Since coming into effect in January 2018, Subchapter Z of the US Tax Code—also known as the opportunity zone provisions—has enabled investors to pour billions of dollars into a broad array of businesses, from real estate development companies to tech startups. Investments in qualified opportunity funds (QOFs) offer a number of distinct tax benefits, not the least of which is reduced capital gains tax liability. But the rules governing these investments are quirky, perplexing and—in some cases—severely restrictive.
For an entity to be recognized as a qualified opportunity fund (QOF) it must self-certify as such and subject itself to the requirements of the “90% test.” Failure to do so or to satisfy the 90% test can lead to significant penalties. In this fifth of our series of articles on QOFs, we discuss in more depth the 90% test.
As mentioned in a previous article, for an entity to be a qualified opportunity fund (QOF) it must hold at least 90% of its assets in “qualified opportunity zone property” (QOZ property). This requirement we refer to as the 90% test.
QOZ property includes “qualified opportunity zone stock” (QOZ stock), “qualified opportunity zone partnership interests” (QOZ partnership interests) and “qualified opportunity zone business property” (QOZB property). In practice, the QOZ property of virtually all QOFs consists of solely QOZ stock or QOZ partnership interests. QOZ stock and QOZ partnership interests are defined as stock or interests in an entity that is a “qualified opportunity zone business” (QOZB). It is rare, although technically possible, for a QOF to directly hold QOZB property in satisfaction of the 90% test.
The QOF must self-certify as such and subject itself to the requirements of the 90% test. The QOF does so by filing IRS Form 8996 with its US federal income tax return. On the Form 8996, pursuant to the 90% test, the QOF must show that the average of the percentage of its property constituting QOZ property held on the last day of the first six-month period during the tax year and the last day of its taxable year is at least 90%. Typically, for a calendar year QOF, this means that the average of its QOZ property on June 30 and December 31 must satisfy the 90% test. The QOF must self-certify every year that it continues to satisfy the 90% test.
If the QOF owns the property versus leases that property, the QOF measures the value of each item of property it holds differently. If the QOF owns the property, the QOF may value such property either according to its financial statements if it prepares such statements in accordance with generally accepted accounting principles (GAAP) or by using the alternative method. If the QOF chooses to use the alternative method, then the QOF values the property that it owns based on its unadjusted cost basis if the QOF purchased or constructed the property for fair market value. Otherwise, the QOF must value such property based on its fair market value. Because the determination of the value of leased property is complex and because it would be unusual for a QOF to hold leased property, we leave the discussion of the valuation of leased property to a future article.
The Special Case of the First Year
In a QOF’s first year of existence, unless the QOF is formed and chooses to self-certify in January, it may have a slightly different set of testing dates for purposes of the 90% test. For example, if the QOF were formed in February, the first six-month period would begin no earlier than February and would end on July 31. If the QOF is not formed until July (or later) in its first tax year, there will be no separate testing date relating to the first six-month period at all, and instead only the assets of the QOF held on the last day of the tax year will be measured.
A QOF may ignore recently contributed property when measuring its assets for purposes of the 90% test. Specifically, if a QOF receives a contribution of property and within five business days reduces that property to cash, cash equivalents, or a debt instrument with a term of 18 months or less (short-term debt), then the QOF may exclude such property entirely from the ratio used to measure compliance with the 90% test on its next testing date. This, combined with the first-year rule described above, means that a new QOF could be formed and fully funded with cash on July 1 of a given year and not need to invest that cash in any QOZP until June 30 of the following year.
Disposing of QOZP and Reinvesting
A QOF that disposes of QOZ property for cash or that receives a distribution of cash from a QOZB risks being noncompliant with the 90% test if the QOF continues to hold that cash on a testing date. To remedy this issue, the regulations permit a QOF that receives cash as a return of capital or on the sale or disposition of QOZ property, to treat the proceeds as QOZ property for purposes of the 90% test so long as the QOF reinvests the proceeds in replacement QOZ property within 12 months of receipt. Until the QOF reinvests the proceeds in replacement QOZ property, the QOF must hold the proceeds in cash, cash equivalents or short-term debt. The 12-month reinvestment window is tolled for delay due to government action (e.g., permitting, zoning, etc), and if a federally declared disaster (e.g., global pandemic) causes a delay, the QOF can extend the 12-month window by an additional 12 months.
Failure to Satisfy the 90% test
Generally, should a QOF fail to satisfy the 90% test, the QOF must pay a penalty for each month of the failure. This penalty is equal to the amount by which the QOF’s actual QOZ property falls short of the required 90% multiplied with the underpayment of tax rate for that month. This rate is the short-term AFR plus 3%.
If the QOF is a partnership, the penalty is taken into account proportionately as part of the distributive share of each partner (including even partners who may not have invested eligible gain). However, if the QOF had reasonable cause for its failure, the penalty is waived.
Click here for the previous article in the series: Basics of QOF Investing: What Is a QOZB?
View all articles in the Qualified Opportunity Funds OTS Series.