Give Your Opportunity Funds a 10-Point Midyear Checkup (Complete by June 30)
Published by Michael J. Novogradac on Thursday, April 1, 2021
As we head into the second quarter of 2021 and (hopefully) begin to emerge from the COVID-19 pandemic, now is the time for investors and fund managers to give their qualified opportunity funds (QOFs) a 10-point midyear checkup. Investing in opportunity zones (OZs) can generate substantial tax benefits, but only if QOFs and their investee businesses satisfy statutory and regulatory tax requirements.
Give your funds this 10-point checkup well before June 30 to be in the best position to cure any issues before they cause serious damage.
1. Review Each Fund’s Organizational Documents
Organizational documents for every QOF should explicitly state that the fund was set up with the purpose of being a QOF. The instructions for IRS Form 8996 also require QOFs to include in their organizing documents a description of the trade or business that the QOF expects to engage in directly or to engage in indirectly through a qualifying OZ business. QOFs must be a corporation or a partnership for tax purposes. QOFs can be a limited liability company, but you must ensure they are not a disregarded entity for tax purposes.
2. Review Annual Federal and State Income Tax Filings
Review this year’s federal and state entity tax filings and review prior years as well, to ensure that your Form 8996 was prepared properly (which includes indicating on your first Form 8996 that the QOF self-certified as a QOF no later than the month in which a gain was received). Also ensure that the partnership Form 1065, corporation Form 1120 or other entity-level tax form correctly noted the entity was attaching Form 8996 to certify as a QOF.
The IRS in early December 2020 sent letters to taxpayers who may have intended to self-certify as a QOF, telling them that they may need to take additional action to meet the annual self-certification requirement. These taxpayers may have failed to properly complete the entity level form and/or may not have properly completed Form 8996 to self-certify as a QOF. They were instructed to file an amended return or an administrative adjustment request and were told that failure to do so could result in their accounts being referred for examination. The IRS noted that investors who made an election to defer tax on eligible gains invested in that entity may also be subject to examination for an invalid election, which could result in owing taxes, interest and penalties on gains that were not properly deferred. If you find mistakes in previous filings, contact your tax professional for assistance to make corrections.
For state filings, ensure the QOF is filing returns in all the states for which it is obligated to file, which can be triggered based on the state in which the QOF was formed, the residency of QOF investors and the location of QOF investments. Closely review and monitor each state’s conformity with the OZ statute.
3. Know your First (or Next) Fund-Level 90% Investment Test Deadline
The 90% test is generally a twice-a-year requirement (at the end of the first six months of a QOF’s taxable year and the end of the taxable year) for a QOF to hold at least 90% of its assets in qualified OZ property unless it can demonstrate that the failure was due to reasonable cause. The IRS issued temporary relief from that requirement for testing dates from April 1, 2020, through June 30, 2021, which generally means the next 90% investment test deadline isn’t until June 30, 2022.
Taxpayers qualifying for this relief are deemed to have reasonable cause for failing to meet the 90% test. This means that on Part IV of Form 8996, a QOF must calculate the per-month penalty for failure to meet the standard during the time in which IRS relief was granted, but enter “0” on line 8, the total penalty line.
However, this relief may contain a trap for the uninformed. IRS regulations require that property must meet the qualified OZ property standard for at least 90% of the time the QOF holds the property. If a QOF fails the 90% test during the relief period because property fails to be qualified OZ property, it is unclear whether a QOF needs to include the relief period in determining if the property is qualified OZ property for purposes of measuring the 90% of the QOF holding period of the property requirement. The OZ Working Group has asked the IRS to confirm that the holding period of property does not include the period of time during the relief period in which property failed to be qualified OZ property. Without sufficient guidance, any period of noncompliance coming out of the relief period could have repercussions.
This makes points 7 and 8 below all the more important. This also heightens the importance for many QOFs to complete this review well before June 30.
4. Know Your 12-month Reinvestment Period
Generally, QOFs have 12 months in which to reinvest proceeds from the return of capital or the sale or disposition of some or all of their investment in qualified OZ property before the end of the 10-year hold period. Doing so allows the proceeds to be treated as qualified OZ property for purposes of the 90% investment test. However, the IRS provided COVID-19-related relief that allowed any QOF with a 12-month reinvestment period that included June 30, 2020, to receive up to an additional 12 months to reinvest.
That means some QOFs may have a maximum reinvestment period of no more than 24 months, but if you intend to use the extra time, ensure that June 30, 2020, was in your original 12-month period. Your QOF must also otherwise satisfy OZ requirements and invest the proceeds in a manner originally intended before June 30, 2020.
