Qualified Opportunity Funds- The IRS Throws a Life Preserver

Take-Away: The IRS earlier this year provided some relief to the highly technical qualification rules for an Opportunity Fund investment, or business, which is intended to encourage more investments in Opportunity Zones to fulfill Congress’ objectives to support distressed economic areas.

Background: Opportunity Zones and Qualified Opportunity Funds were created in the 2017 Tax Act. [IRC 1400Z.] They are intended to promote investment in economically distressed communities. Investors are encouraged to invest through three primary benefits.

• Gain Deferral: First, the investor can achieve a deferred capital gain on the disposition of their existing asset to an unrelated person, if that gain is reinvested in a qualified opportunity fund. The sale or exchange must take place with the reinvestment of the gain proceeds no later than the earlier of 180 days from the sale or exchange, or  December 31, 2026, aka the Day of Reckoning. This leads to a deferral of the gain possibly to December 31, 2026, but that requires the reinvestment of the gain within 180 days of the property’s original disposition.
• Deemed Basis Assigned: Second, some of that deferred gain can be washed away if held in an opportunity fund for a specified holding period. The investor starts out to defer the gain until the earlier of the subsequent disposition of the investment or the Day of Reckoning, as the outside date. The mechanism to preserve the gain for a later date is that the investor starts out with a zero basis in the opportunity fund investment. If the investment in the fund is held for 5 years, there is a 10% basis assigned to the investment; if held for 7 years, the basis assigned is another 5%, or a deemed basis of 15% total is assigned to the opportunity fund investment.
• Appreciation Avoids Taxation: Third, if the investment in the opportunity fund is held long-term, i.e. more than 10 years, all of the appreciation in that opportunity fund investment is not subject to tax- the appreciation completely escapes any tax.

IRS Regulations: The IRS initially came out with its Final Regulations with regard to qualified opportunity funds in December, 2019, just prior to the pandemic. The big eye-opener in those Final Regulations dealt with gifts of an opportunity zone investment. While the statute refers to the gain recognition when there is a ‘sale or exchange’ of an opportunity fund investment (prior to the Day of Reckoning) the Regulations added a ‘disposition’ of the opportunity fund investment as a trigger event to cause the deferred gain to be recognized. Consequently, a gift of the opportunity fund investment will cause immediate recognition of the deferred gain as a deemed disposition of the investment.

IRS Notices: Then the pandemic hit. The IRS responded with several Notices that are designed to provide some relief from many of the technical rules associated with a qualified opportunity fund investment, all of which are designed to continue to encourage investments in these funds at a time when investors were spooked with a crashing market or reluctant to make further investments in an uncertain economy. All three Notices, Notice 2020-23 (in April, 2020), and Notice 2020-39 (in June, 2020) and finally Notice 2021-10 (in January, 2021) are all intended to provide relief from the delays and disruption caused by the pandemic. It is the last IRS Notice issued in January of this year that is summarized below which provides relief in 5 categories, admittedly highly technical in nature but important for those who have invested in, or who are considering an investment in an opportunity fund business.

• 180-Day Rule Relaxed: The deferred gain must be invested within 180 days of its original recognition, as previously discussed. The Notice extended the 180-day reinvestment period if the gain was originally recognized between April 1, 2020 and March 31, 2021, to the last day of that period, i.e. March 31, 2021. This extension of the 180-day period to March 31, 2021 is automatic.
• 90% Test Relaxed: A condition that must be met to be treated as an opportunity fund investment is that 90% of the fund’s assets, after a specified period of time, must be invested directly in a qualified opportunity fund, or through a qualified opportunity zone business, i.e. a second-tier entity which the regulations permit. The Notice provides that a failure to reach that 90% threshold for the period between April 1, 2020 and June 30, 2021 will automatically be disregarded.
• 30-Month Improvement Period Relaxed: In order for the Opportunity Zone Fund statutory structure to work, an investor actually has to hold an investment in an economically distressed community, be it in the fund itself, or more commonly through a ‘drop-down’, second-tier entity of the qualified opportunity zone business. There are two principal ways to proceed in this regard: either (i) make an original acquisition of the asset; or (ii) acquire the property and at least double its tax basis over 30 months. The Notice provides that for the period that begins on April 1, 2020 and ends on March 31, 2021, the IRS will disregard that one-year period from entering into the determination of whether the 30-month substantial improvement requirement to double the tax basis has been met. In short, there is more time in which to double the tax basis of acquired property that is within an Opportunity Zone.
• Working Capital Safe-Harbor Relaxed: The general rule is that a qualified opportunity zone business can only have 5% of its assets invested in certain financial property. There is a statutory exception that provides that as long as the business has holdings in cash, cash equivalents, and debt instruments, and complies with certain requirements in the Regulations, the business can have an additional 31 months in which to basically deploy that capital in the business. Thus, it still gets to be treated as a qualified opportunity zone business, which in turn allows it to meet the 90% ‘test.’  The Notice gives the business an additional 24 months on top of the original 31  months, or potentially 62 months, in which to deploy working capital and stay within the statute’s working capital safe-harbor.
• Reinvestment Period Relaxed: Sometimes an interest in an qualified opportunity zone fund will be sold. Or, a qualified opportunity fund will sell its assets or its business. The statute allows the qualified opportunity zone fund 12 months in which to reinvest in another qualified opportunity fund and thus continue to defer gain recognition. That period is extended in the Notice by another 12 months, 24 months total, if the 12-month ‘clock started to tick’ on or before June 30, 2020.

Conclusion: It is unclear how many investors have taken advantage of qualified opportunity funds or invest in businesses owned by such funds. The tax benefits from those investments can be substantial. It is nice to see the IRS in its Notice 2021-10 take a lenient approach to enforce many of the conditions or ‘tests’ imposed by the statute that such a fund or business must meet. President Biden’s earlier announcements on tax ‘reform’ does not propose to abolish qualified opportunity funds, but his tax proposals would curtail some of the tax deferral benefits that currently exist under IRC 1400Z.