New IRS Rules on Opportunity Zones Could Bring VCs Back In

May 13, 2019

The Tax Cuts and Jobs Act of 2017 created a relatively little known, but potentially powerful investment vehicle known as Opportunity Zones.  Opportunity Zones are tax-preferred investments in certain geographic areas.

Source: Unsplash; breaking the gates into Opportunity Zones

In theory, the idea behind Opportunity Zones is great.  Investors, including venture capital funds, invest in specified low-income areas.  In exchange for raising funds for investments in under-served communities, investors are eligible for certain tax deductions and exemptions on capital gains. 

Initially, the response from the venture capital community was strong.  High-profile investors like AOL cofounder Steve Case and former Facebook president Sean Parker expressed interest in creating Qualified Opportunity Funds.  Their initial enthusiasm waned as potential restrictions on what counts as an opportunity zone and what counts as revenue were considered. 

That initial enthusiasm may be coming back.  On April 21st, the Internal Revenue Service (IRS) released new guidance on the usage of opportunity zones.

First Big Answer

The first big question from investors with a Silicon Valley mindset regarded the rule on 50% of gross income.  Venture capital investors were shying away from Opportunity Zones because of a concern about how the requirement that “50% of the gross income of a business must come from within the opportunity Zone” would be implemented. Did that mean that all the revenue for the business had to be generated within the Opportunity Zone boundaries?  The answer from the IRS on April 21st was no.  Rather, the 50% requirement could be satisfied by showing that 50% of the company’s employee hours or wages occurred within the Opportunity Zone.  This largely generated a sigh of relief from venture capital, private equity, and other technology-focused investors because most of a technology company’s revenue would stem from business outside of the Opportunity Zone, which would have implied that almost none of their investment would qualify for the tax preferred status.  Again, a large sigh of relief.

Second Big Answer

A second question venture capital investors were concerned about was the location of an opportunity zone.  What if a fund manger wanted to sell assets in one opportunity fund and invest in a different opportunity fund?  Would the tax advantages go away with such a sell? 

As with the first question, the IRS’ updated guidance sided with the investors.  The IRS indicated that the tax benefit of an Opportunity Zone investment is tied to the length of time a person has his funds in an opportunity fund, not how long the assets have been in a specific fund.

Conclusion

Overall, Opportunity Zone funds will likely continue to gain steam as investors find out more about the positive aspects of the funds.  If you’re a private equity or venture capital analyst, you may want to consider directing your company towards Opportunity Zones.  After adjusting for taxes, Opportunity Zone investments may beat other types of investment opportunities.

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