On June 4, 2020, the Internal Revenue Service published Notice 2020-39 (Notice) which provides relief to qualified opportunity funds (QOFs) and their investors in light of the COVID-19 pandemic. Here is a summary, and more details follow below:
- Investors who otherwise would be required to reinvest capital gains into a QOF any time this year on or after April 1 now have until December 31, 2020 to reinvest such gains.
- A QOF’s failure to hold at least 90% of its assets in “QOZ property” on any semi-annual testing date from April 1, 2020 through December 31, 2020 will not cause the entity to fail to qualify as a QOF.
- Qualified Opportunity Zone Businesses taking advantage of the working capital safe harbor can add an additional 24 months to their working capital safe harbor period.
- The period between April 1, 2020 and December 31, 2020 is disregarded for purposes of the 30-month “substantial improvement” period.
- QOFs that received proceeds from the disposition of QOZ property have up to 12 additional months to reinvest those proceeds in QOZ property.
I. Overview of Opportunity Zones.
Congress created opportunity zones in 2017 to encourage investments in economically distressed communities. The Opportunity Zone program provides taxpayers the opportunity to defer gain on the sale or exchange of an asset if the gain is reinvested in a Qualified Opportunity Zone Fund (a “QOF”) within 180 days. Note that the entire proceeds from an asset sale need not be invested in a QOF; rather, only the portion of the proceeds that represent gain must be invested in a QOF. The gain is deferred until the sooner of (i) the date the taxpayer sells its investment in the QOF or (ii) December 31, 2026. If the taxpayer invests in the QOF in 2020 or 2021, the amount of gain that will ultimately be recognized is reduced by 10%.
Additionally, if the taxpayer holds its QOF interest for 10 years, the taxpayer will recognize no taxable gain when they sell that investment. In order to be a QOF, an entity must be organized for the purpose of investing in QOZ Property and 90% or more of its total assets must be QOZ Property. QOZ Property includes both new and substantially improved tangible property, including commercial real estate (e.g., offices buildings, apartment complexes, etc.) and equipment located in qualified opportunity zones. These investments can be direct or through subsidiary corporations or partnerships that operate businesses in qualified opportunity zones. Each U.S. state has its own qualified opportunity zones.
II. Relief regarding 180-day investment requirement for QOF investors.
If a taxpayer has gain from the sale or exchange of property with an unrelated person, the taxpayer can elect to exclude from gross income the amount of such gain that the taxpayer invests in a QOF during the 180-day period following the date of such sale or exchange (“180-day investment requirement”).
The Notice states that if a taxpayer’s 180th day to invest in a QOF falls on or after April 1, 2020, and before December 31, 2020, the taxpayer now has until December 31, 2020 to invest the gain in a QOF.
III. Relief regarding 90% investment standard for QOFs.
For an investment vehicle to qualify as a QOF, it must be corporation or a partnership organized for the purpose of investing in QOZ property (other than another QOF). The QOF must satisfy the 90% investment standard, meaning it must hold at least 90% of its assets in QOZ property, determined by the average of the percentage of QOZ property held by the QOF measured semi-annually on (i) on the last day of the first 6-month period of the QOF’s tax year (June 30 for calendar year taxpayers), and (ii) on the last day of the QOF’s tax year.
If the average of the percentages of the QOZ property held by a QOF on the semi-annual testing dates fails to meet the 90% investment standard, the QOF must pay a penalty for each month that the QOF fails to meet the standard. However, no such penalty is imposed “with respect to any failure if it is shown that such failure is due to reasonable cause.”
The Notice provides relief by stating that, in the case of a QOF whose (i) last day of the first 6-month period of the tax year or (ii) last day of the tax year falls within the period beginning on April 1, 2020, and ending on December 31, 2020, any failure by that QOF to satisfy the 90% investment standard for that tax year is disregarded for purposes of determining whether the QOF meets the 90% investment standard rules. This prevents QOFs from being held liable for the statutory penalty.
IV. Relief regarding working capital safe harbor for QOZ businesses.
An entity must meet certain requirements to be a “QOZ business,” including the requirement that less than 5% of the average of the aggregate unadjusted bases of the entity’s property be attributable to “nonqualified financial property” (as defined in the Internal Revenue Code — essentially cash and cash equivalents). However, if the QOF satisfies the “working capital safe harbor”, the QOF may hold an unlimited percentage of its assets in cash and short-term instruments.
One of the safe harbor requirements is that the business keep a written schedule consistent with the ordinary start-up of a trade or business for the expenditure of the working capital assets within 31 months of the receipt by the business of the assets. A QOZ business can extend the working capital safe harbor period to a maximum of 62 months. If a QOZ business is located in a QOZ within a presidentially declared disaster area, then the QOZ business may receive an additional 24 months to expend its working capital assets.
The Notice provides relief by stating that, as a result of the emergency declaration by President Trump on March 13, 2020 regarding COVID-19, all QOZ businesses covered by the working capital safe harbor before December 31, 2020 now will receive up to 24 additional months to expend the working capital assets of the QOZ business (i.e., the QOZ business now has up to 86 months to expend working capital).
V. Relief regarding 30-month substantial improvement period for QOFs.
QOZ Property includes tangible property acquired after 2017 if (i) the entity puts the property to its original use in the QOZ (“original use requirement”), or (ii) the property is substantially improved (“substantial improvement requirement”).
The substantial improvement requirement is met only if, during any 30-month period beginning after the date of acquisition, there are “additions to basis with respect to such property” that, in the aggregate, exceed the adjusted basis of that property as of the beginning of that 30-month period (“30-month substantial improvement period”).
The Notice provides relief by stating that, for purposes of the substantial improvement requirement, the period beginning on April 1, 2020 and ending on December 31, 2020 is disregarded in determining any 30-month substantial improvement period.
VI. Relief regarding 12-month reinvestment period for QOFs.
If a QOF sells or disposes of some or all of its QOZ property or if a distribution with respect to the QOF’s QOZ stock is treated as a return of capital, and if the QOF reinvests some or all of the proceeds in QOZ property by the last day of the 12-month period beginning on the date of the distribution, sale, or disposition, then the reinvested proceeds are treated as QOZ property for purposes of the 90% investment standard.
To qualify for such treatment, the QOF needs to hold such proceeds continuously in cash, cash equivalents, or debt instruments with a term of 18 months or less. If the QOF’s plan to reinvest some or all of such proceeds in QOZ property is delayed due to a presidentially declared disaster, then the QOF may receive up to an additional 12 months to reinvest the proceeds, provided that the QOF invests the proceeds in the manner originally intended before the disaster.
The Notice provides relief by stating that if any QOF’s 12-month reinvestment period includes January 20, 2020, then that QOF receives up to an additional 12 months to reinvest the proceeds in QOZ property.