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. Fortunately, the Internal Revenue Service (IRS) has answered requests from opportunity zone stakeholders by issuing guidance providing relief. To help you understand the relief provisions and 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 IRS released Notice 2020-39, which extended the investment window to Dec. 31, 2020, for any 180-day deadline that otherwise would have ended between April 1 and December 30. This expands the original July 15 extension in Notice 2020-23.
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 at the end of 2020.
Unfortunately, this relief could have the following negative impacts on QOFs:
- QOFs that have more immediate needs for capital may find it challenging to raise capital before the end of the year since there won’t be any opportunity zone investors with expiring 180-day periods before Dec. 31, 2020. Additionally, potential investors can take full advantage of the extension to give themselves more time to better understand the impact of COVID-19.
- QOFs may experience capacity constraints late in the year both with their internal staff and their external advisors if there is a rush to close deals all at once to coincide with the extended investment deadline.
Extension of 30-month substantial improvement requirement
Property that doesn’t otherwise satisfy the original use test is treated as qualified opportunity zone business property (QOZBP) if it’s substantially improved within a 30-month period after acquisition. Notice 2020-39 allows a QOF or QOZB to disregard the period between April 1, 2020 and Dec. 31, 2020 when calculating the 30-month period.
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. All opportunity zones are in federally declared disaster areas effective Jan. 20, 2020, as confirmed by Notice 2020-39. However, it’s still unclear when an extension of less than 24 months will apply.
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. Notice 2020-39 allows this extension where the original reinvestment period included Jan. 20, 2020. However, it’s still unclear when an extension of less than 12 months will apply.
Reasonable cause exception: QOF penalty relief
Notice 2020-39 also automatically applies the statutory “reasonable cause exception” to prevent the imposition of QOF penalties for failing to meet the 90% investment standard during the period between April 1, 2020 and Dec. 31, 2020. This relief will benefit any QOF that would have failed the 90% investment standard due to consequences of the pandemic, including:
- 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.
The automatic nature of this relief is very important considering that QOFs would otherwise have been required to provide evidence of reasonable cause to the IRS to avoid penalties and that currently there’s no protocol to get penalty relief under the reasonable cause exception.
QOF relief: 90% investment standard
Notice 2020-39 also provides that any failure by a QOF to satisfy the 90% investment standard on a testing date that falls within the period beginning April 1, 2020 and ending Dec. 31, 2020, is disregarded for purposes of determining whether the QOF or any otherwise qualifying investments in the QOF satisfy the opportunity zone statutory and regulatory requirements for any taxable year of the QOF. However, it’s unclear if the Notice provides relief from the requirement that a partnership or corporation must qualify as a QOZB during substantially all (90%) of the QOF’s holding period. If not, 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 noncompliance is cured as soon as possible, rather than relying upon an interpretation that Notice 2020-39 provides relief from the QOZB holding period requirement.
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 will not 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.
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.
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 advisor. Questions? Give us a call. We can help.