The COVID-19 pandemic has impacted all facets of the economy, and opportunity zones (OZs) are no exception. The uncertainty weighs on qualified opportunity funds (QOFs), qualified opportunity zone businesses (QOZBs), and investors alike. To help you mitigate the impact of COVID-19, we offer the following considerations.
The turbulent economic environment may make it difficult for investors to find good OZ investments within the required 180-day investment window. To aid investors in making a timely investment in a QOF, the Internal Revenue Service (IRS) released Notice 2020-23, which extended the investment window to July 15, 2020, for any 180-day deadline that otherwise would have ended between April 1 and July 15.
QOFs should be aware of the potential to parlay the extension of the 180-day investment deadline into an extension of their deadline to invest in qualified opportunity zone property (QOZP). In particular, QOFs can effectively grant themselves an extra six months to invest in QOZP by delaying receipt of capital contributions into July 2020. For example, a QOF that receives an investment in June 2020 will be required to invest those funds into QOZP by Dec. 31, 2020. However, if that QOF can delay receipt of that investment into July 2020, it will have until June 30, 2021, to invest the funds into QOZP.
Also, since many investors sold stock in reaction to the COVID-19 pandemic, QOFs that are actively raising capital should prepare to accommodate a potential influx of investments from investors whose 180-day period will expire in late summer or early fall.
QOZB relief: 31-month working capital safe harbor
A QOZB can generally hold working capital if they follow a written plan to expend the funds within 31 months. Significant delays as a result of shelter-in-place requirements could put a QOZB in jeopardy of falling outside of the 31-month working capital safe harbor. The final OZ regulations provide an automatic extension of the 31-month period of not more than 24 months if the QOZB is in a federally declared disaster area. In response to the COVID-19 pandemic, all 50 states have been declared federal disaster areas.
QOFs that are actively raising capital should prepare to accommodate a potential influx of investments from investors.
The regulations also allow a QOZB to pause its 31-month window if the project is delayed awaiting government approval. As government entities limit services, be sure to properly document project delays caused by timing of government approvals.
QOF relief: 12-month reinvestment period
A QOF has 12 months to reinvest proceeds from the sale of property or a return of capital without impacting the 90% investment standard. The regulations allow not more than an additional 12 months if the reinvestment is delayed due to a federally declared disaster, provided the QOF invests the proceeds in the manner originally intended before the disaster.
Reasonable cause exception: QOF penalty relief
Absent additional relief, the “reasonable cause exception” in the statute is the best potential for relief from QOF penalties for failing to meet the 90% investment standard due to the economic fallout from COVID-19. While “reasonable cause” is undefined, the unprecedented nature of the pandemic may provide QOFs with a basis to claim this exception, particularly in the following situations:
- QOFs unable to complete due diligence due to shelter in place restrictions.
- QOFs invested in QOZBs that fail the 70% tangible property standard because of construction delays.
- QOFs invested in QOZBs that fail the 50% gross income test or 40% intangible property test because shelter-in-place restrictions significantly reduce work inside OZs and/or cause employees to work remotely outside of OZs.
Currently, there’s no protocol to get penalty relief under the reasonable cause exception. Consequently, it’s imperative that QOFs maintain contemporaneous records to fully document the nature and extent of any delays and the cause-and-effect relationship between unexpected circumstances and the failure to satisfy the 90% investment standard. This may include tracking specifics like shipping delays of construction supplies and materials, timelines for shelter-in-place or lockdown orders, or dates when employees were required to work remotely outside of an OZ.
Don’t forget that extended noncompliance by a QOZB without a timely cure can cause a QOF to fail the QOZB 90% holding period test.
Don’t forget that extended noncompliance by a QOZB without a timely cure can cause a QOF to fail the QOZB 90% holding period test. Consequently, QOFs should attempt to ensure QOZB compliance is cured as soon as possible, rather than relying upon a potential penalty waiver.
Qualified improvement property (QIP) correction
The CARES Act corrected the depreciable life of QIP from 39 years to 15 years, thereby making it bonus-eligible. QIP acquired and placed in service between Sept. 27, 2017 and Dec. 31, 2022, is eligible for 100% bonus depreciation. Thereafter, bonus depreciation is phased out through 2026. If the QOZB becomes an electing real property trade or business to prevent limitation of its interest deductions, it won’t be allowed to claim bonus depreciation on QIP. However, reducing the depreciable life of QIP (to 20 years for taxpayers making the real property election) will still provide significant tax benefits for QOF investors.
However, reducing the depreciable life of QIP (to 20 years for taxpayers making the real property election) will still provide significant tax benefits for QOF investors.
This change can significantly increase the after-tax rate of return for QOF investments, since depreciation isn’t recaptured upon a sale that satisfies the 10-year holding period. To the extent deductions can be accelerated without being subject to recapture, this correction can create a permanent tax benefit for investors in commercial and mixed-use buildings in OZs considering that many interior improvements to nonresidential buildings fall under the definition of QIP.
Possible future OZ relief
While there’s no guarantee, there is potential for further OZ-specific relief. Although relief is contingent upon subsequent action by Congress, Treasury, or the IRS, we’re closely monitoring the status of the following relief requests that have been supported by OZ stakeholders like EIG’s Opportunity Zone Coalition and Senator Tim Scott:
- Extend the 30-month substantial improvement period.
- Automatically apply the reasonable cause exception to QOF penalties under certain predetermined circumstances.
- Broaden the 180-day investment period extension.
- Provide relief from the 50% gross income safe harbor and the 40% intangible property test for QOZBs with employees teleworking or furloughed due to COVID-19.
- Increase the number and/or length of regulatory six-month cure periods.
The impact of the pandemic on OZs will be significant, but remember that knowledge is power. Negative effects can be mitigated through proactive planning with your tax adviser. Questions? Give us a call. We can help.