Prevailing conventional wisdom would imply that the best way to secure the tax benefits available to investors through funds such as hedge funds and real estate funds is to structure these vehicles as limited partnerships, despite the complex tax filings this can require.

However, as investors examine the options available through a relatively new type of tax-advantaged fund—the opportunity zone fund—they should be aware that this well-worn conventional wisdom may not apply to this growing field.

That’s because there may be significant differences in the treatment of capital gains invested in opportunity zones between the federal tax code and tax regulations in some states. Under certain circumstances, this may mean that investors in opportunity zone funds structured as partnerships can end up with all the tax complexity with few, if any, of the tax benefits.

As they consider which opportunity zone funds to add to their portfolios, investors should pay attention to how such funds are structured. Funds structured as corporations (or LLCs that elect to be taxed as corporations) may provide a simpler way forward that preserves the potential tax benefits that make opportunity zones an attractive investment in the first place.

It pays to perform a simple bit of due diligence up front to avoid headaches down the line.

Conforming Vs. Nonconforming States
First, a primer on opportunity zones. The Tax Cuts and Jobs Act of 2017 allows investors in real estate and businesses in these designated zones to defer capital gains taxes on investments until Dec. 31, 2026 if those gains are rolled into an opportunity zone investment within 180 days of gain recognition. If they hold the investment for five years, their tax basis increases by 10%; hold it seven years, and the basis rises by an additional 5%. The deferred gain will be recognized on the earlier of disposition of the investment or Dec. 31, 2026. If the investors hold for 10 years, they won’t incur any additional federal capital gains taxes on any further appreciation.

However, the federal code allows for states to determine for themselves whether they will adjust their tax codes to match the federal treatment of capital gains in opportunity zones. Some states have fully conformed, while others have partially conformed. A small subset have not conformed at all, including California, where the state legislature in 2019 considered a proposal that would have made the state partially conformant with the federal opportunity zone law but did not ultimately pass any legislation.

More so than other states, California’s nonconformity is a potential sticking point for investors interested in opportunity zones, given that it’s the United States’ largest economy and home to a vast real estate market. More to the point, there are 879 opportunity zones in California, more than in any other state or U.S. territory.

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