Qualified Opportunity Zone Reminders

Over the past several months, stakeholders in the opportunity zone program have been hoping for new legislation to enhance and extend the program. Anticipation around this new OZ legislation has waned to some degree as Congress focused its efforts on several important matters including the debt ceiling and other tax policies. As a result, the future of new OZ legislation is unclear. However, investors, qualified opportunity funds, and project sponsors in the OZ space still have several considerations to make as they navigate the formation of new projects and the continued progress of existing projects. In this post, we’ll highlight three important reminders OZ stakeholders should consider about their OZ investment or project.

OZ Benefits Are Only Available to Capital Gain Investors

The benefits of the OZ program are only available to investors who contribute capital gains into an investment vehicle organized as a Qualified Opportunity Fund (QOF). Simply owning property in an opportunity zone, contributing property to an OZ project joint venture entity, or contributing cash not arising from a capital gain do not offer investors any OZ benefits. The OZ program is intended to generate new capital investment into designated geographic areas, but only after investors have liquidated another investment at a gain, deferred recognition of that gain by making an election under Sec. 1400Z-2(a), and timely invested that gain into a QOF. The most significant tax benefit of the OZ program, the ability to step up the basis after ten years and sell an investment for no taxable gain, is only available if an investor had first deferred recognition of a capital gain and then holds a qualifying investment in a QOF.

Taxpayers may consider eligible capital gains from many sources, including installment sales for which the taxpayer is still receiving payments, gross gains within a stock portfolio even if the portfolio produced an overall net capital loss, gains from the sale of a business, and gains from real estate transactions or vacation homes.

Deadline for Funds to Deploy Recently Contributed Capital

Generally, a QOF must invest at least 90% of its assets in qualified property, a test which is administered annually but measured twice a year, computed by taking the mathematical average of the percentage of assets held in qualified property on both June 30 and December 31 for a calendar year QOF. An important provision allows a QOF to exclude from the qualified property measurement any cash received as a contribution to equity, provided the amounts are held continuously in cash, cash equivalents, or short-term debt instruments with a maturity less than 18 months. The exclusion is available for up to six months, which usually overlaps one of the QOF’s semi-annual testing dates.

If they have not done so already, QOFs that raised capital in the second half of 2022 may need to deploy that capital into qualified property by June 30, 2023, the first testing date of the 2023 calendar year. Those funds were likely excluded on the December 31, 2022 testing date under the “six-month rule,” but failing to acquire qualified property by June 30, 2023 may cause the QOF to incur substantial penalties since a failure on the first testing date can cause the QOF to fail its annual 90% test even if it passes the second testing date. As June 30 approaches later this month, QOFs should take action and be proactive in assessing compliance with the 90% investment test.

Sponsors May Have Additional Time to Spend Working Capital

The working capital safe harbor provisions in the OZ regulations offer project sponsors the time and flexibility to spend their equity sources on costs which have been specifically designated in writing. Since early 2022, inflation and interest rates have caused many concerns for OZ projects under development or in construction. The IRS has not issued any relief (nor are they expected to do so) extending the time for project delays caused by these economic uncertainties. As a result, OZ project sponsors may be experiencing compression in their original development timelines.

In general, working capital assets must be spent within 31 months of when those funds are received by a qualified opportunity zone business (QOZB). However, the regulations also provide relief for a QOZB located within a federally declared disaster area, providing an affected QOZB up to an additional 24 months to spend its working capital assets. During 2022 and early 2023, several disaster areas were declared due to extreme weather conditions, including those in the southeast, in the west, and several others. The IRS releases specific guidance for each individual disaster declaration, and a comprehensive list can be found here. Not all disaster areas qualify for the relief and extension of time, but OZ project sponsors should review the location of their QOZB relative to any of the federally declared disaster areas and consider if relief applies.

CLA’s opportunity zone working group can help you navigate the questions that arise in the course of your OZ investment and project planning cycle.