With the issuance of Notice 2020-39 (the Notice), the Internal Revenue Service (IRS) has provided relief for Qualified Opportunity Zone Funds (QOFs) and for investors in QOFs. While the relief provided in the Notice does not solve every challenge for QOFs and investors during the pandemic, investors and sponsors alike should warmly receive the specific relief. The relief effectively softens some of the most significant constraints imposed by the qualified opportunity zone (QOZ) rules on QOFs and investors during the pandemic and should provide comfort to newly launched QOFs seeking to comply with the applicable tax requirements while offering more opportunities for investors to invest in QOFs.
Relief for Investors: Increased Availability of Eligible Gains. One of the consequences of the coronavirus (COVID-19) pandemic was that there was an extensive selloff during the month of March, which undoubtedly caused many investors to see a decline in the value of their investments. Many investors, however, will also have realized a capital gain on any stock sold during that time. Investors must have capital gains in order to take advantage of the benefits available to taxpayers under the QOZ rules; those who were taken by surprise by an unexpected selloff of their capital assets may take comfort in the fact that they are now eligible to defer (and potentially reduce such gains) by timely reinvesting those gains in a QOZ. In addition, if those investors hold their QOZ investments for at least 10 years, they may be eligible to take any appreciation on that investment completely tax-free. Pursuant to the Notice, and subject to certain exceptions, an investor may still be eligible to invest their capital gains in a QOF regardless of the fact that they are in a net loss position for the year.
Extended Deadline for Investing Eligible Gains. Ordinarily, taxpayers have 180 days from the date of the sale or exchange generating capital gain to invest such gain in a QOF and receive the associated QOZ tax benefits. In response to the pandemic the IRS first issued Notice 2020-23, which extended the due date for many tax filings including the 180-day period requirement for QOZ Investors to reinvest eligible gains into a QOF. Under the recently issued Notice 2020-39, the IRS has further extended the deadline for taxpayers whose 180-day period was set to expire on or after April 1, 2020 and before December 31, 2020. The deadline has now automatically been extended to December 31, 2020 such that if the taxpayer’s deadline falls in between those two dates, the taxpayer’s last day of its 180-day period is deemed to occur on December 31, 2020. This welcome relief will give investors a much longer time to identify suitable QOZ investments for their eligible gains and the automatic nature of the extension should facilitate more investments. Note, however, a taxpayer is still required to make a valid deferral election by filing IRS Forms 8949 and 8997 with a timely filed (including extensions) or amended federal income tax return for the year in which the gain should have been recognized had the investor not invested in a QOF.
Relief for QOFs. The Notice also provides significant relief affecting the formation and ongoing operation of QOFs making it much easier to comply with the rules during the pandemic emergency.
Additional Observations on the Notice. The Notice’s relief and extensions should provide investors, QOFs, and QOZBs with additional time to identify investments, to complete QOZ projects, and invest in QOZBs. Accordingly, as we have observed from our practice, we are continuing to see strong support for the QOZ program despite the immediate challenges raised by the pandemic as the program is designed for investors with a long-term investment horizon.
While we expect the IRS to be fair to QOFs and QOZBs who can demonstrate reasonable cause and substantial compliance with the applicable limitations during the pandemic crisis, participants need to continue to be diligent in documenting compliance under the QOZ rules. For example, because a QOF’s satisfaction of the 90% asset test will often depend upon the qualification of QOZB subsidiaries, a QOF will want to ensure that any QOZBs in which it invests are keeping proper records as well. Thus, it is critical to document everything and anything that may affect a QOF’s ability to qualify as a QOF, including at the QOZB-level, if applicable. For example, consider a QOF that will fail the 90% asset test if its subsidiary does not qualify as a QOZB. If that QOZB is unable to meet the 70% threshold for tangible property because the shipping of materials to the QOZB has been delayed because of the pandemic, any QOFs invested in that QOZB should continue to document these events to demonstrate reasonable cause, especially if the problem will continue beyond the applicable relief provided by the Notice.
Additional Legislative Relief Possible. The QOZ program has generally received bipartisan support in the houses of Congress, and while there can be no certainty, it is possible that we may see more legislation issued in order to promote and encourage the program. An example of such promising legislation is HR 6529, which was introduced in the House of Representatives on April 17, 2020. The bill, if passed, would greatly expand the number of businesses that could qualify as QOZBs by including certain “qualified small businesses.” A qualified small business is one with gross revenues below $1 million and which has experienced supply chain disruptions, staffing challenges, decrease in sales or customers, or partial or full suspension of business as a result of the pandemic. The bill, if passed, would greatly increase the availability of good assets (e.g., QOZBs) for QOFs to invest in, making it easier for such funds to satisfy the 90% asset test.
Participants in the QOZ program should consult their tax advisors regarding the relief provided by Notice 2020-39.
For our clients, we have formed a multidisciplinary Coronavirus COVID-19 Task Force to help guide you through the broad scope of legal issues brought on by this public health challenge. Find resources on how to cope with the post-pandemic reality on our NOW. NORMAL. NEXT. page and our COVID-19 page to help keep you on top of developments as they unfold. If you would like to receive a daily digest of all new updates to the page, please subscribe now to receive our COVID-19 alerts, and download our biweekly COVID-19 Legal Issue Compendium.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:
Richard C. LaFalce