Authored by Colin Walsh and Michael Wronsky
The opportunity zone (OZ) space is among the innumerable sectors of the economy adversely impacted by COVID-19. From reservations on the part of potential investors due to liquidity considerations, to questions about the viability of going concern on the project side, uncertainty abounds. In an effort to alleviate some of these concerns, in June, the IRS continued its efforts to provide taxpayers with coronavirus-related compliance relief via OZ-focused Notice 2020-39, which relaxed many of the program’s timing requirements.
Pandemic aside, additional compliance questions remain unanswered after 544 pages of comprehensive final regulations were released in December 2019. This article serves as a reminder of the relief provided by Notice 2020-39 as well as an overview of the remaining gray areas as they have emerged in practice. Lastly, we provide a brief comparison of what could be next for the OZ provisions, based on details on the respective candidates’ tax platforms that have been released ahead of the forthcoming presidential election.
The IRS provided investors and qualified opportunity funds (QOFs) extensions to comply with many rules that require time-sensitive actions to take advantage of the OZ tax benefits. For a more detailed discussion of Notice 2020-39, please see our previous tax alert, but in summary, the provided relief automatically:
In addition to the automatic relief, the notice also confirms that the national emergency declaration issued by the president in reaction to COVID-19 triggers the availability of the federal disaster relief included in the OZ regulations. Specifically, a QOZB will have more time to acquire or construct property, or start a business within an OZ pursuant to a working capital safe harbor (WCSH).
QOZBs generally can apply up to two consecutive 31-month WCSH periods to carry out a written plan for the aforementioned purposes, but the OZ regulations allow for “not more than an additional 24 months” in light of a federally declared disaster. It is unclear based on the wording of the regulations and the notice whether the additional 24 months is automatic or if QOZBs must demonstrate they need the extra time based on facts and circumstances. However, informal commentary by IRS officials suggests the latter is true. We therefore strongly recommend that QOZBs utilizing this relief provision be diligent and thorough in maintaining documentation to support its need to do so, should it be questioned or challenged upon IRS examination.
Despite the welcome relief provided by Notice 2020-39, the scope of the economic crisis surely has caused investor groups and project managers to question whether staying the course of their OZ plans is economically feasible. When the decision is reached to dissolve a QOF, the regulations prescribe a voluntary decertification process whereby a QOF withdraws its status as such and, as a consequence, its investors are deemed to have inclusion events and must recognize their deferred gains.
However, the regulations delegate designing the decertification process to the IRS and, to date, no guidance or forms have been released on the matter. We do know that under the regulations, decertification will not be effective until the month that follows the month specified by the QOF, which cannot be any earlier than the month the QOF applies for decertification. As such, to the extent decertification is planned for 2021, fund managers must take care to maintain the 90% asset standard through the month subsequent to the designated decertification month to avoid penalties.
As discussed, a QOF that fails to hold 90% of its assets in QOZBP will be charged potentially steep penalties, unless it can demonstrate that the failure was due to reasonable cause. Despite being lobbied by taxpayers and practitioners to detail what constitutes reasonable cause for this purpose, the Treasury Department declined to do so when finalizing the OZ regulations. As a result, once Notice 2020-39’s automatic relief period ends on Dec. 31, 2020, taxpayers who run afoul of this requirement will have to determine whether their facts and circumstances present an adequate defense to penalty assessment.
The preamble to the final OZ regulations do provide a hint in pointing to Section 20.1 of the Internal Revenue Manual (IRM) as the standard for determining whether reasonable cause has been established with respect to the 90% asset test. The IRM in general outlines that reasonable cause requires the taxpayer to have exercised “ordinary business care and prudence,” and their failure to comply with the law at issue was due to circumstances beyond their control. Potential instances as outlined by the IRM may include the death, serious illness or unavoidable absence of the person with the sole authority to direct the QOF’s actions; fire, casualty, natural disaster or other disturbance; an inability to obtain records; reliance on erroneous advice. It is critical to note that these are merely examples and may not on their own rise to the level of reasonable cause.
To determine whether the 90% asset standard has been met, a QOF must divide the total QOZBP over its total assets. If the quotient is greater than or equal to 0.9, no penalty is due; if less, the QOF must self-assess a balance due. As part of this exercise, a QOF can exclude from both the numerator and the denominator contributions of capital it received no longer than six months before the testing date, so long as those contributions were continuously held in cash, cash equivalents or debt instruments with terms of 18 months or less. For QOFs whose only assets are these excludable contributions, this presents a mathematical quandary as it must report zero for its QOZBP over zero for its total assets — a result that is undefined. This is a common fact pattern in a QOF’s initial year, e.g., investors contribute cash to the QOF just a few days before Dec. 31, and the QOF still holds this cash on Dec. 31.
The QOF should not be assessed any penalties in this scenario, as the ability to exclude recently contributed capital is clearly available so that fund managers have adequate time to deploy the funds to acquire “good” QOZBP. However, as a matter of compliance, it is unclear whether the quotient should be reported as one or zero. If the former, no further calculation is necessary (greater than 0.9); if the latter, a calculation would be required, but the result would be zero as the QOF has no balance of “bad” assets to assess a penalty on. Informal commentary from the IRS promotes the former approach; however, we are hopeful the form instructions will be updated in due course to reflect this. For the time being, we recommend that QOFs with the “zero divided by zero issue” check the yes box on line 14 of the Form 8996 to avoid confusion with the IRS.
In spring 2020, Treasury issued technical corrections to the final OZ regulations. The final OZ regulations contained an example in which an individual realized gain from the sale of real property to a QOF and then invested that gain in the buyer QOF. The final OZ regulations disallowed the individual’s investment under the step transaction and circular cash flows doctrines. The property acquired by the QOF was also deemed a “bad asset” because it was acquired from a related party. For OZ purposes, “related party” is defined as more than a 20% ownership interest.
Prior to the issuance of the technical corrections, many practitioners believed that existing OZ landowners could sell land to a QOF and then subsequently acquire a less than 20% ownership interest in that QOF. The technical corrections established that the step transaction and circular cash flow doctrine will be applied even if the existing property owner acquires a less than 20% ownership interest in the QOF.
What remains unclear is whether an existing OZ property owner can use unrelated gains to acquire an interest in a QOF. For instance, assume an individual both sells real property to a QOF and sells stock to an unrelated third party. Can that investor use the gains from the sale of the stock to acquire an interest in the QOF? This issue remains gray. Existing OZ property owners should exercise caution and consult with tax advisors before proceeding with such a scenario.
The potential for significant tax legislation in 2021, of course, not only hinges upon the outcome of the presidential election, but also the results in both chambers of Congress. That said, it should be noted the available information surrounding the tax platforms of both the Trump and Biden campaigns include mentions of changes to OZs.
Few details have been offered by the Trump campaign, though “expanding opportunity zones” is among them. It is unclear what this would entail, but it stands to reason (and the president’s advisors have alluded to) it would mean additions to the existing 8,766 OZs designated by Treasury.
The Biden campaign’s platform echoes long-standing bipartisan calls to add reporting requirements to the program rules and corresponding reviews by Treasury to ensure that the program is achieving its intended benefit of aiding low-income communities. Additional incentives would be created to encourage partnerships between OZ project management and local not-for-profits and community leadership, to promote coordination such that the benefits to the local economies and job creation are optimized.
We encourage you to reach out to your Baker Tilly tax advisor regarding how any of the above may affect your tax situation.
For more information on this topic, contact our team.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.