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Opportunity Zone Investments through Qualified Opportunity Zone Funds

Real estate developers were some of the earliest participants in the tax mitigation programs created under the Tax Cuts and Jobs Act of 2017.  Thousands of Qualified Opportunity Funds (QOFs) were established, offering investors the ability to roll over capital gains into a tax – advantaged investment structure or as they are called Qualified Opportunity Zone Businesses (QOZBs).  Some of the benefits include deferring the payment of the capital gains tax on the amount invested, the investment grows federal capital gains tax free if held for at least ten years, and the elimination of depreciation recapture on subsequent sale of assets.  This program is still available today, and all indications are that the program will be renewed through the proposed 2025 tax plan.  While many of the QOZBs were established to develop real estate located within the Opportunity Zones, the Securities and Exchange Commission (SEC) determined that, except in only very limited circumstances, the QOF investment is an investment in securities, not real estate.

1. The Opportunity Zone Compliance Tightrope

At its core, the Opportunity Zone program is first and foremost a tax program.  It is therefore governed by a series of rules issued by the Internal Revenue System (IRS) and the U.S. Treasury – rules that cover everything from fund formation to asset testing and investment timelines. Yet the structure of these investments, particularly the securities being sold, falls under the purview of the SEC. That means compliance demands mastery across two regulatory fronts: tax law and securities law. A misstep on either side risks disqualifying a fund from the tax benefits that underpin the entire QOZ structure.

Furthermore, we need to understand which entities make up Opportunity Zones. First, we have a Qualified Opportunity Fund (QOF), a fund entity comprised of money, subject to federal capital gains tax, that is deposited into a bank account owned by the QOF entity. Second, we have a Qualified Opportunity Zone Business (QOZB), which is a business entity that sells its securities through an offering to the QOF. But what is even more important than understanding these types of entities is ensuring the drafting of correct formation documents. If those documents are incorrect or imprecise, that could result in penalties or the derailment of the fund.

2. Beyond Syndication: Why Fund Formation Matters More Than Ever

It’s a mistake to think of QOF formation as simply another real estate syndication. QOF formation documents cannot rely on the same private fund exemptions that real estate syndications have historically relied on. Below is a simplified chart to see how the IRS and SEC regulate QOF and QOZB:

Entity Structure

QOFs must be structured as either a corporation or a partnership for federal tax purposes.  A single member Limited Liability Company (LLC) will not satisfy this requirement because it is considered a disregarded entity. Drafting documents that inadvertently create an ineligible entity type (such as a disregarded entity or sole proprietorship) can derail the fund from the outset.

Investment Company Act of 1940 Exemption

Real estate syndications are often structured to rely on Section 3(c)(5) exemptions from the Investment Company Act of 1940 (40 Act).  A QOF, however, must generally rely on either 3(c)(1) or 3(c)(7), requiring a focus on accredited and qualified investors, and introducing limitations on fund size and investor qualifications.

Fundraising Regulations

While Regulation D under the Securities Act of 1933 provides offering exemptions for QOFs, compliance with state Blue Sky laws and timely Form D filings remain mandatory. Failure to meet these obligations can expose fund managers and investors to severe penalties and retroactively risk the fund’s compliance standing.

Self-Certification Requirements

To qualify as a QOF, the entity must self-certify using IRS Form 8996 and file it with its federal income tax return. This may seem administrative, but it is critical to the health of the QOF. The fund's organizational documents must support its eligibility, including purpose clauses aligned with the QOZ investment intent. This step is often overlooked and requires coordination with the QOZB’s tax document preparation. The QOF fund manager must communicate with the QOZB manager to prepare accurate returns in order to maintain the designation. This includes the following:

90% Asset Test: At least 90% of a QOF’s assets must be invested in qualified opportunity zone property. Legal documents must include language that commits the fund to ongoing compliance with this asset test, along with mechanisms to monitor and report investments.

Investment Holding Periods: To maximize tax benefits, investors must meet specific holding periods (10 years[1]). Fund documents should clearly outline investment strategies, exit plans, and compliance with timing requirements to ensure alignment with investor expectations and regulatory mandates. This includes a working capital plan provided by the QOZB.

3. Fund Management

Effective fund management is essential to ensure a QOF fully benefits from tax mitigation. Once funds are invested in the QOF, they must be deployed into a QOZB within 180 days. While some QOZBs generate revenue quickly, others may take years to develop before producing income. Regardless of timing, these payments are considered revenue and are subject to regular income tax.

The fund manager is responsible for accurately categorizing these payments on tax returns to avoid triggering an inclusion event when a QOF investor receives their basis back, potentially jeopardizing tax benefits. This can occur, for example, if the underlying QOZB property is refinanced and the QOF distributes funds to investors. Even partial return of basis requires close monitoring.

Sophisticated fund managers may structure returns through non-liquidation events like refinancing, but doing so requires careful planning and professional tax and legal guidance.

4. The Critical Role of QOZB Management

The quality of the QOZB manager, or Sponsor, is as critical as the structure of the QOF itself. While the tax mitigation offered through QOF allows the investment to grow capital gains tax free, this still is an at-risk investment in a speculative project. The quality of the QOZB sponsor may be able to alleviate some of this risk and that should be set forth in the QOZB operating agreement. The waterfall structure, the explanation of how the profit and revenue will be distributed throughout the life of the QOZB, should clearly set forth any hurdles or minimum thresholds the QOZB must meet before different class members receive distributions. Strong QOF managers insist on setting Sponsor thresholds for capital contributions before allowing additional capital calls on the QOF, protecting the fund and its investors from undue dilution or risk.

Conclusion: Compliance Is the Strategy

Qualified Opportunity Zone Fund formation is not merely a formality, it's a high-stakes process that demands meticulous compliance with federal tax law, securities regulations, and corporate governance standards. Inadequate attention to these details can result in loss of tax incentives, regulatory penalties, and reputational damage. As the Opportunity Zone program continues to evolve, ongoing legal and regulatory compliance must be viewed, not as a legal box-checking exercise but as a strategic imperative. At Lucosky Brookman LLP, we guide our clients through every stage of Opportunity Zone structuring, offering pragmatic legal and regulatory advice designed to preserve the full value of these powerful incentives.