The federal opportunity zone program is meant to encourage investments into low-income communities to help boost economic development, but many projects may be in jeopardy because of delays. (AP)
If investments in the opportunity zone funds are held for five years, then 10% of capital gains on the prior investment will be forgiven, while 15% of capital gains will be forgiven if the investments are held for seven years. Thus an investor had until Dec. 31, 2019, to receive the higher 15% tax benefit.
The opportunity zone program is designed to bring monetary investments into low-income communities to help boost economic development in those areas, but many projects may be in jeopardy because of delays related to construction, financing and receiving governmental approvals for various plans, according to Aaron S. Gaynor, an associate at Roberts & Holland LLP. If such projects are disqualified, investors may lose out on their associated tax benefits, he said.
If the government does not explicitly act to postpone certain deadlines, investors may face penalties or may even pull out of the investments, which would hurt the communities the program is designed to help, Gaynor said.
"As with the economy in general, I am seeing a general slowdown in investment in qualified opportunity zones, and the development of projects in QOZs," he said. "I have not seen much in the way of calling off a project entirely, but that may change as COVID-19 challenges persist and if the economy enters a recession."
The government needs to take action as simple as a news release or a notice to clarify what, if any, opportunity zone deadlines are postponed, Gaynor said.
In December 2019, the government issued final regulations on opportunity zones that provided two methods of investing in the program. Under a one-tiered structure, a qualified opportunity fund directly holds qualified zone property. In a two-tiered structure, a QOF invests its money into one or more opportunity zone businesses whose tangible property is substantially located in a zone and at least 50% of whose gross income comes from the active conduct of the business, according to the rules.
An investor in a one-tiered structure must invest gains into a QOF within 180 days of the sale or exchange that gave rise to that gain, according to the final rules. Many investors made sales or exchanges of capital gains right before 2019 ended in order to take advantage of the maximum 15% potential relief, meaning their 180-day window will close toward the end of June. Even though 180 days might have previously been enough time to invest those gains into a qualifying QOF, that may not be enough time now that the country is in the midst of the pandemic, Gaynor told Law360.
If an investor has already successfully invested in a QOF, generally the fund must hold 90% of its assets in qualified property, as measured every six months, or face a penalty, the final rules said. But even if the fund is successfully formed, Gaynor said, it is now harder to make sure 90% of the assets in the fund are good assets over six months. That is because many elements of the projects, such as physical construction and government approvals for projects like permits, are delayed by government shutdowns of nonessential businesses, Gaynor said.
"Six months is a long time, but given things are moving at a slower pace, people may be more nervous about their ability to close a deal," he said.
By law, each month the opportunity zone fund fails to meet the 90% test will result in a penalty . However, the QOF may not be disqualified if it is acting in a good-faith, nonabusive manner under a reasonable cause exception in the law.
"I would like to believe that coronavirus-related delays would constitute reasonable delays," Gaynor said. "I would recommend that Treasury or the IRS issue guidance to create a safe harbor or safe harbors for what will constitute reasonable cause for COVID-19 related penalties."
While QOFs may face problems with investing capital gains within 180 days or meeting the 90% asset test, two-tiered QOZ business structures may actually receive some relief because President Donald Trump declared a national emergency, according to Jessica M. Millett, a tax partner at Duval & Stachenfeld LLP.
While QOFs must hold 90% of their assets in opportunity zone property, as measured every six months, or face a penalty, the first set of opportunity zone proposed regulations relaxed the six-month test by providing a working capital safe harbor to allow two-tiered structured opportunity zone businesses to hold cash or other working capital for up to 31 months if the cash was held to acquire, construct or substantially improve tangible property in an opportunity zone. The final regulations then expanded the 31-month working capital safe harbor such that if a QOZB project required multiple infusions of cash, the second infusion of cash could trigger another 31-month period.
While there are already 62 months to invest opportunity zone money into QOZBs, the final regulations may actually go further in providing disaster relief, Millett told Law360. If a project otherwise meets the requirements of a 31-month working capital safe harbor and is in a federally declared disaster area, then the QOZB may receive an additional 24 months if the delay is a result of that disaster, the final rules said.
"This is a separate tolling rule in the regulations that says if the QOZB is located in an opportunity zone that is in a federal disaster area, then the QOZB can get up to an additional 24 months on top of the 31-month safe harbor," she said. "There is an interpretation of the regulations which would treat [Trump's] declaration of a national emergency as also triggering a 24-month extension nationwide, but it is not clear yet whether Treasury will explicitly approve this interpretation."
The final rules also provided QOFs an extra 12 months to reinvest proceeds if qualified zone property is delayed by
a federally declared disaster under Section 165. Trump's declaration was issued as a national emergency, which may not be the same thing as a federally declared disaster, so it is unclear whether the extensions have been triggered, Millett said. In the past the IRS has interpreted, for purposes of Section 165, the term "disaster" to mean both a disaster and an emergency, but it would be reassuring to have guidance from Treasury clarifying the matter, Millett said.
Meanwhile, recent IRS notices extending tax deadlines may have already answered whether Section 165 has been triggered, because in postponing certain tax deadlines the government relied on a part of the Internal Revenue Code that can be used only if there is a federally declared disaster, according to Gaynor.
Under Section 7508A , the IRS has broader powers, including the ability to extend tax deadlines, when the president declares a federally declared disaster under Section 165, which is the same section that is cross-referenced to extend QOF deadlines by 12 months and QOZB deadlines by 24 months, he said.
Because the IRS already moved certain tax deadlines, it also has the authority to move other opportunity zone deadlines as well, such as the substantial improvement deadline that applies to both QOFs and QOZBs, Gaynor said.
For an existing building to qualify as property, a QOF or QOZB must substantially improve the property, which means there must be improvements to double its cost basis within 30 months, according to the final rules. This "substantial improvement" provision does not have a safety value as explicitly stated for the 12-month and 24-month extensions, but Treasury could use its general authority under Section 7508A to extend deadlines for time sensitive acts to provide relief for the 30-month substantial period, he said.
"The problem with both of these provisions is that it is unclear the extent to which they apply without explicit guidance from Treasury or the IRS," he said. "My recommendation is for the government to issue explicit guidance on this."
Treasury should also consider freezing the income tax rates for investors, according to Marc L. Schultz, a tax partner at Snell & Wilmer LLP. If tax rates go up between now and 2026, investors may be less inclined to defer gains by placing them in the funds since they would risk paying more in taxes later, he said.
Under the Tax Cuts and Jobs Act , the 39.6% top individual tax rate was reduced to 37%. However, since lawmakers recently committed to spending $2 trillion under the coronavirus relief legislation, it is reasonable to assume that there could be pressure to increase taxes in the future, Schultz said. The potential for an increase in taxes down the road is a major risk for investors, he said.
"What [the government] should do is freeze the tax rates for folks that invest in QOFs to the year of the investment so we know what our tax rates are right now," he said. "That would be a huge help to get people to invest."
--Editing by Tim Ruel and John Oudens.
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