COVID-19 Relief for Qualified Opportunity Funds: - GPW Certified Public Accountants

News Update

On June 4, 2020 the IRS released Notice 2020-39 providing relief for Qualified Opportunity Funds (QOFs) and their investors in response to the ongoing COVID-19 pandemic. This relief includes:

Extending the 180-day period in which a taxpayer can defer gains by investing such gains into a QOF through December 31, 2020 if the taxpayer’s 180^th day to invest in a QOF would have fallen on or after April 1, 2020 and before December 31, 2020.

GPW Observation: The extended investment period under Notice 2020-39 is significant, as it creates a tax planning opportunity for tax year 2019. A taxpayer who realized taxable gains in 2019 on assets held directly after October 4, 2019, or recognized capital gains through ownership of an interest in a pass-through entity (such as a partnership or S corporation) with a tax year ending December 31, 2019, will have until December 31, 2020 to invest in a QOF, thereby deferring those gains for the 2019 tax year.

Confirming a 24-month extension of the period in which businesses financed by QOFs have to meet the requirements of the 31-month working capital safe harbor.
Confirming a 12-month extension to reinvest proceeds from opportunity fund sales for purposes of satisfying the 90% investment test.
Relief from penalties under IRC Sec. 1400Z-2(F) for failure to hold less than 90% of its assets in a Qualified Opportunity Zone due to reasonable cause on any semi-annual testing dates from April 1, 2020 through December 31, 2020.

GPW Observation: This means a QOF with a calendar taxable year will not need to satisfy the 90% investment test until June 30, 2021.

Allowing the period of April 1, 2020 through December 31, 2020 to be suspended for purposes of the 30-month substantial improvement test, thereby providing an extension of time to meet this test.

For more guidance regarding relief related to Qualified Opportunity Funds, see the IRS frequently asked questions.

Overview of Qualified Opportunity Funds and Their Advantages:

Note the general information below outlines the normal Qualified Opportunity Fund rules. Keep in mind the relief and extensions as stated above for any time window or date range deadlines.

The 2017 Tax Cuts and Jobs Act (TCJA) added two new provisions designed to encourage investment and economic growth in certain low-income communities. IRC Sec. 1400Z-1 designated certain communities as Qualified Opportunity Zones (QOZ) and IRC Sec. 1400Z-2 provided significant tax incentives to taxpayers (which includes individuals, C-corporations, S-corporations, partnerships, trusts and estates) for investments in businesses located in such QOZ areas.

These incentives include:

Temporary deferral of capital gain recognition from the sale or exchange of property to the extent the gains are reinvested into a QOF.
Partial permanent exclusion up to 15% of previously deferred gains when certain holding period requirements in a QOF are met.
Permanent exclusion of post-acquisition gains from the sale of an investment in a QOF if held longer than ten years.

Two other advantages of deferring gain by investing in a Qualified Opportunity Fund over other deferral options like the IRC. Sec. 1031 exchange include:

When deferring gains by investing in a QOF, taxpayers can still receive cash without recognizing any gain, whereas, in an IRC. Sec. 1031 exchange, the taxpayer must recognize gain to the extent boot is received.
Pass-through entities have the choice when disposing of property as to whether they want to defer the gain at the entity level by investing in a QOF or pass the gain out to the owners, thereby giving each owner the option to directly reinvest his or her share of gain into a QOF. No such similar option is available in an IRC. Sec. 1031 transaction.

Intention Behind the Provisions:

The intent of these incentives is to improve the lives of those living in the opportunity zones by either increasing businesses that create jobs, providing additional options to the residents in those areas, or improving the area’s housing options through development. To ensure these provisions would benefit the designated QOZ an anti-abuse provision was put in place via Treas. Reg. 1.1400Z2(f)-1.

What is a Qualified Opportunity Fund?

Qualified Opportunity Funds can be any investment vehicle which is organized as a corporation or partnership for the purpose of investing in Qualified Opportunity Zone Property (QOZP), which is determined by the average of the percentage of QOZP held in the fund as measured:

on the last day of the first 6-month period of the taxable year of the fund, and
on the last day of the taxable year of the fund.

