best structure and establish qualified opportunity funds to maximize the benefits of the new legislation. However, these initial efforts were largely stymied by a lack of clarity on how the new law would be implemented, especially with respect to large multi-asset funds that are a standard investment vehicle in many other areas of real estate and business investment. While the second round of proposed regulations issued in April 2019 provided helpful guidance on many key issues, there remain several challenges that need to be addressed before the full investment power of multi-asset funds will be unleashed.[1]

The OZ legislation provides investors with three primary tax benefits: deferral of eligible gain until Dec. 31, 2026 (unless there is an earlier inclusion event), reduction of up to 15% of any eligible gain invested into a qualified opportunity fund, and elimination of gain on a disposition of an investor’s QOF investment if the investor held the interest in the QOF for at least 10 years (10-Year Exclusion Benefit).


This third benefit of the program is the one that will likely have the greatest economic impact, and is achieved through an election by the taxpayer to increase the tax basis of the investment to equal “the fair market value of such investment on the date the investment is sold or exchanged.”[2] Prior to issuance of the second round of regulations, this language was interpreted to mean that an investor would only get the exclusion benefit by selling the investor’s investment in a QOF. This obviously hindered the formation of multi-asset funds, since a single QOF set up to hold multiple assets would likely require the fund manager to find a single buyer interested in buying a QOF with multiple assets, as opposed to a separate buyer for each of the assets. In response, fund managers have been utilizing various other alternative fund structures, including the use of a REIT as the QOF or the establishment of a series of parallel partnerships each separately qualifying as a QOF, as explained in further detail below.


Pursuant to Code §562(b), REITs are entitled to a dividends paid deduction for all distributions made within 24 months of the adoption of a plan of liquidation.[3] Meanwhile, Code §331 treats amounts received by REIT shareholders pursuant to a liquidation as payment in exchange for the stock of the corporation.[4] This combination of rules allows for a QOF which has been set up as a REIT to adopt a plan of liquidation after the ten-year holding period has been met and then to make liquidating distributions (not taxed at the REIT level, and treated as deemed purchase payments at the shareholder level) as the REIT sells its assets over a 24-month period. However, because the distributions must be made within a two-year period, a fund with a large number of assets will not have much time to fully liquidate its portfolio. REITs have other limitations (such as investors having zero basis in their stock) and complications (i.e., asset and income requirements) that are beyond the scope of this article, making them a less effective choice than a typical partnership as a QOF vehicle.


The unique rules described above applicable to REITs do not apply to partnerships, and so investors in a partnership QOF with multiple assets would presumedly need to sell their interests in the partnership QOF in order to obtain the 10-year exclusion benefit. This could be difficult to accomplish, since the selling partners would need to find a buyer interested in purchasing the entire partnership portfolio of assets. As an alternative, fund managers have utilized a parallel QOF structure whereby separate QOFs are used to invest (directly or indirectly) in each asset in the portfolio, so that each asset can be sold separately by selling the controlling QOF. Investors in this fund structure are obligated to invest into each QOF on a pro rata basis, meaning no cherry picking. The fund manager then looks to sell off each separate QOF after the 10-year holding period is reached, thereby preserving the 10-year exclusion benefit for investors. While this structure fits within the technical parameters of the existing provisions, it is administratively cumbersome and, among its many awkward consequences, requires a manager to issue separate K-1s to partners from each separate QOF.


Treasury was aware of the challenges facing multi-asset fund formation and tried to address some of these issues in the second round of regulations. First, in a long list of events that would cause an investor to include its deferred gain into income, Treasury provided a rule that states that a contribution by QOF owners of qualifying QOF interests to a partnership in a transaction governed all or in part by Code §721(a) is not an inclusion event. This rule theoretically allows a fund with parallel QOF entities to have its investors contribute their QOF interests into an “aggregator” partnership after they invested their eligible gains into the parallel QOFs. It is believed that Treasury proposed this indirect and rather awkward “solution” due to a concern that it lacks regulatory authority to allow investors to invest directly into the aggregating partnership as the legislation requires investors to invest directly into a QOF.[5]

Given that funds may have many separate investors, this provision reduces substantially the compliance burden inherent in a parallel QOF structure by allowing investors to receive one K-1 from the aggregator partnership rather than a separate K-1 from each parallel QOF. However, it will be helpful if Treasury makes it clear that it will not apply the step-transaction doctrine in a situation where investors make a direct investment into multiple QOFs followed by a drop-down of those QOF interests into an aggregator partnership pursuant to a pre-determined plan.