With the issuance of Notice 2020-39 (the Notice), the Internal Revenue Service (IRS) has provided relief for Qualified Opportunity Zone Funds (QOFs) and for investors in QOFs. While the relief provided in the Notice does not solve every challenge for QOFs and investors during the pandemic, investors and sponsors alike should warmly receive the specific relief. The relief effectively softens some of the most significant constraints imposed by the qualified opportunity zone (QOZ) rules on QOFs and investors during the pandemic and should provide comfort to newly launched QOFs seeking to comply with the applicable tax requirements while offering more opportunities for investors to invest in QOFs.
Relief for Investors: Increased Availability of Eligible Gains. One of the consequences of the coronavirus (COVID-19) pandemic was that there was an extensive selloff during the month of March, which undoubtedly caused many investors to see a decline in the value of their investments. Many investors, however, will also have realized a capital gain on any stock sold during that time. Investors must have capital gains in order to take advantage of the benefits available to taxpayers under the QOZ rules; those who were taken by surprise by an unexpected selloff of their capital assets may take comfort in the fact that they are now eligible to defer (and potentially reduce such gains) by timely reinvesting those gains in a QOZ. In addition, if those investors hold their QOZ investments for at least 10 years, they may be eligible to take any appreciation on that investment completely tax-free. Pursuant to the Notice, and subject to certain exceptions, an investor may still be eligible to invest their capital gains in a QOF regardless of the fact that they are in a net loss position for the year.
Extended Deadline for Investing Eligible Gains. Ordinarily, taxpayers have 180 days from the date of the sale or exchange generating capital gain to invest such gain in a QOF and receive the associated QOZ tax benefits. In response to the pandemic the IRS first issued Notice 2020-23, which extended the due date for many tax filings including the 180-day period requirement for QOZ Investors to reinvest eligible gains into a QOF. Under the recently issued Notice 2020-39, the IRS has further extended the deadline for taxpayers whose 180-day period was set to expire on or after April 1, 2020 and before December 31, 2020. The deadline has now automatically been extended to December 31, 2020 such that if the taxpayer’s deadline falls in between those two dates, the taxpayer’s last day of its 180-day period is deemed to occur on December 31, 2020. This welcome relief will give investors a much longer time to identify suitable QOZ investments for their eligible gains and the automatic nature of the extension should facilitate more investments. Note, however, a taxpayer is still required to make a valid deferral election by filing IRS Forms 8949 and 8997 with a timely filed (including extensions) or amended federal income tax return for the year in which the gain should have been recognized had the investor not invested in a QOF.
Relief for QOFs. The Notice also provides significant relief affecting the formation and ongoing operation of QOFs making it much easier to comply with the rules during the pandemic emergency.
- The Notice provides for the automatic application of the “reasonable cause” exception to a QOF’s satisfaction of the 90% “good asset” test for testing dates falling on and between April 1, 2020 and December 31, 2020. This effectively means that if the QOF’s semiannual testing dates(s) falls within this period, any failure to comply with the 90% test is deemed to be due to reasonable cause and will be ignored in determining whether the entity qualifies as a QOF. This relaxation of the 90% test will be provide much needed assurances to QOFs so that they will not fail compliance this year due to difficulties they may face during the pandemic, satisfying the applicable requirements which will be especially helpful for new launched QOFs.
- The Notice provides that in determining satisfaction of the 30-month substantial improvement requirement (i.e., doubling basis through improvements) for tangible property to qualify as good Qualified Opportunity Zone Business Property, the period from April 1, 2020 through December 31, 2020 is tolled. In effect, this creates an extension of up to nine months for substantial improvement projects currently under way (i.e., those projects have 39 months to satisfy the requirements) and a shorter extension for projects launched after April 1, 2020. The Notice does not indicate whether the tolling is automatic, however it appears to be so. This relief should help to mitigate challenges encountered by QOFs and Qualified Opportunity Zone Businesses (QOZBs) during the pandemic in satisfying the substantial improvement requirement for tangible property.
- The Notice confirms that the COVID-19 pandemic and the associated federal emergency declaration causes all QOZs to be treated as located in a federally declared disaster area as described in the Final QOZ Regulations for purposes of the 31-month Working Capital Safe Harbor. This means that a QOZB with cash and other working capital assets can treat such assets as fitting within the 31-month period under the Working Capital Sage Harbor for up to an additional 24 months without violating the 5% limitation on holding “nonqualified financial property.” Although the extension under the Final QOZ Regulations appears to be automatic, a QOZB nevertheless needs to spend its working capital in compliance with its written plan and should be able to demonstrate to the IRS through contemporaneous documentation that it was reasonable to take up to an additional 24 months in spending such working capital.
- The Notice provides that the 12-month reinvestment period to reinvest proceeds received by a QOF from selling a QOZ investment or from a return of capital from an underlying QOZB investment, is extended for up to an additional 12 months if the reinvestment period intersects January 20, 2020. Provided that the QOF complies with certain other requirements under this 12-month reinvestment rule, if the QOF’s plan to reinvest such proceeds is delayed due to the federally declared disaster, the QOF may receive up to another 12 months to reinvest those proceeds in the manner originally intended before January 20, 2020.
Additional Observations on the Notice. The Notice’s relief and extensions should provide investors, QOFs, and QOZBs with additional time to identify investments, to complete QOZ projects, and invest in QOZBs. Accordingly, as we have observed from our practice, we are continuing to see strong support for the QOZ program despite the immediate challenges raised by the pandemic as the program is designed for investors with a long-term investment horizon.
While we expect the IRS to be fair to QOFs and QOZBs who can demonstrate reasonable cause and substantial compliance with the applicable limitations during the pandemic crisis, participants need to continue to be diligent in documenting compliance under the QOZ rules. For example, because a QOF’s satisfaction of the 90% asset test will often depend upon the qualification of QOZB subsidiaries, a QOF will want to ensure that any QOZBs in which it invests are keeping proper records as well. Thus, it is critical to document everything and anything that may affect a QOF’s ability to qualify as a QOF, including at the QOZB-level, if applicable. For example, consider a QOF that will fail the 90% asset test if its subsidiary does not qualify as a QOZB. If that QOZB is unable to meet the 70% threshold for tangible property because the shipping of materials to the QOZB has been delayed because of the pandemic, any QOFs invested in that QOZB should continue to document these events to demonstrate reasonable cause, especially if the problem will continue beyond the applicable relief provided by the Notice.
Additional Legislative Relief Possible. The QOZ program has generally received bipartisan support in the houses of Congress, and while there can be no certainty, it is possible that we may see more legislation issued in order to promote and encourage the program. An example of such promising legislation is HR 6529, which was introduced in the House of Representatives on April 17, 2020. The bill, if passed, would greatly expand the number of businesses that could qualify as QOZBs by including certain “qualified small businesses.” A qualified small business is one with gross revenues below $1 million and which has experienced supply chain disruptions, staffing challenges, decrease in sales or customers, or partial or full suspension of business as a result of the pandemic. The bill, if passed, would greatly increase the availability of good assets (e.g., QOZBs) for QOFs to invest in, making it easier for such funds to satisfy the 90% asset test.
Participants in the QOZ program should consult their tax advisors regarding the relief provided by Notice 2020-39.