Value of Third-Party Assistance in Opportunity Zones Compliance

Published by Jason Watkins on Tuesday, August 3, 2021
Journal Cover Thumb August 2021

The opportunity zones (OZ) incentive that became law in late 2017 as a part of tax reform (H.R. 1) has generated a tremendous amount of investment into low-income communities, particularly since the final regulations were issued in late 2019. In addition to resolving most of the uncertainties stakeholders had around the OZ incentive, the final regulations also detailed a number of the tests that qualified opportunity funds (QOFs) and qualified OZ businesses must pass to
maintain compliance.

Engaging with a third-party to provide semiannual compliance reporting is a step that many QOFs undertake. This enables QOFs to identify potential compliance problems before they result in costly penalties or an impact to their investors’ capital gain deferrals.

QOFs are required to meet a 90% assets test whereby a QOF must hold a minimum of 90% of its assets as qualified OZ property measured on specifed testing dates.

The test is calculated as of the end of the first six-month period of the QOF’s tax year (if applicable) and on the last day of the QOF’s tax year and the results are reported on IRS Form 8996, which is 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 average is less than 90%, the QOF will be subject to a penalty for each month it failed to meet the 90% test. 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. For both the first and second quarters of 2021, the underpayment penalty rate was 3%.

Additionally, most QOFs invest in qualifying property indirectly through a qualified OZ business and a qualified OZ business has its own set of requirements that it must meet so it can qualify as an eligible investment for a QOF. A qualified OZ business is tested annually, and the initial years are of vital importance as one bad year can be lethal under the 90% holding period test (discussed later).

Qualified OZ businesses are required to meet myriad complex tests including:

  • 70% owned/leased tangible property tests,
  • Original use/substantial improvement analysis,
  • 50% gross income test,
  • Active trade or business test,
  • 40% intangible property test,
  • 5% nonqualified financial property test, and
  • Excluded business test.

Fortunately, there are safe-harbors available in the regulations to help start-up businesses to meet these requirements.

Additionally, a QOF is subject to a 90% holding period test and the regulations interpret this to mean that this test is applied cumulatively.  This means that the failure of a business to qualify in the early years could be lethal for a QOF owner because the investment would not be qualified until the QOF could meet the test on a cumulative basis.  A failure in year one, means the earliest the investment could qualify would be year 10 to achieve 90% on a cumulative basis.

Luckily, a qualified OZ business that fails to meet the requirements is eligible for a one-time cure period, whereby a QOF that relies on its investment in the qualified OZ business to pass the QOF’s 90% test can still treat its investment into the qualified OZ business as qualified, provided the qualified OZ business meets the requirements on its next semiannual testing date. Since only a single cure period is possible per QOF investment, this further illustrates the importance of engaging a third party to perform a midyear test to red-flag any potential issues with the QOF and/or qualified OZ business meeting their respective requirements.

Penalties for failing to meet the 90% test can be quite costly, with monetary penalties in the short term and potentially, more severe long-term consequences. While a 3% penalty does not sound particularly punitive, the monthly assessments can quickly add up. Keep in mind that if a QOF intends to pass the 90% test through an indirect investment into a qualified OZ business, that qualified OZ business failing to meet the qualified OZ business requirements means that the QOF will likely fail the test at close to 0%, meaning that its shortfall for the 90% test would approach 90% of its total assets. For example, a QOF with $10 million of assets needs to hold at least $9 million in qualified property. If the qualified OZ business fails to meet the requirements, the QOF will own 0% qualified OZ property and will be subject to a monthly penalty of $22,500 ($9 million x 3% ÷ 12). Failure for an entire year would result in a penalty of $270,000.

Given the complexity of the requirements and the possibility for severe penalties, it is advisable for QOFs to annually 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 QOFs engage public accounting firms that specialize in the opportunity zones incentive to perform these procedures annually and document the results of their procedures in an agreed-upon procedures report. The agreed-upon procedure reports are maintained by the QOFs to support compliance in the event of an IRS audit.


The OZ incentive is driving a great deal of investment into low-income communities but there are a number of potentially costly traps for an unwary 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 regular OZ compliance reporting 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.