Economically distressed communities received a powerful investment tool with the passage of tax reform legislation under the Tax Cuts and Jobs Act of 2017: the opportunity zones (OZ) incentive. Third-party assistance is a key pathway to remaining in compliance.

The incentive allows a taxpayer to defer recognizing and paying tax on capital gains until Dec. 31, 2026, if the gain is invested into a qualified opportunity fund (QOF). Due to the complexities of the incentive detailed in the final regulations issued in late 2019, taxpayers with capital gains looking to use the OZ incentive may face challenges and difficulties structuring their investment appropriately. Engaging with a third party to provide semiannual compliance consulting and reporting is a step that many QOF sponsors undertake. This enables QOF sponsors to identify potential compliance problems before they result in costly penalties or worse, impact their investors’ capital gain deferrals and QOF investment appreciation gain elimination benefits.

A QOF is the investment vehicle created to invest in OZ properties. An entity can establish a QOF if it follows guidelines set by the statute and self-certifies according to guidance from the U.S. Department of the Treasury and the IRS. A QOF must hold at least 90% of its assets in qualified OZ businesses and/or business property measured on specified testing dates. The test is calculated as of the end of the first six-month period of the QOF’s tax year and on the last day of the QOF’s tax year and the results are reported on IRS Form 8996, included with the QOF’s annual tax return. The QOF meets the requirement if the average of the two tests is at least 90%. If the QOF fails to meet the 90% requirement, it must pay a penalty for each month it fails to meet the investment requirement, which can be quite costly. The penalty is calculated by multiplying the amount by which the QOF failed to meet the 90% test by an underpayment penalty rate published quarterly by the IRS.

Most QOFs invest in qualifying property indirectly through a qualified OZ business, which have their own set of requirements so that they can qualify as eligible investments. The qualified OZ business is tested annually (note that certain tests are averages for the period tested annually) and required to meet numerous complex tests including: (i) 70% owned/leased tangible property test (ii) original use/substantial improvement analysis (iii) 50% gross income test (iv) active trade or business test (v) 40% intangible property test (vi) 5% nonqualified financial property test, and (vii) excluded business test. Critically, if a joint venture in which a QOF is investing does not meet the requirements for a qualified OZ business for any one period, this may taint that QOF investment for many years and cause the QOF to have to liquidate its investment prematurely.

Given the intricacy of the requirements and the possibility for severe penalties, it is recommended that QOF sponsors engage or require the engagement of qualified professionals to assess whether a qualified OZ business is in fact qualified and to document the results of their procedures. Many QOF sponsors have engaged public accounting firms that specialize in the OZs incentive to (i) advise on the QOF balance sheet and status of the joint ventures in which it invests before a testing date in order to identify potential problems in advance and (ii) to issue annual or semiannual reports documenting the entity’s compliance with OZ regulations.

Aside from ongoing compliance, there exist an array of challenges that real estate developers and investors face when forming QOFs and qualified OZ businesses and structuring deals. It is advisable for QOF sponsors and qualified OZ business developers to engage qualified professionals to ease the burden by assisting with the project structuring, reviewing and/or assisting with complex financial modeling and projections, reviewing and providing comments on various transaction documents, including QOF organization documents, and drafting term sheets and admission documents for contemplated qualified OZ business investments.

Conclusion

The OZ incentive is driving many investments into low-income communities but there are several potentially costly traps for a QOF that fails to meet compliance requirements. Planning from inception to use an expert third party to assist with understanding OZ rules and regulations and to provide various services demonstrates to a QOF’s investors (and potential investors) that the QOF intends to provide them with the highest level of service and due diligence possible.