5. Track the Measurement Period for the 30-Month Substantial Improvement Test
If your QOF–or, more likely, the businesses in which your QOF invests–is renovating existing property, then calculate the 30-month substantial improvement test period and ensure you are on target to incur sufficient costs during the applicable period. Relief from meeting the requirement (more than doubling the basis of property within 30 months) was tolled for the period from April 1, 2020, to March 31, 2021. This means, depending on when the original 30 months started, the deadline could be rapidly approaching. If, for instance, a qualifying OZ business was 12 months into the 30-month period on April 1, 2020, it had 18 months remaining as of April 1, 2021. The relief didn’t restart the 30-month period, it suspended it.
6. Collect Information from Your Qualified OZ Businesses
QOFs are required to provide the IRS with information from qualified OZ businesses in which they have invested. Verify that you have the correct information from all qualified OZ businesses, including the Employer Identification Number, the census tract numbers for all properties and the amount of tangible property owned or leased by the qualified OZ business as of the last day of the first six-month period of the QOF’s tax year and the last day of the tax year.
7. Verify that Your Qualified OZ Businesses Meet IRS Standards and are Projected to Continue to Do So Well into the Future
To ensure compliance with the 90% test, make sure qualified OZ businesses into which the fund has invested are complying with the necessary tax requirements. Avoiding the short-term penalties (due to COVID-19 relief) doesn’t ensure qualification once the relief period ends. Identify deadlines for when each business needs to meet each test and ensure that it is on track to do so.
The key tests are:
- At least 70% of the tangible property owned or leased by the OZ business must be qualified OZ business property. The frequency of a QOF check-in for this depends on the nature of the business, but it’s a good practice to have a mechanism to monitor compliance–perhaps having qualified OZ business’s financial statements available for monthly or quarterly review. If that isn’t in your operating agreement, consider negotiating with the qualified OZ business to include that provision.
- At least 50% of the total gross income of the business must be derived from the active trade or business within an OZ. There are multiple ways to measure this: where services are performed based on hours worked; where services are performed based on amounts paid; whether the tangible property of the business and management or operational functions performed in an OZ are necessary for generation of 50% of the gross income; and verification (based on all facts and circumstances) that at least 50% of the gross income is derived from the active conduct of a trade or business in an OZ.
Many qualified OZ businesses had employees work from home during the pandemic, which may require changes in the measurement method, particularly if using one of the methods involving where services are performed.
- At least 40% of the intangible property of the business must be used in the active trade or business in the OZ. As with the 70% test, consider including access to financial records in operating agreements with qualified OZ businesses to track this.
8. Review Qualified OZ Businesses’ Working Capital Plan
Ensure that qualified OZ businesses in which the QOF has invested have a written plan and a schedule to meet the 31-month safe harbor for investments that acquire, construct or rehabilitate tangible business property and confirm that the qualified OZ businesses’ actions are consistent with the plan.
IRS relief provides up to a 24-month extension for qualified OZ businesses in a federally declared disaster area, but part of the requirement is to meet all requirements for the safe harbor. Pay particular attention to the non-qualifying financial property test, as this requirement may be the easiest to fail. A qualified OZ business cannot hold 5% or more of its assets in non-qualifying financial property; monitor this closely. Having access to a qualified OZ business’s financial statements may be the simplest way to do so.
9. Prepare and Compare Forecasts
The most significant OZ benefit is the 10-year-hold, fair-market-value step-up in basis. This means a QOF and its qualified OZ businesses must comply with OZ rules for 10-plus years. Prepare and compare 10-year forecasts to keep a finger on the pulse of whether each qualified OZ business will continue to meet requirements and allow your QOF to continue to meet the 90% test. Regularly comparing current information from the qualified OZ businesses to a forecast helps identify departures and can give you a heads up for potential danger–allowing your QOF and the qualified OZ business to make changes in order to meet those standards.
10. Determine Effect of 2020 Census on the OZs Where Your Fund Invested or Plans to Invest
More than half of OZs (56%) have a change in geographic area, based on U.S. Census Bureau 2020 census tract boundary data released early this year, so there’s a fair chance that your QOF’s investments are in OZs that have changes. That could have significant repercussions, depending on how the IRS addresses those changes.
At press time, the IRS had not issued guidance regarding the effect of census tract changes on OZ investments. Novogradac’s Opportunity Zones Mapping Tool allows users to identify which OZs have boundary changes as a result of the 2020 census and the tool will ultimately be updated to show 2020 OZ boundaries. Take time to learn whether your QOF’s investments are in an OZ that has boundary changes, so you’re not caught off-guard by future IRS guidance on the implications of OZ boundary changes on prior and future OZ investments.
Conclusion: Work the List
This list is not exhaustive, but highlights the need to remain vigilant concerning the OZ incentive. Awareness of your QOF’s deadlines, checking in with the qualified OZ businesses and measuring conformity to forecasts now can prevent problems later.
Consider joining the OZ Working Group for up-to-date information and discussions on technical guidance in the OZ industry.