QOZs and Multi-Asset Funds: Tread Carefully
The many investors already leveraging the recently created Qualified Opportunity Zone program are continually asking whether a Qualified Opportunity Fund (QOF) should hold a single asset or, in the interest of diversification and economies, multiple assets. With the benefits of a single capital raise, a single fund is enticing – and it may bring less uncertainty to the table.
While the latest round of IRS guidance will facilitate multi-asset funds, there can be substantial tax drawbacks to utilizing the multi-asset structure. These drawbacks must be considered before making a final determination.
The hallmark benefit of the Qualified Opportunity Zone (QOZ) program is that if an investor holds a QOZ interest for 10 years, no tax will be recognized on the appreciation of the investment. This is accomplished through a basis step-up in the (QOF) interest to fair market value immediately prior to the sale. Because it is the sale of the QOF interest that triggers the FMV step-up, a fund was precluded from selling assets and receiving the 10-year QOZ tax benefit. This led to the creation of many single-asset funds, largely because the sale of a fund interest was incongruent with anticipated exit strategies of multi-asset funds. It would be impossible for a fund to dispose of assets at different times or to different purchasers without forfeiting the 10-year QOZ tax benefit.
The second set of proposed regulations provided some relief on this issue by providing QOZ investors a special election to exclude capital gains from a fund’s sale of QOZ property. Under this new guidance, if the fund sells qualifying assets that it owns directly, a QOZ investor may exclude the associated capital gain. On the surface, this seems to solve the multi-asset obstacle. But not so fast. There are several nuances to this new guidance that are often overlooked.
- It is unclear if a sale of assets by a lower-tier entity would qualify for the basis step-up under the new guidance. For reasons outside the scope of this editorial, it is nearly universal that a multi-asset fund will own assets in lower-tier entities, rather than holding the assets directly. The new guidance seems to suggest that the fund must sell the interest in the lower-tier entity as opposed to the underlying assets. Furthermore, if a lower-tier entity disposes of an asset, it is questionable whether the investor can exclude the gain from the sale of that asset.
- The new guidance and the associated election only applies to capital gain from the sale of QOZ property. This means that if there is ordinary income, or if non-qualifying assets are sold (a fund is permitted to hold a percentage of non-qualifying assets), income/gain cannot be excluded. Contrast this with a single-asset fund where all appreciable gain is excluded upon disposition of the fund interest.
- The election to exclude capital gains is not available to funds that are organized as corporations.
- Specific to this special election, the proposed regulations may not be relied upon until they are finalized. Many have overlooked this. Although unlikely, there is no assurance that this rule will be in effect tomorrow, let alone 10 years from now.
Despite these highlighted issues, the new IRS guidance does help alleviate some of the concerns investors previously had regarding the exit strategy for multi-asset funds. However, the IRS still has work to do if multi-asset funds are to be on par with their single-asset counterparts.
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