Qualified Opportunity Zone Property (QOZP) can include:

Qualified opportunity zone stock,
Qualified opportunity zone partnership interest, or
Qualified opportunity zone business property. I.e. Tangible property used in a trade or business of the QOF if:
- Such property was acquired by the QOF after December 31, 2017
- The original use of such property in the QOZ commences with the QOF, or the QOF substantially improves the property. (Substantial improvement being that during the 30-month period beginning after the date of acquisition of such property, additions to basis with respect to such property in the hands of the QOF exceed an amount equal to the adjusted basis of such property at the beginning of such 30-month period in the hands of the QOF.
- During substantially all of the QOF’s holding period for such property, substantially all of the use of such property was in a qualified zone.

Basic Steps to Investing in a Qualified Opportunity Fund (QOF)

The taxpayer has eligible gain (either capital gains or qualified 1231 gains) from a sale or exchange of property to an unrelated third party, which would be recognized for income tax purposes prior to January 1, 2027.
The taxpayer re-invests the gain amount within 180 days (from the date of the transaction that gave rise to the eligible gain) into a QOF, which enables the gain to be deferred until the year of sale of the QOF investment or December 31, 2026 (whichever is earlier).
The QOF either holds Qualified Opportunity Zone Business Property (QOZBP) directly, or indirectly by holding QOZ stock or a QOZ partnership interest.
Depending on the length of time the taxpayer holds the interest in the QOF before selling, varying amounts of the original deferred gain can be permanently excluded.
If the taxpayer holds the interest in the QOF for at least five years before selling, the taxpayer can exclude 10% of the original deferred gain.
If the taxpayer holds the interest in the QOF for at least seven years before selling, the taxpayer can exclude 15% of the original deferred gain.
Any remaining deferred gain is to be recognized on December 31, 2026 unless an ‘inclusion event’ has occurred prior to that date.
The gain from any post-investment appreciation in the QOF is permanently excluded from income if the investment is held for at least 10 years.
When the previously deferred gain is included in income, the gain will have the same attributes in the year of inclusion that it would have had if it had not been deferred.
The taxpayer has eligible gain (either capital gains or qualified 1231 gains) from a sale or exchange of property to an unrelated third party, which would be recognized for income tax purposes prior to January 1, 2027.
The taxpayer re-invests the gain amount within 180 days (from the date of the transaction that gave rise to the eligible gain) into a QOF, which enables the gain to be deferred until the year of sale of the QOF investment or December 31, 2026 (whichever is earlier).
The QOF either holds Qualified Opportunity Zone Business Property (QOZBP) directly, or indirectly by holding QOZ stock or a QOZ partnership interest.
Depending on the length of time the taxpayer holds the interest in the QOF before selling, varying amounts of the original deferred gain can be permanently excluded.
If the taxpayer holds the interest in the QOF for at least five years before selling, the taxpayer can exclude 10% of the original deferred gain.
If the taxpayer holds the interest in the QOF for at least seven years before selling, the taxpayer can exclude 15% of the original deferred gain.
Any remaining deferred gain is to be recognized on December 31, 2026 unless an ‘inclusion event’ has occurred prior to that date.
The gain from any post-investment appreciation in the QOF is permanently excluded from income if the investment is held for at least 10 years.
When the previously deferred gain is included in income, the gain will have the same attributes in the year of inclusion that it would have had if it had not been deferred.

Inclusion Events:

Deferred gain must be recognized on a dollar for dollar basis in the year a taxpayer:

Decreases their direct equity investment in a QOF, or
Receives a distribution in excess of the taxpayer’s basis in the QOF.

Additional Tests to Qualify as a QOF:

To meet the requirements to benefit from the QOF provisions, there are various other tests that must be met that depend on the type of QOF investment. For example:

