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Interpreting and Completing OZ-Related Tax Forms

Published by Barbara Malesky and Jason Watkins on Friday, April 2, 2021

Journal Cover April 2021   Download PDF

Under the opportunity zones (OZ) incentive, taxpayers are able to defer capital gains through investment into a qualified opportunity fund (QOF) that subsequently invests in qualified OZ property.

In order for the capital gains to be properly deferred, taxpayers and QOFs are required to file certain tax forms beginning with the tax year in which the capital gain was realized and continuing until the year of the taxpayers’ disposition of their investment in the QOF. A taxpayer defers a capital gain by disclosing the associated QOF investment on Form 8949. Beginning with the year that a taxpayer makes their initial QOF investment and continuing through the year they dispose of their last QOF investment, they are required to file Form 8997 to disclose certain information about QOF investments acquired, held, or disposed of during the tax year. Once a QOF receives its initial gain-deferred investment, it is required to file Form 8996 to self-certify as a QOF and to disclose other information. In all subsequent years, the QOF will be required to continue to file Form 8996, including the year in which it chooses to decertify as a QOF.

Form 8949–Sales and Other Disposition of Capital Assets

Investors are required to report an election to defer tax on eligible gain invested in a QOF on Form 8949 attached to a timely filed return. On this form, they are required to list the employee identification numbers (EINs) of all QOFs in which they invested, as well as the dates of the investments and the amount of deferred gain as a negative number. A QOF investment that is deferring a gain should be listed on the line directly below the line containing the capital gain that is being deferred.

If an investor sells or exchanges an investment in a QOF that triggers an inclusion event or receives a distribution in excess of basis that triggers a partial inclusion event, the amount of the previously deferred gain that now requires inclusion is reported on Form 8949 by checking box C in Part I or checking box F in Part II, depending on whether the capital gain was short-term or long-term in character. The EIN of the disposed QOF investment will be entered in column A, column B-E will need completed as applicable, column F will need answered “Y” and the amount of the previously deferred gain being recognized will be entered in column G as a positive number.

Form 8997–Initial and Annual Statement of Qualified Opportunity Fund Investments

An investor in a QOF uses Form 8997 to inform the IRS of the QOF investments and deferred gains held at the beginning and end of the current tax year, as well as any capital gains deferred by investing in a QOF and QOF investments disposed of during the current tax year. Part I of the form includes any gain-deferred QOF investments made before the beginning of the current tax year and Part II will include any gain-deferred QOF investments made during the current year. Part III is completed to report any inclusion events that occurred during the current tax year related to QOF interests. Examples of an inclusion event include where a taxpayer’s QOF interests are sold or transferred, the QOF investment ceases to be a QOF, or if the taxpayer receives distributions from the QOF that are in excess of their basis in the QOF. Treasury Regulation Section 1.1400Z2(b)-1(c) contains a full list of inclusion events and exceptions.

Form 8996–Qualified Opportunity Fund

A corporation or partnership uses Form 8996 to certify that it is organized to invest in OZ property. In addition, a corporation or partnership files Form 8996 annually to report that the QOF meets the 90% investment standard of Internal Revenue Code Section 1400Z-2 and to calculate the penalty should it fail to meet the investment standard. The form is also used to report certain information about qualified opportunity zone property held by the QOF.

Part I

Taxpayers use Part I of the form to answer general questions about the organization of the QOF, to self-certify or decertify as a QOF, and to disclose whether any investors have disposed of, in whole or part, their equity interest in the QOF.

In the tax year that contains the first period that the taxpayer is a QOF, Line 3 must be answered “yes” and the QOF should list the first month it has chosen to be a QOF in Line 4. The month chosen should be no later than the first month in which the QOF received a gain-deferred investment.

Part II

Part II is used to determine whether the QOF has met the 90% investment standard by calculating the percentage of qualified OZ property held on both the last day of the first six-month period (if applicable) of the fund’s taxable year (Lines 7, 8 and 9) and on the last day of the fund’s taxable year (Lines 10, 11 and 12).

QOFs also have the option to disregard recently contributed property (e.g. cash investments) for the purposes of this test. Excluded amounts must satisfy each of the following criteria:

The amount of contributed property was received by the QOF solely in exchange for an interest;

The contribution or exchange occurred not more than six months before the date of the test from which the amount is excluded; and

Between the date of the contribution and the asset test, the amount of property was held continuously as cash, cash equivalents or debt instruments with a term of 18 months or less.

Part III

The results of the six-month (if applicable) and year-end tests are averaged to determine if the 90% investment standard was met. If the result is less than 90%, the QOF has failed the test, will check “no” and will be required to complete Part IV of the form to compute the amount of penalty incurred. Typically, the resulting penalty determined in Part IV would be listed in Line 15. However, due to COVID-19 relief provided under Internal Revenue Service (IRS) Notice 2021-10, any failure by a QOF to satisfy a 90% investment standard test that falls between the period beginning April 1, 2020 and ending June 30, 2021 will be considered due to reasonable cause under IRC 1400Z-2(f)(3) and will result in no penalty for that taxable year, resulting in the taxpayer entering 0 on Line 15.

Part IV

Although there will be no penalty due from the failure of a 90% test, a QOF will still be required to calculate the penalty for any months in which it failed to meet the investment standard. This is calculated by taking the total assets held by the QOF on the last day of each month multiplied by 90%, less the total QOZP held on the last day of the month, entering 0 if the result is less than zero. This amount is then multiplied by the underpayment rate (currently 3%) and divided by 12. The penalty does not apply to any months before the first month the QOF self-certifies as a QOF.

Part V

Taxpayers use this section to identify all QOZ business property directly owned or leased by the QOF as of both the last day of the first six-month period of the tax year and on the last day of the tax year, including the QOZ Tract number in which the business property is located.

Part VI and Part VII

Taxpayers use these sections to identify any QOZ stock or partnership interests (QOZB) held by the QOF as of both the last day of the first six-month period of the tax year and on the last day of the tax year. The information required to be disclosed includes the QOZ tract number in which all property is held by each QOZB along with each QOZB’s employer identification number (EIN). Additionally, the QOF is required to list the total tangible property owned or leased by the QOZB as of both testing dates listed above.

Conclusion

A failure to complete the required forms for investors and QOFs or errors in their preparation could have serious consequences up to and including a failure to properly defer a capital gain. Additionally, in preparing numerous returns for our QOF clients, we have noted that many QOFs have not made arrangements with the QOZBs in which they invested to gather the information required to complete the Form 8996. Completing these tax forms correctly can be a challenging task. Accordingly, taxpayers are encouraged to consult with their tax professionals when filing their returns.

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