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Opportunity Zones Q&A: Are Distributions from an OZ Fund Taxable as Ordinary Income?

In hosting our Opportunity Zones webinar series, we’ve received many great questions covering a wide range of important topics. To help further your understanding of this exciting program, our General Counsel, Kelly Alton, a nationally recognized tax attorney who previously worked at the Office of Chief Counsel of the Internal Revenue Service National Office in Washington, DC, has partnered with Novogradac & Company, a previous webinar co-presenter, to provide some initial responses.

This is the fourth installment of our Opportunity Zones Q&A blog series. You may read the previous questions and answers here:

  1. Previously Held Property
  2. Can an LLC Qualify as an Opportunity Fund?
  3. How Much of an OZ Fund Can One Investor Own?

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Q: Are distributions from an OZ Fund taxable as ordinary income?

A: Let’s assume that your Qualified Opportunity Fund (QOF) is a partnership (this includes an LLC taxed as a partnership).

The answer to your question depends on what you mean by “distributions.”

If you mean “cash distributions,” then non-liquidating distributions of cash by a partnership (even a Qualified Opportunity Fund partnership) to its partners, by definition, are not taxable events, except in certain relatively unusual circumstances.

Conversely, if you mean “allocations of income to the partners in the QOF partnership,” then it all depends on the nature of the income recognized by the Qualified Opportunity Fund. Keep in mind that a partnership, by its very nature, is a pass-through entity. Rather than paying tax on the income it earns, it allocates its income (or loss) to its partners, who in turn pay tax on that income. The nature of the activity at the QOF level will dictate the nature of the income (i.e., ordinary income vs. capital gain vs. other types of income), which will in turn dictate how that income is taxed to the partners.

For example, if the QOF owns real property and that real property earns taxable income from the operation of that real property (after factoring in all applicable deductions), then the QOF would allocate that income to its partners, and those partners would recognize that income on their tax returns at the partner level. In this scenario, the income so allocated would likely be taxed at ordinary rates, assuming the income is not offset by losses, etc.

However, to further complicate the issue, the second set of proposed regulations on Qualified Opportunity Funds that the IRS and Treasury released this year establish new rules defining “inclusion events” which would accelerate an investor’s deferred gain that was used to acquire his QOF investment. Under these rules, an inclusion event would typically occur if the QOF investor reduces his interest in the QOF or cashes out, with an exception available for certain types of otherwise tax-free transactions. These rules are worth noting here because distributions from a QOF in excess of basis can constitute an inclusion event. This would cause inclusion in the investor’s income of some or all of his deferred capital gain.

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