Introduction

On January 19, 2021, the IRS published guidance in Notice 2021-10, extending critical deadlines and rules relating to investments in qualified opportunity zones. First, any investors facing a deadline between April 1, 2020, and March 31, 2021, to invest their qualified capital gains in a qualified opportunity fund (“QOF”) now have until March 31, 2021, to invest those gains. Second, for purposes of the “substantial improvement,” requirement whereby QOFs or Qualified Opportunity Zone Businesses (“QOZB”s) must “double the basis” of property within any 30-month period in order for it to be qualified opportunity zone business property (“QOZBP”), the entire period from April 1, 2020 to March 31, 2021, is disregarded – the 30-month improved period is tolled during that period. Third, All QOFs having a testing date between April 1, 2020, through June 30, 2021, for the requirement that 90% of its assets be invested in qualified opportunity zone property, and fail the test, will automatically be granted “reasonable cause” relief from the failure. Although not explicitly stated, we expect that the failure to meet the 90% test on these dates will also be disregarded for purposes of determining whether the QOF meets the opportunity zone requirements for any tax year. In addition, the Notice allows an additional 12 months on top of the original 12-month period that a QOF has to reinvest proceeds from a sale of property by the QOF or the return of capital to the QOF, if any of the original reinvestment period includes June 30, 2020.  Finally, the Notice allows up to an additional 24 months to spend funds intended to be covered by a working capital safe harbor by June 30, 2021, extending the safe harbor period to up to 55 months (up to 86 months for start-up businesses).

The relief provided by these new rules extends similar relief granted in 2020 in Notice 2020-39. The relief is automatic, and no request or filings have to be made, though investors and QOFs must still properly file all required opportunity zone forms.   

Explanation of the Provisions

180 Day Investment Standard. An investor must invest capital gains from the sale of any property to an unrelated party in a QOF to receive opportunity zone benefits. The investment must generally be made within 180 days of the date of the sale. In the case of sales by pass-through entities such as partnerships, limited liability companies taxed as partnerships, and S corporations, an owner of the pass-through entity may also invest the capital gains within 180 days starting on the last day of the pass-through entity’s tax year or within 180 days beginning on the due date, without extensions, of the entity’s tax return for the year of the sale.  

Notice 2021-10 provides that the deadline for an investor whose 180-day period runs out between April 1, 2020 and March 31, 2021, is postponed to March 31, 2021.  Previously, in Notice 2020-39, the IRS had extended the deadline for investors whose investment deadline expired between April 1 and December 31, 2020, to December 31, 2020. This new rule extends that deadline to March 31, 2021, and “resurrects” the opportunity to invest certain capital gains that previously had to be invested in a QOF by December 31, 2020.

QOF Qualification. A QOF must hold 90% of its assets in qualified opportunity zone property. Most often the assets of a QOF consist of interests in a qualified opportunity zone business (“QOZB”). In any event, this 90% standard is measured annually by testing the percentage of qualified property held by the QOF on two test dates, usually June 30 and December 31 of each year, and taking the average of the two tests. A QOF that fails a test will be assessed a penalty for the year (basically an interest charge for each month the QOF fails to meet the 90% standard based on the shortfall). A QOF can avoid the penalty by showing it had “reasonable cause” for the failure.

Notice 2021-10 provides that any QOF that has a testing date between April 1, 2020, and June 30, 2021, and fails that test will automatically be granted reasonable cause relief. Moreover, the failed test will be disregarded for all purposes relating to the qualification of the QOF or otherwise qualifying investments satisfy the requirements of the opportunity zone rules. This is important because a failed test can cause a failure of other requirements, not only in the year of the test but in later years. 

30-Month Substantial Improvement Period. As stated earlier, most QOFs hold interests in entities designed to qualify as QOZBs. One requirement of a QOZB is that 70% of the QOZB’s tangible property must be qualified opportunity zone property. This means that it must have been purchased from an unrelated party after December 31, 2017, and either (i) the original use of the property in the qualified opportunity zone must commence with the QOZB or (ii) the QOZB must substantially improve the property within 30 months of the acquisition of the property.¹

Notice 2021-10 provides that the period between April 1, 2020 and March 31, 2021, is ignored in determining whether a QOZB has met the 30-month timetable for substantially improving a property. So, for example, if property is acquired January 1, 2020, the 30-month period will not run out on June 30, 2022, but instead 12 months later, on June 30, 2023.

Working Capital Safe Harbor Period. A QOZB must hold less than 5% of its assets (measured by the average of the aggregate unadjusted bases of the QOZB’s property) as nonqualified financial property (including cash, financial accounts, stock, partnership interests, etc.). A QOZB can exclude reasonable amounts of working capital held in cash, cash equivalents and debt instruments with a term of 18 months or less from this test. In addition, a QOZB can exclude from the test amounts held pursuant to the “working capital safe harbor.” The requirements of the working capital safe harbor include a written schedule for the expenditure of the working capital subject to the safe harbor within 31 months. In certain circumstances the time line for expenditures can be extended.

Notice 2021-10 expands the working capital safe harbor expenditure period for up to an additional 24 months for working capital intended to be covered by the working capital safe harbor before June 30, 2021. This extends the working capital expenditure period for up to 55 months for this capital and, in certain circumstances relating to multiple working capital safe harbors for start-up businesses, the expenditure period can extend to as much as 86 months. 

Reinvestment Period for QOFs. QOFs that sell a property or receive distributions from a QOZB as a return of capital and reinvest the proceeds within 12 months in qualified property may treat the proceeds as qualified property provided that, prior to the reinvestment, the proceeds were held in cash, cash equivalents, or debt instruments with a term of 18 months or less.  For any reinvestment period that includes June 20, 2020, Notice 2021-10 extends this 12-month reinvestment period for up to an additional 12 months, for a maximum reinvestment period of 24 months, provided that the QOF satisfies the general requirements and invests the proceeds in the manner the QOF originally intended before June 30, 2020.

Polsinelli Practice Tip

The momentum of opportunity zones was accelerating exponentially until the COVID-19 crisis, and the crisis has slowed it considerably. This is true even as the opportunity zone program has become more and more critical to these communities. The program was designed to encourage investments in low-income struggling areas, and these areas have been hit very hard by the economic devastation of the crisis. Various deadlines were extended by Notice 2020-39, but the COVID-19 crisis is continuing, and the additional extension of the 180-day investment deadline keeps alive capital gains from 2019 (!) realized by partnerships and other pass-through entities.  

The tolling of the substantial improvement period and extension of the working capital safe harbor period are also potentially huge benefits for deals slowed by the pandemic (or otherwise). The waiver of penalties associated with a QOFs failure to qualify in 2020 and the first half of 2021, and the tolling of the substantial improvement period, will also prevent the possible loss of opportunity zone benefits that would have been caused by the crisis, through no fault of QOF sponsors. The Notice reinforces the confidence investors should have in the long-term viability of the program and the dedication of the Treasury and the IRS to provide reasonable regulation of the program. We expect that the opportunity zone program could accelerate again exponentially as the COVID-19 crisis eases and people get back to business.

1 Substantial improvement is defined as investing funds sufficient to increase the owner’s adjusted basis in the improvement (not the land) by 100% -- essentially doubling the basis of the improvement.