More Changes May Be Needed for the Opportunity Zone Incentive to Assist in the COVID-19 Crisis Recovery Efforts
On Thursday, April 9, 2020, the Treasury issued Notice 2020-23. This notice amplifies previous related notices and provides relief under Section 7508A of the Internal Revenue Code for persons that Treasury has determined to be affected by the COVID-19 pandemic. This is the result of President Trump’s emergency declaration under the Stafford Act on March 13, 2020.
With respect to the Opportunity Zone (OZ) incentive, this Notice provides a specific but limited extension of the taxpayer’s 180-day investment period to invest in a Qualified Opportunity Fund (QOF) with respect to an eligible gain. Specifically, this Notice extends the last date of the taxpayer’s 180-day investment period to July 15, 2020, where such last date will terminate or has terminated on a date on or after April 1, 2020, and before July 15, 2020.
This Notice may be welcomed news to some. Still, as we deal with the COVID-19 health crisis, federal income tax incentives for businesses will likely be necessary for economic recovery. As COVID-19 relief efforts turn their focus on recovery efforts, current economic and community development tools may be necessary to assist in these efforts. The OZ Incentive could be a critical financing tool for this purpose.
The OZ Incentive is designed to encourage private capital investment in real estate projects and operating businesses located in certain population census tracts in need of private capital investment, called Qualified Opportunity Zones. There are approximately 8,766 OZs across all 50 states, six territories and the District of Columbia. This represents approximately 11 percent of all population census tracts. According to Economic Innovation Group, OZs account for more than 25 percent of the nation’s food deserts (i.e., low-income population census tracts without a full-service grocery store within a one-mile radius in urban areas and within a 10-mile radius in rural areas).
The OZ Incentive had significant momentum at the time that this crisis started. Private capital was being raised in impressive amounts by QOFs. Additionally, Treasury and the Internal Revenue Service (IRS) were commended for their taxpayer-friendly approach to the recent release of the OZ Incentive Final Regulations. Many QOFs had already deployed significant capital into projects throughout the country.
OZs have already experienced significant job losses as a result of the COVID-19 crisis. A large proportion of the transactions that have already been undertaken with the OZ Incentive involve real estate. However, the Final Regulations provide critical guidance to enable the incentive to attract long-term private equity capital for operating businesses.
Prior to the crisis, QOFs were considering using this incentive to invest in a number of operating businesses as a result of the issuance of the Final Regulations. Current relief incentives for small businesses are focused on low interest rate loans for businesses. The OZ Incentive may be seen as a complementary incentive to attract equity capital for these businesses.
The following are five possible changes that could attract more private capital to be used in real estate projects and operating businesses during this crisis. Note that some of these possibilities would take congressional action.
Provide a Longer Term for Investing in a QOF
In order to elect to defer some or all of a taxpayer’s eligible gains resulting from the sale or exchange of property with an unrelated person for federal income tax purposes, a taxpayer, with certain exceptions, must invest and acquire a qualifying investment in the QOF during the 180-day period beginning on the date of which the gain would be recognized for federal income tax purposes (i.e., the date of the taxable sale or exchange).
The Final Regulations provide flexibility on the date that the 180-day investment period commences for an equity holder of a pass-through entity when the taxable sale or exchange is generated by such pass-through entity. This is often the structure employed when real estate is sold.
Equity holders of pass-through entities are provided three different commencement dates for the 180-day investment period, one of which provides that the 180-day investment period can commence on the date that the federal income tax return is due (without extensions) for the pass-through entity for the taxable year in which the taxable sale or exchange occurs. For many pass-through entities that generate an eligible gain in the 2020 taxable calendar year, this date will be March 15, 2021. The other two commencement dates include the date of the taxable sale or exchange of the asset by the pass-through entity and the last day of the pass-through entity’s taxable year for the year of the taxable sale, which is likely to be December 31, 2020 for eligible gains generated by such pass-through entity in the 2020 taxable calendar year.
Even with the flexibility provided for pass-through entities, a blackout period exists for investments in a QOF when the eligible gain from the pass-through entity occurred early in a taxable year.
For example, if a pass-through entity incurs an eligible gain from the taxable sale of an asset on January 31, 2020, then then blackout period will commence on July 30, 2020. This means that an equity holder of the pass-through entity would not be able to invest in a QOF after this 180-day investment period until December 31, 2020. Further, when an individual directly sells an asset for cash consideration generating an eligible gain, the 180-day investment period for such individual will generally commence on the date of the taxable sale or exchange of the asset. This means that individuals who sold stocks on January 31, 2020 generally need to invest in a QOF and acquire a qualifying investment in the QOF by July 29, 2020.
As stated above, the Notice provided some relief for taxpayers whose 180-day investment period terminated on or after April 1, 2020, and before July 15, 2020. This may be helpful but more flexibility for commencement of the 180-day investment period may be needed. The OZ Incentive involves a long-term investment. As a result of this uncertain climate, taxpayers will likely want to make investments in QOFs closer in time to the commencement of the development of a real estate project or the startup of an operating business.
Changing the 180-day investment period to a 360-day investment period with respect to eligible gains where the 180-day investment period either commenced within the 2020 calendar year or terminates within the 2020 calendar year may simplify the process, provide a taxpayer with more time to choose an investment strategy that matches up with the development of a real estate or the startup of an operating business, and could avoid the issue of a blackout investment period when the sale or exchange is incurred by a pass-through entity.
Provide More time for the QOF to Hold Cash Before Investing in the Qualified Opportunity Zone Business
A QOF is required to hold at least 90 percent of its assets in Qualified Opportunity Zone Property (OZP). Failure to satisfy the 90 percent requirement can result in a penalty on the QOF for each month of such failure. However, no penalty is to be imposed with respect to a failure to satisfy the 90 percent requirement where it is shown that such failure is due to reasonable cause.
