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Qualified Opportunity Funds: The Gift That Keeps On Giving

John Pantekidis

Since the second series of Treasury regulations regarding Qualified Opportunity Zones (QOZs) were created this spring, tax attorneys across multiple disciplines have been focused on capturing as much tax alpha as possible. And the new regulations have unveiled new opportunities. For example, Treasury is now allowing Qualified Opportunity Fund (QOF) investors to sell their QOF entity interests after the expiration of the requisite 10-year holding period and avoid depreciation recapture.

In a previous article on QOZ strategies, I outlined the three initial tax benefits afforded by the QOZ Program. They included an initial deferral of capital gains realization, a partial forgiveness of that capital gains (i.e., up to 15% forgiveness), and complete capital gains avoidance of post-QOF appreciation, so long as the QOZ requirements were satisfied.

I also outlined how any investments in real estate developments would require the use of qualified nonrecourse financing to maximize the tax efficiency of annual cash distributions after property stabilization but before the 2026 tax realization event. The depreciation allowed from the tax basis attributable to the debt would shelter any taxable income and subsequent distributions, not to mention the inflation-protection benefits afforded by low-cost, fixed-rate leverage.

Now, based on the most recent regulatory release, there are two more significant tax benefits of the QOZ program that weren’t initially available. As a fourth benefit, any depreciation taken during the life of QOFs can permanently escape depreciation recapture if the QOF interests are sold, as opposed to selling the underlying property. While this may add a layer of complexity at the back-end (i.e. exit) in terms of finding a buyer for the QOF entity, the benefits to investors are enormous.

The fifth is a very material tax benefit that goes beyond pure income tax planning and permeates multi-generational aspects not available before. A new provision allows QOF investors to gift their interests to grantor trusts without violating the QOZ rules. This transfer ability can provide numerous tax benefits, particularly within the context of the timely usage of additional lifetime gift exemption provided to U.S. taxpayers by the passage of the 2017 Tax Cuts & Jobs Act (TCJA).

As illustrated in the diagram below, a typical QOF is comprised of a Delaware LLC, taxed as a partnership for federal income tax purposes, that in turn invests in another Delaware LLC (e.g., Qualified Opportunity Zone Business (QOZB)), which in turn owns the physical real estate to be developed into a cash-flowing investment property.

Other parties, such as real estate developers, general partners, other QOFs and non-QOZ investors can also become members of the QOZB entity. The major governance powers usually remain with the GP/Managing Member, with some level of negative controls by the QOF entity. Additionally, the GP receives a percentage of the profits after investors receive their return of capital and a preferred return, depending on the negotiating power and prowess of the relative parties to these transactions.


Operating agreements to these two entities contain multiple member restrictions that are par for the course for such ownership vehicles. Under well-established tax principles found in numerous court cases, discounts of between 35% and 45% are allowed on the underlying net asset values of interests in such co-investment vehicles for federal gift and estate tax purposes, depending on the specific facts and circumstances of each case.

Let’s take an example. Assume an ultra-high net worth (UHNW) individual is informed by their estate planning attorneys they should use their additional $5 million plus of exemption provided to them under the TCJA before a potential change in a presidential administration or congress that could perhaps take it away. This would involve the said UHNW taxpayer gifting $5 million of cash and/or other assets to a multi-generational grantor trust (“Children’s Trust”). Based on their attorneys’ recommendation, the easiest manner of using these exemptions is through cash gifts to a multi-generational trust, to which in prior years the UHNW taxpayer also sold interests in another co-investment vehicle, valued at a 40% discount, taking back a promissory note from the Trust in an amount of $5 million with an interest rate of 2.5% (i.e., the mid-term Applicable Federal Rate at the time of the transaction).

Imagine now that the same taxpayer instead deployed $8.3 million into a QOF, structured similar to the diagram above. It is entirely plausible for that investor to obtain a qualified appraisal of that interest, valuing it between $4.5 million and $5.5 million for federal gift tax purposes. Let’s assume a 40% discounted valuation, which translates into an approximate $5 million taxable gift, similar to the straight cash gift.

Based on the underlying pro forma of the QOF, after the property is stabilized after three years and refinanced at the higher valuation, investors are expected to receive approximately 40% of their capital in a tax-free manner. For this investor, this means that the Children’s Trust will receive $3.3 MM in cash, available to reduce the promissory note to the Grantor. Additionally, based on the pro forma, this QOF will be distributing approximately 12% of the remaining capital in free cash flows annually, or just over $610,000 per annum to the Children’s Trust.

If we juxtapose the two potential gifting alternatives, the QOF gift allows for a full pay-back of the existing promissory note in five to six years, with the Trust still owning an incredible cash-flowing asset that has a tremendous appreciation potential as well. The same $5 million cash gift recommended by their estate planning attorneys would result in the pay-back of the note with no remaining yielding asset.

The one potential draw-back to such a gift of a QOF interest pertains to the “tax burn” characteristics of any grantor trust. All taxable activity within a grantor trust is reported and paid by the grantor because the grantor is considered the owner of the assets for federal income tax purposes – i.e., this is referred to as the “tax burn.”

However, I have seen several situations where a holistic balance sheet approach to multi-generational tax planning was not adopted and a core asset base for the matriarch and patriarch was not maintained and that this tax burn becomes overly burdensome, requiring the grantor to shut it off. In such situations where the Children’s Trust now becomes a non-grantor trust, any QOF investments that were gifted into the trust technically no longer qualify for QOF status. Again, this normally occurs only in those cases where multi-generational planning was accompanied by poor balance sheet planning and ongoing management, resulting in an asymmetrical transfer of wealth to the next generation, accompanied by a powerful tax burn profile, depleting the core asset base of the grantor.

To summarize, the recent regulations has now offered taxpayers additional tax benefits for QOF investors that makes well-designed QOF investments even more attractive. It’s worth noting that such investments should only be made if the underlying investment can be justified from a fundamental investment perspective, exclusive of the tax benefits. But with proper planning and structuring, these regulations can help turn a good investment into an exceptional one.

I’m the Chief Investment Officer and General Counsel at TwinFocus, a multi-family office with $6.5 billion in assets under advisory for more than 30 globally-situated

I’m the Chief Investment Officer and General Counsel at TwinFocus, a multi-family office with $6.5 billion in assets under advisory for more than 30 globally-situated families. My firm takes a unique balance sheet approach to managing the wealth of our ultra-high-net-worth clients by incorporating the nuances and complexities of family members across generations and integrating all aspects of domestic and cross-border tax, legal, investment, philanthropic and multi-generational planning to provide a comprehensive family office strategy. This multi-disciplinary approach allows me to design creative solutions to complex and evolving family office challenges. I was a practicing tax attorney before becoming an investment consultant, giving me a unique perspective for identifying and diligencing alternative investments from a tax, legal and fundamental investment standpoint others lack. My firm has become a pioneer in researching and designing non-traditional approaches to alternative investment strategies to complement other portfolio holdings and maximize after-tax returns.