The IRS issued “corrections” to the final Opportunity Zone regulations (the “Final Regulations”) on August 5, 2021, addressing two specific areas:

1) the decertification of QOFs (the “First Correction”), and

2) the proper application of the Working Capital Safe Harbor (WCSH) and, in particular, rules governing the 70% tangible property test (the “Second Correction”).

We offered our initial thoughts on these two corrections in the Opportunity Zone Magazine article “The Quiet Corrections.” However, both corrections continue to be extremely interesting – and crucially important in structuring a successful QOF/QOZB investment. This article offers our additional insights on the important – and almost entirely undefined – process of decertification. 

“Throwing in the towel” for a Qualified Opportunity Fund

Many taxpayers who recognized capital gain in 2018 through 2020 dropped that gain into their own “home baked” private Qualified Opportunity Fund (QOF) with the expectation that investing that money would prove to be relatively easy. Wrong-O. First of all, everyone learned that because of the 90% Investment Standard (90% Test) it was relatively difficult to create and operate a successful business at the QOF level. Likewise, creating a successful Qualified Opportunity Zone Business in an attractive OZ location proved to be more daunting than many imagined. Now that the COVID extension rules have come to an end, these taxpayers are trying to decide whether to continue looking for a good investment – or simply throw in the towel and recognize the gain.

The First Correction addressed the decertification of QOFs and was implemented as a case of “addition by subtraction.” The First Correction chopped out an entire subparagraph from the then-existing regulations, because the IRS is still trying to figure out the decertification process and wanted to eliminate language that would have tied their hands and limited their options. 

However, while waiting for further guidance from the IRS, the 2021 year has come to an end and a significant number of private QOFs are facing the tough decision of whether to liquidate. This process – whether you call it termination, liquidation, or decertification – should result in an “inclusion” event triggering the recognition of the capital gain that the taxpayer elected to defer when the QOF was first established. We refer to this type of gain in this article as “decertification gain.”

Can I reinvest the gain into another QOF or QOZB?

Can the taxpayer take that decertification gain and invest it timely into a new private QOF – thereby doing an end run around the penalties that would otherwise be applicable to the prior QOF? We think probably not – anticipating that the IRS might well apply liquidation-reincorporation principles to treat the “new” QOF as a continuation of the “old” QOF, with corresponding penalties. The IRS might also see the entire scheme as abusive, and disallow the deferral of the original gain, causing tax to be due (with interest and penalties) retroactive to the original year of recognition. 

But a different conclusion might be appropriate if the taxpayer invests that decertification gain into a large sponsored QOF that in turn drops the invested funds into a viable QOZB project. Note that the original QOF cannot invest its funds into the larger QOF: QOF investments into another QOF are expressly banned by the statute. The QOF is allowed under the regulations to “merge” into the larger existing QOF – except that the large QOF probably does not want a merger that leaves it potentially on the hook for the unknown liabilities of the small private QOF. The larger QOF, if interested at all, might instead allow the small private QOF to invest directly into its one (or more) QOZB entities, and keep the QOF risk pools separated. 

However, given that a merger or a direct investment into a QOZB would be mechanically permissible, it seems that from a policy standpoint it may be appropriate to let the private QOF trigger an inclusion event and then allow the taxpayer 180 days [1] in which to rollover the decertification gain by investing in the larger QOF. So long as that larger QOF has a material difference in the number of members (i.e., the arrangement does not look like a conventional liquidation-reincorporation transaction) there does not seem to be any policy reason to prohibit this transaction. However, there is currently no clear or explicit guidance on this idea of “reinvesting” decertification gain – and it may require a change in the regulations that is unlikely to occur given the other tax discussions taking place in Washington, DC at this time. 

What happens if a QOF fails the 90% test?

A somewhat different issue arises if a QOF (post-Covid extensions) takes in funds and then is tested for purposes of the 90% Test and fails because of difficulty in locating a suitable investment. A variation would be if the QOF sets up a QOZB and the QOZB, in turn, finds at some later point in time that it cannot credibly continue to implement its original business plan. In both cases the taxpayer may begin facing penalties under the 90% Test. A question is whether the taxpayer should be eligible to request a waiver of the penalty for “reasonable cause” by showing diligent good faith efforts to meet investment deadlines.

For example, if a taxpayer invests eligible capital gain into a private QOF on January 1, 2022, the taxpayer gets a “free pass” for the first six-month period because cash invested during that period is disregarded, but then “fails” the 90% Test if it remains in cash during the full second six-month period to December 31, 2022.  But if the taxpayer is diligently seeking investments and invests in an unrelated QOZB project in April 2023, the IRS might be persuaded to view this as a “reasonable cause” situation if the taxpayer can demonstrate diligent, reasonable efforts to locate and invest in a QOZB. The taxpayer’s ultimate success in this endeavor coupled with workmanlike efforts to invest in an eligible Opportunity Zone may justify a finding of “reasonable cause.”

What if a QOF fails and there is no “reasonable cause”?

At the other extreme is a taxpayer who puts money into a QOF and then does absolutely nothing to try and find a viable investment or business activity. It could be that a true “bad faith” investment would not even qualify as an eligible investment of gain triggering deferral but note that the 90% Test takes effect so quickly that there is really no need to spend too much time on those situations – the penalty is expensive and will kick in no later than the second year, so bad faith investments will either terminate quickly or bear painful penalties. 

An interesting thought exercise is to look at what the IRS pulled back in the First Correction and try and figure out what they think they did wrong the first time. The excised language generally provided binding mechanisms for decertifying QOFs, and a plausible explanation is that the IRS was trying to provide the Service greater flexibility in addressing the decertification process. The IRS may have been concerned about unintended consequences from allowing taxpayers to decertify themselves without formal decertification action by the IRS.

All of this points to the fact that some QOFs are holding funds, or holding investments in QOZBs, that may not be successful, and the question facing taxpayers with an impending testing date under the 90% Test is whether to stand pat or throw in the towel. For the reasons articulated above, taxpayers acting in good faith should probably be allowed either to redirect the decertification gain into a new QOF or argue for additional time, under the “reasonable cause” standard, to make eligible investments without incurring penalties.

On the other hand, we anticipate that the IRS will have little or no sympathy for projects that never got implemented and where invested funds simply sat in a bank account. In those cases, it may make sense to throw in the towel and recognize the gain – before the IRS throws the book at you.



 
[1] Arguably this should be simultaneous rather than with a new 180-day window for investment. If the investor knew the QOF was going to fail and found a way to resolve before the inclusion event, then the low-income community (LIC) was not harmed. Money was invested timely, just not in the manner expected. No harm no foul. When the new 180-day window is granted, the LIC is harmed to the extent that the investment in the community is delayed for an additional 6 months. That would be the policy reason to prohibit the transaction if a new 180-day window is allowed.
 

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