What’s Missing from the IRS’s Tax Relief Guidance for Opportunity Zones
What’s Missing from the IRS’s Tax Relief Guidance for Opportunity Zones
Originally published in Bloomberg Tax on July 23, 2020. Copyright ® 2020 The Bureau of National Affairs, Inc. 800-372-1033 www.bloombergindustry.com. Reproduced with permission.
To find the latest information on this topic, read Relief Provided for Qualified Opportunity Funds and Investors.
Since its creation in 2017, the opportunity zone program has seen halting progress, initially because of lack of clarity around investment parameters and what constitutes qualified real property, and more recently because of the economic impact of the global pandemic. After the IRS issued final rules in December 2019, opportunity zone investment activity picked up significantly but abated again in early March when the full force of the coronavirus began to emerge.
Investment activity began to tick back up in mid-May. And with the IRS’s June 4 guidance for qualified opportunity zone funds (QOFs) and investors affected by the coronavirus, we expect that activity to continue: According to an Economic Innovation Group survey released on June 23, 56% of respondents, including investors and QOF managers and qualified opportunity zone businesses (QOZBs), say their level of engagement with opportunity zones “will remain undiminished and may even increase over the year ahead.”
The IRS’ most recent guidance confirmed investors’ beliefs about how the program would ultimately function. However, in keeping with tradition, this guidance, Notice 2020-39, leaves some questions unanswered:
1. Can the deadline for taxpayers to redistribute and invest capital into distressed and low-income communities be extended as a result of Covid-19?
As originally drafted, the opportunity zone program is scheduled to expire on Dec. 31, 2026. However, because of the initial lack of clarity, which made many potential investors hesitant to invest, many missed out on the 5% basis increase that expired at the end of 2019 and would have resulted in a total 15% exclusion of deferred capital gains by the end of 2026. If the program were extended to 2030, investors would regain that 5% basis increase, which could further spur investment.
As written, the opportunity zone program stipulates that taxpayers who see capital gains from the sale of assets have 180 days to redistribute the amount of the realized gain into a QOF. Notice 2020-39 provides that if a taxpayer’s last day to invest in a QOF would have fallen on or after April 1 and before Dec. 31, 2020, the taxpayer now has until Dec. 31, 2020, to invest that gain into a QOF.
Assuming an extension does not happen, industry groups separately are lobbying for a 15% step up in basis to take effect this year, effectively guaranteeing that if the program ends in 2026 rather than 2030, investors still receive the full tax benefits if they invest within the April 1 to Dec. 31 period.
2. Will employees working remotely outside of a QOZ, because of Covid-19, affect the 50% of gross income QOZB safe harbor provision?
Another elision of Notice 2020-39 is whether a business will still be deemed a QOZB given the impact that state and local stay-at-home mandates may have on the 50% gross income test. According to the final regulations, among the requirements to qualify as a QOZB is that 50% of total gross income must derive from business actively conducted within the QOZ. However, stay-at-home mandates may make meeting that standard difficult.
The final regulations outline criteria for meeting the 50% gross income test, including services performed in the QOZ based on hours or the amounts paid for services. Current and prospective investors should quantify the extent to which gross income was or may be generated outside the QOZ in the regular course of business.
3. Will businesses fail to qualify as a QOZB if employees use intangible property outside a QOZ while working remotely because of Covid-19?
Another requirement to qualify as a QOZB is for a substantial portion (40%) of the business’s intangible property to be used in the active conduct of the QOZB. The final rules in December provided that intangible property—anything from intellectual property to software—will be treated as such if the use of the intangible property is “normal, usual or customary in the conduct of the trade or business,” and the intangible property is used in the QOZ “in the performance of an activity of the trade or business that contributes to the generation of gross income for the trade or business.”
A company with multiple business lines or differing activities may have branch locations inside and outside a QOZ: for example, a manufacturing operation that has production activities inside a QOZ and a distribution warehouse outside the QOZ, perhaps even in another state. Investors have expressed uncertainty regarding how to determine or measure the location of the business’s intangible property.
With employees having worked remotely for months and potentially working remotely, at least in part, for the foreseeable future, QOZBs may fail to meet this standard. Businesses should keep a close eye on legislative and regulatory developments in the event that the IRS provides guidance that businesses will not be penalized for using intangible property outside a QOZ while working remotely.
4. Can there be a cure period if an entity can demonstrate that the loss of QOZ qualification resulted from Covid-19?
The opportunity zone program was slow to get off the ground because of a lack of clarity around its parameters and mechanics, and the aforementioned lack of clarity could lead to renewed hesitation on the part of investors looking to participate in the program. For interested parties and for those already operating in opportunity zones, one possible remedy is for the IRS to release guidance stipulating that the loss of qualification may be remedied through a cure period.
In the final rules in December, in response to investors’ concerns that relief was unavailable to QOFs that discover that an entity in which they invested failed to qualify as a QOZB, the IRS provided for a six-month cure period for a non-qualifying trade or business if it is found to have caused the QOF to fail the 90% investment test. An analogous cure period could be instituted for businesses that lose QOZB status as a result of the coronavirus as well.
