Opportunity Zone Incentive - Critical Dates in 2021
March 16, 2021
By Marc L. Schultz and Kade D. Miller
Investors, fund sponsors, real estate developers, and businesses using or planning to use the Opportunity Zone incentive (the OZ Incentive) should be aware of some upcoming critical dates. Some of these dates are the result of Notice 2021-10, which was recently issued by the Treasury and the Internal Revenue Service. Notice 2021-10 extended certain relief previously provided last year in Notice 2020-39 related to the COVID-19 pandemic.
MARCH 31, 2021
Notice 2021-10 provides that if a taxpayer’s 180-day investment period has ended or will end between April 1, 2020, and before March 31, 2021, with respect to an eligible gain, then the last date for the taxpayer to make an investment in a qualified opportunity fund (QOF) is extended to March 31, 2021. This extension is the second extension after Notice 2020-39 extended this date to December 31, 2020, for taxpayers with a 180-day investment period that ended on or after April 1, 2020, and before December 31, 2020.
This is great news for investors with unused 2019 eligible gains where such investor’s 180-day investment period ended on or after April 1, 2020. It is also helpful for investors with unused eligible gains from early 2020. Essentially, these investors could still invest in a qualified opportunity fund and take advantage of the OZ Incentive with respect to these previously unused eligible gains.
The following are two examples where the 180-day investment period would be extended to March 31, 2021, with respect to an eligible gain created in 2019:
- Individual taxpayer directly sells an asset it owns directly, such as stock, on or after October 4, 2019, generating an eligible gain; and
- Individual taxpayer is a partner of a calendar year pass-through entity, such as a limited liability company, and is allocated an eligible gain on December 31, 2019, from the sale of an asset by the limited liability company during 2019.
Taxpayers with 2019 eligible gains described above will have already paid income tax on such gains when they filed their 2019 federal income tax returns. In the event that they invest in a QOF on or prior to March 31, 2021, with respect to such 2019 eligible gains, they will need to file an amended return and claim a refund.
JUNE 30, 2021
Extension of 31-Month Working Capital Period
No more than five percent of the average of the aggregate unadjusted tax bases of the property of a qualified opportunity zone business (QOZB) may be attributable to nonqualified financial property (NQFP). NQFP includes cash and certain other assets, but does not include reasonable amounts of working capital held in cash, cash equivalents or debt instruments with a term of 18 months or less (collectively, the “Working Capital Assets”).
The regulations provide a safe harbor (a “Working Capital Safe Harbor”) for determining whether Working Capital Assets are considered to be reasonable working capital. The Working Capital Safe Harbor requires, among other requirements, that the QOZB have a written plan identifying the Working Capital Assets it holds for the development of a trade or business within an Opportunity Zone, along with a written schedule demonstrating the expenditure of the Working Capital Assets within 31 months of receipt by the QOZB. The Working Capital Assets must be used in a manner that is substantially consistent with such written plan and schedule.
The regulations provide that the QOZB can receive not more than an additional 24 months to spend its Working Capital Assets if the QOZB is located within a federally declared disaster area, so long as the QOZB satisfies the Working Capital Safe Harbor provisions. This language is ambiguous as to whether obtaining the full 24 months is automatic. Notice 2021-10 confirmed the availability of receiving not more than an additional 24 months for QOZBs holding Working Capital Assets intended to be covered by the Working Capital Safe Harbor before June 30, 2021. Still, the QOZB must satisfy the other requirements of the Working Capital Safe Harbor. Notice 2020-39 already confirmed the same for Working Capital Assets intended to be covered by the Working Capital Safe Harbor before December 31, 2020.
It is important to understand that the additional period is not necessarily a full 24 months, but rather a period of not more than 24 months. The IRS has informally stated that the amount of additional time, not to exceed the 24 months, depends on the particular circumstances. As a result, proper documentation should be kept that demonstrates the need for the exact amount of additional time. Consideration should also be made as to amending a written plan when this additional time is being sought by stating the reason for this additional time and including an alternative construction schedule reflecting the use of such additional time.
Relief from Penalty for Failure to Satisfy 90% Requirement
One of the requirements for an entity to satisfy the requirements to be a QOF is to hold at least 90 percent of its assets (the “90% Requirement”) in qualified opportunity zone property (OZP). The 90% Requirement is determined by taking the average of the percentage of OZP held by the QOF, as measured on the last day of the first six-month period of the taxable year of the QOF, and on the last day of the taxable year of the QOF (each a “Semi-Annual Testing Date”). Failure to satisfy the 90% Requirement can result in a penalty on the QOF for each month of such failure. However, this penalty will not apply where it is established that such failure is due to reasonable cause.
Notice 2021-10 provides that, in the case of any QOF with a Semi-Annual Testing Date falling between April 1, 2020, and June 30, 2021, failure by the QOF to satisfy the related 90% Requirement for that year shall be treated as due to reasonable cause and no penalty will be imposed for such failure. This means that a calendar year QOF that is newly formed during, and commences its first calendar month as a QOF in, February 2021 will not obtain relief under Notice 2021-10 for failure to satisfy the 90% Requirement for the Semi-Annual Testing Dates occurring on both July 31, 2021, and December 31, 2021. However, a calendar-year QOF that commenced as a QOF in November 2020 will not be assessed a penalty for failure to satisfy the 90% Requirement on both June 30, 2021, and December 31, 2021. Note that this relief does not apply to Semi-Annual Testing Dates occurring in 2022.
One practical application of this provision pertains to cash held at the QOF. Cash is not considered to be OZP, and holding too much cash on a Semi-Annual Testing Date (with one exception not discussed in this legal alert) can result in a penalty. However, an equity interest (satisfying certain requirements) in a QOZB that is acquired in an original issuance for cash by the QOF would be considered to be OZP.
Under the 90% Requirement, QOFs have a limited period to convert any contributed cash from taxpayers into qualifying equity in a QOZB. For example, a newly formed calendar year QOF that received investments from taxpayers during December of a calendar year is required to convert at least 90 percent of such cash into equity in a QOZB on or before June 30 of the subsequent year or incur a penalty.
Under Notice 2021-10, a newly formed calendar year QOF that received investments from taxpayers during December 2019 will not incur a penalty if it converts at least 90 percent of such cash into equity in a QOZB on or before June 30, 2022. This expansive relief does not apply to a calendar year QOF that commences its first calendar month as a QOF in, February 2021.This QOF will need to convert at least 90 percent of such cash into equity in a QOZB on or before December 31, 2021.
DECEMBER 31, 2021
The amount of eligible gain to be deferred (the “Deferred Gain”) with respect to an investment in a QOF will be required to be taken into taxable income in 2026 unless an inclusion event occurs prior to 2026. The amount of such Deferred Gain can be reduced by 10 percent to the extent that an investor invests in the QOF and obtains a qualified investment in such QOF on or prior to December 31, 2021.
We expect that this potential reduction in the Deferred Gain will result in an influx of capital to QOFs during 2021. The 10 percent reduction is becoming even more important because of the risk that income tax rates could increase in the near future. Because the income tax rate at the time that the Deferred Gain becomes subject to income tax is the rate that will be applied to the Deferred Gain, the 10 percent reduction is helpful because it provides a hedge against the possibility that the income tax rates will be higher in 2026.
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