Potential Tax Wrinkles
The wrinkles introduced by various states’ nonconformity mean that investors in opportunity zone funds structured as partnerships may reap fewer benefits than they expect, while still having to bear the complexity of filing taxes in every state where the fund holds assets.
For example, if an investor invests capital gains in an opportunity zone fund with holdings in California that is structured as a partnership, she can defer federal capital gains taxes on the investment; if she is a California resident, however, she must immediately pay the state’s 11% capital gains tax on the portion of the investment that is located within the state.
Then, if the investment generates profit—through rents or other activities—this taxable income flows directly through to investors. But because the federal tax law doesn’t allow investors to take income allocations out of the opportunity zone funds without losing the ability to defer capital gains on their original investment, investors are essentially realizing phantom income—that is, they aren’t receiving cash for the income, but they still have state tax liability.
Alternatively, if the opportunity zone fund is taxed as a corporation, its income is taxed first on the corporate level if the corporation as a whole is profitable. Individual holders would only be taxed if the corporation makes a distribution out of after-tax profits.
Opportunity zone funds structured as corporations, however, are unlikely to make such distributions, because doing so would create a taxable event and undercut investors’ purpose for investing in the fund in the first place. This dynamic would have the benefit of limiting investors’ tax liabilities in such cases.
Pay Attention To Business Structure
The situation around each investment fund and its respective tax treatment are specific to the fund. However, because some states—including the one with the highest concentration of opportunity zone investments, California—don’t conform to federal law when it comes to taxation of capital gains, there could be complications that create negative tax outcomes for unwary investors.
Investors and their financial advisors should do their due diligence on whether a given opportunity zone fund is a good way to protect capital gains. They should look at whether it’s structured as a corporation or a partnership. The tax benefits of a corporate structure could defy conventional wisdom.
Robert Sher is co-founder of Greenbacker Capital, an investment firm focused on the sustainable infrastructure sector.