The 90 percent requirement is tested twice per year and cash is generally not treated as OZP. A QOF can disregard cash contributed to the QOF not more than six months before the testing date. This means that the QOFs may have a limited period of time to convert any contributed cash into OZP under the 90 percent requirement. An equity interest in a Qualified Opportunity Zone Business (QOZB) meeting certain requirements can be considered OZP for this purpose. Generally, a QOF has between six to 12 months, depending upon when the cash was invested in the QOF by a taxpayer, to convert such cash into OZP, which also means that a QOF may have between six to 12 months to invest such cash into an QOZB.
One possibility is to extend the date to convert cash into OZP by at least an additional six months for a QOF for testing dates that occur within the 2020 calendar year. A perfect example involves calendar year QOFs that received cash from taxpayers back in December 2019. These QOFs are generally required to invest at least 90 percent of such cash into a QOZB no later than June 30, 2020. As a result of the COVID-19 crisis, this investment timeline could be extremely difficult to satisfy for most QOFs. An extension here may be needed as a result of this crisis. One mechanism for accomplishing this extension could be to determine that any failure in 2020 to satisfy the 90 percent requirement as a result of the QOF failing to invest sufficient cash into a QOZB in exchange for equity in such entity would avail the QOF of the reasonable cause exception because of the COVID-19 crisis.
Freeze the Income Tax Rate for When the Deferred Gain is Subject to Income
Taxpayers with eligible gains that acquire a qualified investment in a QOF will be subject to income no later than December 31, 2026, on such deferred eligible gain. This means that the income tax rate that may apply to the deferred gain likely will be the income tax rate for the taxable year in which the amount is included in the taxpayer's income (which is likely to be the 2026 taxable year.)
With the expected amount of stimulus that will be needed to manage this crisis, it is likely that more revenue is going to be needed to service the federal debt. Accordingly, there is a possibility that income tax rates in 2026 will be higher than they are currently in 2020.
One way of addressing this could be to keep the income tax rate for the deferred gain at the same income rate that would have applied to the taxpayer on such gain had the taxpayer not invested in the QOF and is subject to income in the taxable year of the sale. This could eliminate the income tax rate risk that taxpayers must consider when availing themselves of the OZ Incentive. Taxpayers may be more inclined to invest in a QOF when the income tax rate that will be applied to the deferred gain is the same income tax rate for the year that that the taxpayer incurred the gain related to acquiring a qualifying investment in the QOF.
Extend the Partial Exclusion Date
The taxpayer’s initial income tax basis on his or her acquired qualifying investment in the QOF is zero. To the extent that the taxpayer holds the qualifying investment for at least five years, the taxpayer’s income tax basis in such qualifying investment in the QOF typically is increased by 10 percent of the deferred gain. To the extent that the taxpayer holds such qualifying investment for at least seven years, the taxpayer’s income tax basis in such qualifying investment typically would be increased by an additional 5 percent of the deferred gain.
It should be noted that taxpayers who acquire qualifying investments in a QOF after December 31, 2019, will not achieve the seven-year holding period on or before December 31, 2026, and therefore such taxpayers may not be able to obtain the maximum increase in tax basis in their qualifying investments equal to 15 percent of their deferred gain on or prior to the date that the deferred gain is included in income.
This could be addressed by reducing the taxpayer’s holding period to obtain the additional 5 percent tax basis increase in his or her qualifying investment in the QOF to five years rather than seven years. This should allow taxpayers that acquire a qualifying investment in 2020 and in 2021 to seek the maximum 15 percent partial exclusion of the deferred gain that is required to be included in income.
Extend The Date That the Deferred Gain is Required to be Included in Income Beyond December 31, 2026
The amount of eligible gain that is deferred by the taxpayer will be required to be included in income of the taxpayer upon the earlier of the following: December 2026 or the date of an occurrence of an inclusion event as prescribed in the Final Regulations.
One of the significant income tax benefits of the OZ Incentive is the exclusion from income for federal income tax purposes (the 10-Year benefit) upon the disposition of a taxpayer’s direct or indirect investment after holding the qualifying investment in the QOF for at least 10 years. The Final Regulations provide that the 10-Year benefit will apply where the QOF and the QOZB are partnerships for federal income tax purposes and the QOZB sells its assets (excluding the sale of inventory) after taxpayers have achieved the 10-Year Holding Period.
A taxpayer who invests in a QOF and acquires a qualifying investment in the QOF will have to pay income tax on the deferred gain prior to any liquidity transaction related to the 10-Year Benefit. Shortening the amount of time between these two events should make the OZ incentive more attractive for investors. Currently, a taxpayer who invests in a QOF in 2020 will not obtain the 10-Year Benefit until 2030, but could have taxable income in 2026 and need to pay income tax in 2027 on such income. Extending the date that the deferred gain will be required to be included in income beyond December 31, 2026, could be a game changer for taxpayers who have already acquired or will be acquiring a qualifying investment in a QOF. Deferring the income inclusion date to December 31, 2029, would likely match up a taxpayer’s need for liquidity to pay income tax in 2030 for income required to be included on December 31, 2029, and the QOF’s ability to sell its direct or indirect assets after taxpayers have met their 10-year holding period with respect to a qualifying investment acquired in 2020.
In conclusion, the notice provides helpful relief to some. Still, more can be done. Above are five potential changes with respect to the OZ Incentive. There are many other potential changes to this incentive that could significantly enhance this incentive with respect to the recovery efforts. These changes include recently sent changes by tax practitioners to the Treasury and the IRS with respect to the Final Regulations.