Qualified Opportunity Zone Issues, Challenges and Other “Pain Points” for Investors and Developers by Arthur J. Lieberman
Posted on February 28, 2023
Opportunity funds are going into their sixth year since their 2018 launch. They got off to a slow start as the IRS struggled to issue guidance on the many statutory rules applicable to these funds while the states struggled to designate the areas eligible for qualified opportunity fund investments. Covid also became a challenge, causing the IRS to issue a number of administrative relief provisions to help these funds get off the ground without violating the newly issued rules. Now that these hiccups are behind us and these funds are moving forward with projects starting to come online, several issues, challenges and pain points have emerged.
Tax Benefits of Qualified Opportunity Funds
Qualified opportunity funds (QOFs) are organized to invest at least 90 percent of their assets in qualified opportunity zone property, including stock or ownership interests in qualified opportunity zone businesses (QOZBs). To qualify as QOFs, these investment vehicles must be structured as U.S. partnerships, corporations or LLCs that elect to be treated as partnerships or corporations for federal income tax purposes.
Under current law, qualifying investments into QOFs receive the following tax benefits:
- Deferral of tax on qualifying capital gains invested in a QOF until Dec. 31, 2026, and
- Elimination of capital gains tax on the sale of a QOF interest or the QOF’s sale of a Qualified Opportunity Zone Business held for at least 10 years.
This second point is really the main tax benefit of opportunity zone investing because it permanently eliminates the gain rather than deferring it. However, this benefit applies only if the investment actually appreciates in value over this time. This is why any opportunity zone investment must make economic sense before factoring in any tax savings.
Challenges and “Pain Points” for Investors and Developers
For investors, the main pain point of opportunity zone investing is the practical application of the 180-day period for reinvestment of qualified gains into a QOF.
As a general rule, taxpayers must start counting down the 180 days starting on the date they sell an asset and create the capital gain they intend to reinvest into a QOF. Each qualified gain realized starts a separate 180-day clock, which can make the application of the 180-day rule confusing when there are multiple gains recognized during the year.
Further complicating this is the flexibility afforded gains recognized through partnerships, S corporations, mutual funds and REITs. For calendar year partnerships and S corporations, a taxpayer has three options for when the 180-day clock starts: either the date the partnership or S corporation realizes the gain, December 31 of that year, or March 15 of the following year. For example, for gains flowing through partnerships or S corporations recognized in the last half of 2022, a taxpayer has until September 10, 2023 to make a qualifying QOF investment, which can occur more than a year from the date of the gain. For mutual funds and REITs, the 180-day clock starts on December 31, but a taxpayer can instead elect to start the clock on the date he or she receives a capital gain dividend.
It can get very complicated in a hurry. However, the good news is that with proper planning a taxpayer can make a qualifying investment into a QOF well into 2023 and have that reduce gains on his or her 2022 tax return. It is important for taxpayers to remember to extend their 2022 return if they want to make 2023 QOF investments after April 15 and apply them to their 2022 returns.
For developers, several pain points center around cash-management issues. Because of the 180-day rule applicable to investors, cash often shows up before it is needed in the business, which can cause tax problems for the QOF. When a QOF receives cash from an investor, a different clock starts ticking. A QOF cannot hold more than 10 percent of its assets in nonqualifying property on each semiannual testing date, and cash is considered a nonqualifying asset. The way the rules operate is to give the QOF between six and 12 months to deploy the cash into qualifying investments. A QOF cannot simply hold cash; therefore one problem developers have is deploying cash into a qualifying investment within the allotted timeframe. Oftentimes, cash is contributed to a QOF before the QOF has a deal lined up, which can put a lot of pressure on the developer to find a qualifying investment that makes economic sense.
Another cash-management issue concerns the QOZB subsidiaries of a QOF, which likewise cannot just hold cash. These subsidiaries are limited to 5 percent of their assets in cash and other financial assets, but a reasonable amount of working capital is excluded from this test. Most developers utilize the working capital safe harbor to exclude cash earmarked for construction, acquisition or rehab costs from the 5 percent test. This requires proper planning to draft and implement a working capital safe harbor plan.
Aside from cash, another issue for developers centers around the requirement to “double the basis” of an existing property purchased directly by a QOF or its QOZB subsidiary. For these kinds of investments, rehabilitation must be substantially completed within 30 months of purchase. Since land is excluded from the double the basis rule, this needs to be broken out of the total purchase price, preferably by an appraiser who values the land and building separately in their appraisal.
There are also challenges for developers who attempt a land assemblage within an opportunity zone. If a QOF purchases a vacant piece of land or razes an existing building, the double the basis rule does not apply. However, the 30-month rule to substantially commence a business still applies. For a QOF attempting a land assemblage with a long-term buildout, this puts pressure on the need to get started on development while the assemblage process is still underway. Planning is essential in these circumstances.
Opportunity Zones can offer investors and developers significant tax savings along with some unique challenges they can minimize and overcome with the guidance of experienced tax advisors.
About the Author: Arthur J. Lieberman is a director with the Tax Services practice of Berkowitz Pollack Brant Advisors + CPAs, where he works with real estate companies and closely held businesses on deal structuring, tax planning, tax research, tax controversies and compliance issues. He can be reached at the CPA firm’s Miami office at (305) 379-7000 or firstname.lastname@example.org.