On Thursday, June 4, the Internal Revenue Service (IRS) released Notice 2020-39 (the OZ Relief Notice), which provides certain forms of relief for opportunity zone (OZ) investors, qualified opportunity funds (QOFs), and qualified opportunity zone businesses (QOZBs) affected by COVID-19. The OZ Relief Notice provides five forms of relief related to the OZ tax incentive with respect to (i) extending the deadline for investors to invest in a QOF, (ii) providing penalty relief to QOFs, (iii) temporarily tolling the substantial improvement period for a QOF or QOZB, and (iv) clarifying applicability of extensions due to the federally declared disaster with respect to (A) the period to satisfy the working capital safe harbor applicable to QOZBs and (B) the 12-month reinvestment period applicable to QOFs, each as discussed in more detail below.
Extension of Time to Invest in a QOF
The OZ tax incentive, enacted in late 2017, generally permits any person that would otherwise be required to report capital gains (individuals, corporations, REITs, trusts, tax-exempt entities, partnerships, etc.) to invest those gains in QOFs within a 180-day period and make an election on their tax return in order to defer the payment of tax on those capital gains (to the extent invested in a QOF) until as late as the end of 2026. Additional benefits are also available pursuant to the OZ tax incentive, including potential partial forgiveness of the tax on the original capital gain and exclusion of future capital gains, provided certain requirements are satisfied.
Previously, the IRS issued Notice 2020-23 (the Extension Notice), which, among other extensions, extended the 180-day period for certain taxpayers with eligible capital gains to invest some or all of those gains in a QOF in order to be able to elect benefits under the OZ tax incentive. The Extension Notice, issued Friday, April 10, 2020, specifically stated that if the deadline to invest in a QOF fell between April 1, 2020 and July 14, 2020, such deadline was extended to July 15, 2020.
Pursuant to the new OZ Relief Notice, if the deadline for a taxpayer’s 180-day investment period would be on or between April 1, 2020 and December 30, 2020, the deadline is automatically extended to December 31, 2020, and no correspondence, filing, or other communication with the IRS is required to receive this relief. This means that if the event triggering capital gains occurred (or occurs) on any date on or between October 5, 2019 and July 4, 2020, the deadline to invest in a QOF is extended to December 31, 2020. For example, under the general OZ rules, if Individual B sold publicly-traded stock on November 1, 2019 for a gain of $2 million, Individual B would have had until April 28, 2020 to make an investment in a QOF in order to be able to elect OZ benefits. However, pursuant to the OZ Relief Notice, Individual B now has until December 31 (an additional 247 days, in this example) to make an investment in a QOF in order to be able to elect OZ benefits. Please note that in certain circumstances, the 180-day time period might not begin on the date of the capital gain-generating event (e.g., for certain partners in partnerships that recognize gain and do not elect OZ benefits at the partnership level).
Although the extension of the deadline to invest in a QOF is automatic, a taxpayer will still need to (i) make a valid OZ election in accordance with the instructions to Form 8949 (Sales and other Dispositions of Capital Assets), (ii) complete Form 8997 (Initial and Annual Statement of Qualified Opportunity Fund (QOF) Investments), and (iii) file such completed forms with a timely filed (including extensions) federal income tax return or amended federal income tax return for the year in which the gain would be recognized if the OZ tax incentive did not apply.
90% Investment Standard for QOFs
A QOF is required to hold at least 90% of all of its assets in qualified opportunity zone property (QOZP). Satisfaction of this investment standard requirement is determined by averaging the value of a QOF’s assets at two points in the applicable tax year: the end of the first six months of the tax year and the end of the tax year. If the average of the two semiannual testing dates is less than 90%, the QOF is assessed a penalty for each month that it fails to meet the 90% investment standard. Such penalty is eliminated if failing the 90% investment standard is due to reasonable cause.
The OZ Relief Notice provides that if either semiannual testing date of a QOF falls on or between April 1, 2020 and December 31, 2020 (the penalty relief period), and such QOF fails the 90% investment standard for the taxable year, such failure is deemed to be due to reasonable cause and is disregarded for purposes of determining whether such QOF or any investment in such QOF satisfies the OZ tax incentive requirements under the Internal Revenue Code and Treasury Regulations.
This relief generally will be available for: (i) an entity electing to be a QOF for the first time in 2020, with a tax year equal to the calendar year; (ii) an entity electing to be a QOF for the first time in 2020 and formed prior to August 2020, with a tax year other than the calendar year; or (iii) an entity that elected to be a QOF prior to 2020 and has a tax year that begins on or after May 1, 2019 through and including July 1, 2020. For example, if a QOF has a tax year that begins on May 1, for the tax year beginning on May 1, 2019, its year-end testing date (April 30, 2020) falls within the penalty relief period. Additionally, for a QOF that has a tax year that begins on July 1, for the tax year beginning on July 1, 2020, its six-month testing date (December 31, 2020) falls within the penalty relief period. However, a QOF with a fiscal year beginning either (A) April 1, 2019 or earlier, or (B) August 1, 2020 or later, will not have any relief under the OZ Relief Notice for such earlier or later years, because a tax year beginning on April 1, 2019 would be tested on September 30, 2019 and March 31, 2020 (too early for the relief), while a tax year beginning on August 1, 2020 would be tested on January 31, 2021 and July 31, 2021 (too late for the relief).
The penalty relief provided by the OZ Relief Notice is automatic, and no correspondence, filing, or other contact with the IRS is required to receive the relief, but a QOF must accurately complete all of Form 8996 (Qualified Opportunity Fund), except Line 8 in Part IV regarding the penalty should be “0.” Such Form 8996 then must be filed with the QOF’s timely filed (including extensions) federal income tax return for the affected tax years.
