Opportunity Zones are a hot topic. Louisville is consistently mentioned as an attractive city for opportunity funds to invest, and the federal opportunity zones incentive could provide a significant boon to investors in qualified investments.
However, there are several compliance issues investors and their advisers should consider to ensure success.

What are the incentives?

The federal Opportunity Zone incentive offers substantial tax benefits to investors in qualified opportunity funds. Kentucky investors are entitled to similar tax benefits at the state level.
These benefits are intended to encourage investors to access unrealized capital gain from their existing appreciated assets and then use that gain to reinvest in businesses and development projects in economically distressed areas designated as Opportunity Zones.

Temporary deferral 

Investors can defer recognizing the reinvested capital gain as income until the 2026 tax year under certain criteria. They must reinvest the gain in a qualified opportunity fund (QO Fund) within 180 days of when they would be required to recognize the gain for tax purposes (generally, when the asset is sold).
Any asset that generates capital gain when sold qualifies for deferral. This includes publicly traded stock, real property or a privately owned business.

Reduction of deferred gain

Investors who hold an interest in the QO Fund for at least five years receive a 10 percent increase in their basis in the investment, which reduces the amount of the deferred gain the investor realizes in 2026 by 10 percent.
The amount increases to 15 percent if the investor owns the interest for at least seven years. Therefore, an investor with an investment of $1 million that holds its interest for seven years would only recognize $850,000 of the deferred gain in the 2026 tax year.

Permanent exclusion of appreciation 

Investors holding an interest in a QO Fund for at least 10 years can elect to exclude any appreciation in the value of the investor’s interest above the amount of its original QO Fund investment when the investor sells its interest.
For example, should the investor in the example above sell its interest in a QO Fund in 2029 for $3 million, the investor can elect to permanently exclude the $2 million of appreciation in the value of the interest above investor’s $1 million investment.

What is a QO fund?

A QO Fund can be an entity with multiple investors and a fund manager managing a national portfolio of qualifying investments. A QO Fund can also be a local investor looking to redevelop a building in an Opportunity Zone in Louisville.
A QO Fund is simply an entity (partnership, LLC or corporation) that serves as a vehicle for investors to deploy capital into qualifying businesses and property in opportunity zones. It can self-certify and does not need prior approval from the IRS.

What property can a QO fund own?

At least 90 percent of the QO Fund’s assets must consist of qualifying property. Generally, such property consists of either an equity interest in a business operating in an Opportunity Zone or tangible property (including real estate) used in a trade or business activity in an Opportunity Zone.
If the original use of the qualified tangible property does not begin with the QO Fund or a qualifying business owned by the QO Fund, the fund or business is required to substantially improve the property. If a QO Fund purchases a commercial building in an opportunity zone, the QO Fund must substantially improve the property for it to qualify.
Substantial improvement requires capital improvements exceeding the purchase price to the property during the 30-month period after purchase. The IRS recently issued guidance stating any portion of the purchase price attributed to the value of the underlying land won’t be included in the amount necessary to substantially improve the building located on the land.
The federal opportunity zones incentive has generated excitement and could become one of the largest economic development programs in recent history. Investors should be mindful that the potential for tax incentives does not make an otherwise bad investment a good one.
— Chris Coffman is a member at Frost Brown Todd LLC and provides general tax counseling and planning related to the structuring of Opportunity Zone investments. Reach him at ccoffman@fbtlaw.com