A QOF that operates a business directly is required to hold 90% of its assets as Qualified Opportunity Zone Business Property.
A QOF that operates a business through a subsidiary is required to hold 70% of its assets as Qualified Opportunity Zone Business Property.
For property to qualify as Qualified Opportunity Zone Business Property, the property must satisfy the ‘Original Use Test’ or be ‘substantially improved’.
- Original Use Test
  - Is met when property is placed in service in a QOZ that has never previously been placed in service and depreciated in a QOZ.
  - Is met when property is placed in service that had sat vacant for three years after being designated as being in a QOZ or property sat vacant at least one year prior to the date designated as being in a QOZ and such property remained vacant through the date of the purchase.
  - Is met if a QOF constructs its own property to be used in a trade or business of the QOF and the construction began after December 31, 2017.
  - Substantial Improvement Test
    - Is met if during the 30-month period beginning after the date of acquisition of the property, the additions to the basis of the property exceed an amount equal to the adjusted basis at the start of the 30-month period.
- For each tax year, A Qualified Opportunity Zone Business must satisfy all of the following three tests:
  - 50% of Income Test
    - For each tax year, at least 50% of gross income must be derived from the active conduct of a trade or business in the QOZ. The QOZB can meet this test by satisfying any one of the safe harbors below:
      - At least 50% of the hours spent by employees and independent contractors are within a QOZ.
      - At least 50% of the amount paid by a business to employees and independent contractors are for services performed within a QOZ.
      - At least 50% of gross income is generated from tangible property and the performance of management and operational functions located in a QOZ.
  - The Intangible Test
    - A substantial portion of the intangible property must be used in the active conduct of a trade or business in a QOZ.
  - 5% of Assets Test
    - Less than 5% of the aggregate unadjusted basis of the property of the business may be attributable to nonqualified financial property. Nonqualified financial property includes debt, stock, partnership interest, options, futures contracts, forward contracts, warrants, notional principal contracts, annuities, and other similar property. There is a safe harbor to meet the 5% asset test:
      - Working capital assets are not treated as nonqualified financial property, if the amounts are designated in writing to be for the acquisition, construction, or substantial improvement of tangible property in a QOZ.
      - There must be a written schedule for the expenditure of the working capital assets within 31 months of the business’ receipt of the assets. (For qualifying start-up businesses, this can be extended up to 62 months).
      - And the working capital must be used in a manner that is substantially consistent with the written plan.
- A Qualified Opportunity Zone Business may not be a ‘sin business’ as described in IRC. Sec. 144(c)(6)(B), which includes:
  - Any golf course,
  - Country Club.
  - Massage parlor,
  - Hot tub facility,
  - Suntan facility,
  - Racetrack, or other facility used for gambling, or
  - Any store for which the principal business is to sell alcoholic beverages for consumption off premises.

Special Rules for Partnerships and S-Corporations:

If a pass-through entity satisfies the requirements as indicated below, then all of the assets of the entity are considered to be QOZP.

Stock in a corporation is treated as QOZP if:

It was acquired by a QOF after December 31, 2017 directly from the corporation or through an underwriter for cash,
At the time the stock was issued, the corporation was a Qualified Opportunity Zone Business, or was organized for the purpose of being a Qualified Opportunity Zone Business, if the corporation is new, and
During 90% of the QOF’s holding period of the stock, the corporation is a Qualified Opportunity Zone Business.

An interest in a partnership is treated as a QOZP if:

If was acquired by a QOF after December 31, 2017 directly from the partnership for cash,
At the time the partnership interest was issued, the partnership was a Qualified Opportunity Zone Business, or was organized for the purpose of being a Qualified Opportunity Zone Business, if the partnership is new, and
During 90% of the QOF’s holding period of the partnership interest, the partnership is a Qualified Opportunity Zone Business.

If a pass-through entity has eligible gain, it can choose to defer that gain at the entity level, or pass the gain down to its owners, who can choose whether or not to defer the gain by investing gains into a QOF directly.

If the choice is made to defer the gain at the entity level, the deferred gain is not included in the owners’ distributive share of income and does not increase their basis. When the deferred gain is subsequently recognized at the entity level, it will then be included in the owners’ distributive share of income and added to basis.

If an entity chooses to pass the gain down to its owners, and those owners then choose to defer that gain, the owners have a choice on when the 180-day period begins. They can choose to start the 180-day investment period on any of the following dates:

The same date the pass-through entity’s 180-day period would have begun, if applied at the entity level.
The last day of the pass-through entity’s taxable year.
The due date for the pass-through entity’s tax return for the taxable year in which the entity realized the eligible gain, not including extensions.

State conformity:

California does not conform to the Federal QOZ tax provisions.

Map of Qualified Opportunity Zones