30-Month Substantial Improvement Period
Tangible property held by a QOF or QOZB must be qualified opportunity zone business property (QOZBP) in order for such entity to meet either the 90% investment standard (discussed above) for a QOF or a 70% tangible property standard for a QOZB. Tangible property is treated as QOZBP if it is used in a trade or business and satisfies three basic requirements, including that either (i) the original use of the tangible property acquired after 2017 in the OZ must begin with the QOF or QOZB, as applicable, or (ii) the QOF or QOZB, as applicable, substantially improves the property. In order to satisfy the substantial improvement requirement, the QOF or QOZB, as applicable, must improve the tangible property such that it more than doubles its basis in such property within any 30-month period when compared with the start of the 30-month period.
The OZ Relief Notice provides that the period beginning on April 1, 2020 and ending on December 31, 2020 is disregarded for purposes of determining any 30-month substantial improvement period with respect to property held by a QOF or QOZB. In other words, the 30-month substantial improvement period is tolled for the last nine months of 2020. For example, if a QOZB started its 30-month substantial improvement period on December 1, 2019 and had a basis of $1 million in the tangible property, then under the normal operation of the rules, the QOZB would have to make improvements to the property that resulted in the QOZB having a basis in excess of $2 million no later than May 31, 2022. However, the OZ Relief Notice does not count April through December 2020, so the QOZB in this example would have until the end of February 2023 to satisfy the substantial improvement rule. Effectively, QOZBs and QOFs subject to the substantial improvement rule get up to an extra nine months to make sufficient improvements.
Working Capital Safe Harbor for QOZBs
If a QOF makes an equity investment in a partnership or corporation, such entity must be a QOZB in order for the QOF’s investment in such entity to be used to satisfy the 90% investment standard discussed above. In order to be a QOZB, an entity must meet several requirements, including that less than 5% of its property be attributable to nonqualified financial property (NQFP), such as cash, equity investments, certain options and contracts, and other financial property. However, “reasonable working capital” is excluded from the definition of NQFP, provided it is held in cash, cash equivalents, or certain short-term debt instruments. The regulations governing the OZ tax incentive provide for a safe harbor to treat working capital as reasonable, if certain requirements are met, including that there is a reasonable written schedule consistent with the ordinary startup of a trade or business for the expenditure of the working capital assets within 31 months of the date the entity receives the assets. Under certain additional circumstances, the 31-month period may be extended to 62 months, and if the QOZB is located in a federally declared disaster, it may receive no more than 24 additional months to expend the working capital assets under the safe harbor, provided the QOZB meets the other requirement of the safe harbor. Therefore, a QOZB may have as much as 86 months to expend working capital if all safe harbor requirements are met and the business is located in an OZ in a federally declared disaster.
On March 13, 2020, the President issued an emergency declaration in response to the COVID-19 pandemic. As a result of that emergency declaration, the OZ Relief Notice clarifies that all QOZBs holding working capital assets under the safe harbor before December 31, 2020, receive not more than 24 additional months to expend such working capital assets, provided that the QOZB meets all the other requirements of the working capital safe harbor. In other words, the COVID-19 pandemic meets the requirement to trigger the availability of the additional period for federally declared disasters for purposes of the working capital safe harbor through the end of this year.
12-Month Reinvestment Period for QOFs
The regulations governing the OZ tax incentive provide that if a QOF sells or disposes of some or all of its QOZP or receives a distribution with respect to qualifying stock owned by the QOF that constitutes a return of capital, the QOF has a 12-month period from the date of such sale, disposition, or distribution to reinvest the proceeds it receives. If the proceeds are continuously held in cash, cash equivalents, or certain short-term debt instruments, then during the period between receipt of the proceeds and reinvestment during the 12-month period, the proceeds will be treated as QOZP for purposes of the 90% investment standard, discussed above. However, if a QOF’s plan to reinvest some or all of such proceeds is delayed due to a federally declared disaster, the QOF may receive no more than an additional 12 months to reinvest, provided that the QOF invests the proceeds in the manner originally intended prior to the disaster.
The OZ Relief Notice states that if any QOF’s 12-month reinvestment period includes January 20, 2020, that QOF receives up to an additional 12 months to reinvest in QOZP the proceeds from a sale, disposition, or return of capital, provided that the QOF invests the proceeds in the manner originally intended prior to January 20, 2020. For example, if a QOF sold QOZP on December 15, 2019, and intended to invest the proceeds in a new QOZB, but is unable to do so due to the pandemic, the QOF may take until December 14, 2021 to invest those proceeds in a new QOZB.
In addition to the relief described above, the IRS updated its Opportunity Zones Frequently Asked Questions webpage.
How Manatt Can Help: Manatt professionals are prepared to work with investors, QOFs, QOZBs, and other interested persons regarding the OZ tax incentive, including determining who is an eligible taxpayer and what capital gains are eligible, calculating the 180-day investment period, forming or investing in a QOF, interpreting the rules applicable to investments in QOFs, applying the 90% investment standard, satisfying the requirements to be a QOZB, and making use of the COVID-19 relief contained in the OZ Relief Notice.
For More Information: For more information regarding the OZ tax incentive and the OZ Relief Notice, please contact Megan Christensen, partner, Manatt Tax, at firstname.lastname@example.org or 202.585.6594, or Neil Faden, partner, Corporate and Finance, at email@example.com or 212.830.7181.