5. Can future guidance include stronger anti-abuse language?
The current financial crisis has had a significant impact on low-income communities, which, judging from the 2008 financial crisis, may be the last to recover. QOZs, therefore, present an opportunity potentially to lift these areas more quickly out of distress and to begin to build lasting foundational change.
The struggle for the program can be found in its very composition: Opportunity zones are census tracts in distressed and low-income communities across the country that have been identified for preferential tax treatment. However, some of these tracts carry the potential for much higher returns than others: Property along the Gulf Coast that has been severely damaged by hurricanes but that could be cleaned up and used for resort properties, for example, has the potential for much greater returns than affordable housing investments in inner cities. Most investors weighing whether to invest in such a property versus affordable housing will naturally gravitate toward the investment more likely to yield higher returns. This makes it more difficult for the smaller percentage of QOFs and QOZBs that want to provide affordable housing to compete for capital.
Some opportunistic players may also end up leasing real estate in a QOZ without the requirement to improve it, grow a business, or offer jobs to the underserved in the area. To date, there are few examples of QOFs running their own businesses within QOZs.
The IRS and Treasury included broad anti-abuse language in the December rules and provided examples illustrating that land held for speculative purposes does not qualify for the program’s tax benefits—for example, the acquisition of land for and construction of a parking lot is considered speculative, not furthering the purposes of the program, and should not receive opportunity zone tax benefits.
The anti-abuse rules are highly conceptual, lacking necessary specificity, which may lead to varied, incorrect and perhaps abusive interpretations by QOZ business operators and the IRS.
Investors who are evaluating opportunity zones should ensure they are adhering to the intent and spirit of the program—to uplift distressed areas in need of revitalization and create new jobs and investment opportunities.
What IRS Notice 2020-39 Clarified
Though these questions remain outstanding, Notice 2020-39 provided relief for investors and QOFs by extending deadlines, lifting penalties, suspending requirements and correcting amendments to the final rules issued in December, including:
- 180-Day Investment Requirement: Investors are required to make investments in a QOF within a 180-day period. Notice 2020-39 has extended a previous notice’s deferral period (Notice 2020-23): If a taxpayer’s 180th-day investment requirement falls between April 1 and before Dec. 31, the taxpayer now has until Dec. 31, 2020, to invest that gain into a QOF. The December extension will not apply to partnerships and S-corporations that have a March 15 deadline.
- Reasonable Cause Exception: As mentioned above, there is a 90% investment standard test that is performed at six-month intervals. The final regulations provided for a reasonable cause exception but did not provide a definition or give any clear guidance. Notice 2020-39 clarifies that a QOF’s failure to pass the 90% test on any semiannual testing dates from April 1 through Dec. 31 will be considered to be due to reasonable cause and that the failure will not prevent an entity from qualifying as a QOF or an investment in a QOF from being a qualifying investment.
- 12-Month Reinvestment Period: In the event that a QOF sells a property or sees a capital return, the final regulations provided for an extension of 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 an additional 12 months for reinvestment if any of the QOF’s 12-month reinvestment period includes Jan. 20, 2020 (the date of the disaster identified in the Major Disaster Declarations related to Covid-19).
- Substantial Improvement: Under the final regulations, “substantial improvements” must be made within any 30-month period beginning after the date of acquisition of the applicable property. This notice suspends the 30-month substantial improvement for the period beginning on April 1 and ending on Dec. 31.
- Working Capital Safe Harbor for QOZBs: The working capital safe harbor allows a QOZB to hold working capital if it has a written plan to expend the funds within 31 months. The final regulations provide that an extension of not more than 24 months may be provided if the QOZB is within a federally declared disaster area. Because of President Trump’s declaration of a nationwide emergency pursuant to Section 501(b) of the Stafford Act as a result of Covid-19, all 50 states have been declared federal disaster areas. Notice 2020-39 confirms that due to the Covid-19 Emergency Declaration, all QOZBs holding working capital assets intended to be covered by the working capital safe harbor before Dec. 31 will receive not more than an additional 24 months to expend the working capital assets of the qualified opportunity zone business (as long as the QOZB meets the requirements for the working capital safe harbor). This may be especially salubrious for startup businesses, for which it may take years to turn a profit. Under the final regulations, QOZBs had a maximum of 62 months to hold working capital; now they have up to an additional 24 months.
This relief presents planning and investment opportunities, which may be further compounded by the need for investors who sold stock in response to Covid-19 market volatility to find investments where they can allocate their capital gains. To reap the full tax benefits of the opportunity zone program, investors are required to meet a 10-year holding period, which before the coronavirus may have been a detractor. Now, however, given market uncertainty, that holding period may look more appetizing as investors may “leapfrog” this downswing in the market.
As a result, real estate projects and other businesses that investors may have dismissed previously—such as converting abandoned real estate into multi-use retail, shopping centers, and housing, or relocating an existing manufacturing facility from a high-cost real property tax area to a lower real property tax area in a QOZ—could now be within their suite of potential investment options. QOFs should be prepared to receive these funds.