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Not only can private equity (PE) funds and their investors take advantage of the federal tax benefits under the new qualified opportunity zone (the QOZ) program, in many cases they are uniquely positioned to do so better than any other type of investor. The extent to which Qualified Opportunity Zones will be of value to (corporate) private equity funds will be dependent on the regulations that have yet to be promulgated.

This stems from the fact that the QOZ program is not just for real estate projects, but can apply to a wide variety of business types with which PE funds are familiar, including traditional manufacturing and sales-based businesses, as well as technology-based businesses and start-ups. However, there are some unique issues that PE funds (in this case, meaning  an entity, such as an LP or LLC, that is treated as a partnership for federal tax purposes) should consider when deciding whether to take advantage of the QOZ program. Because the QOZ program is in its infancy, with several rounds of Treasury Regulations forthcoming, investors could face some degree of legal and tax uncertainty prior to the issuance of further guidance in certain cases depending on their structure and investments. 

Brief Background of the QOZ Program

A qualified opportunity fund (QOF) is generally an entity treated as a partnership or corporation for tax purposes (which can include an LLC) formed for the purpose of investing in qualifying opportunity zone businesses or property. A QOF must meet several other tests and timing requirements in order to qualify under the QOZ program. Anyone can create a QOF, including a PE fund or its partners.

Under the QOZ program, a taxpayer that reinvests capital gains in exchange for equity in a QOF within 180 days may elect to defer the income inclusion of the capital gain (known as the deferral election) until the earlier of the date they sell their interests in the QOF or December 31, 2026. In addition, an investor of capital gain that holds an interest in a QOF for at least five years can increase its basis by 10% of the deferred capital gain, with another 5% increase after a sevenyear holding period, effectively eliminating the eventual inclusion of up to 15% of the initial capital gain invested into the QOF.

And, most importantly, provided the taxpayer made the deferral election, then after a 10-year holding period, the taxpayer is entitled to elect to step-up its basis in the equity of the QOF to fair market value, which may have the effect of excluding from federal income tax all of the post-investment gain from the sale of the QOF investment. However, under current guidance, capital gain or ordinary income may arise on exit when a QOF that is treated as a partnership has debt or “hot assets” (such as inventory and depreciation recapture) when the QOF equity is sold even after a 10-year hold. Also, whether these benefits apply for state income tax purposes depends on whether a state conforms to the federal law and is determined on a state-by-state basis. Operating income earned by the QOF during the holding period is generally subject to income tax under normal income tax principles.

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