On June 4, 2020, Treasury and the Internal Revenue Service issued Notice 2020-39 to provide relief to investors and OZ funds due to the COVID-19. The change came in response to many OZ working groups as well as members of congress requesting a number of changes to certain timing and other requirements to address the effect of the COVID-19 crisis on OZ investments and transactions.
The notice offers relief under Section 7508A of the Internal Revenue Code, which provides the Secretary of the Treasury with the ability to postpone the time for performing certain acts for up to one year under the Internal Revenue Laws for taxpayers determined to be affected by a federally declared disaster.
On March 13, 2020, the president issued an emergency declaration under the Stafford Act instructing the secretary of treasury to provide relief under Code Section 7508A from tax deadlines as a result of the COVID-19 crisis. Subsequently, all 50 states, the District of Columbia, and 5 territories were issued major disaster declarations, establishing the existence of major disasters beginning on Jan. 20, 2020 in each one of these jurisdictions, which includes every OZ.
With respect to the OZ incentive, the notice provides extensions and postponements of some critical deadlines in 2020 as follows:
INVESTORS - EXTENSION OF 180-DAY INVESTMENT PERIOD
Background: In order to elect to defer some or all of a taxpayer’s eligible gains resulting from the sale or exchange of property with an unrelated person for federal income tax purposes, a taxpayer must invest and acquire a qualifying investment in a qualified opportunity fund (a QOF) during the 180-day period beginning on the date of which the gain would be recognized for federal income tax purposes (i.e. the date of the taxable sale or exchange).
However, taxpayers who are equity holders of pass-through entities are provided three different dates for commencement of their 180-day investment period, one of which provides that the 180-day investment period can commence on the date that the federal income tax return is due (without extensions) for the pass-through entity for the taxable year in which the taxable sale or exchange occurs. This means that, in the event that a calendar year pass-through entity generated an eligible gain in 2019, a taxpayer who is allocated such gain, can use March 15, 2020, as the latest date to commence the 180-day investment period. The taxpayer could also use Dec. 31, 2019, or the date of the taxable sale by the passthrough entity to start the 180-day investment period. Note that this assumes that the pass-through entity will not invest directly in the QOF with respect to such gain.
The Notice: The notice provides that the last date for a taxpayer to make an investment in a QOF is extended to Dec. 31, 2020, where the taxpayer’s 180-day investment period has ended or will end between April 1, 2020, and before Dec. 31, 2020. The following are a couple of illustrations where the taxpayer has until Dec. 31, 2020, to invest in a QOF with respect to an eligible gain created in 2019:
Taxpayer directly sells an asset on or after Oct. 4, 2019, generating an eligible gain; and
Taxpayer is allocated an eligible gain on Dec. 31, 2019, from a calendar year pass-through entity that sold an asset and generated the eligible gain in 2019.
QOFs - MORE TIME FOR THE QOF TO HOLD CASH BEFORE INVESTING IN A QOZB
Background: A QOF is required to hold at least 90% of its assets in qualified opportunity zone property (QOZP). Failure to satisfy the 90% requirement can result in a penalty on the QOF for each month of such failure. The 90% requirement is determined by taking the average of the percentage of QOZP held by the QOF, as measured on the last day of the first six-month period of the taxable year of the QOF, and on the last day of the taxable year of the QOF. However, no penalty shall be imposed with respect to a failure to satisfy the 90% requirement where it is shown that such failure is due to reasonable cause.
Generally, an equity interest acquired by the original issuance for cash by the QOF in a domestic entity treated as a corporation or a partnership for federal income tax purposes that satisfies the requirements to be qualified opportunity zone business (QOZB) is considered to be QOZP. Cash held by a QOF is not treated as QOZP. However, a QOF can disregard cash contributed to the QOF not more than 6 months before the testing date for the 90% requirement. This means that QOFs generally have a limited period of time to convert any contributed cash into equity in an entity that is an QOZB under the 90% requirement. Accordingly, a newly formed calendar year QOF that received investments from taxpayers during December 2019 is required to contribute at least 90% of such cash into equity in a QOZB on or before its June 30, 2020 testing date in order to avoid a penalty.
The Notice: The notice provides that, in the case of any QOF whose 90% semi-annual testing dates fall between April 1, 2020 and Dec. 31, 2020, any failures by the QOF to satisfy the related 90% requirement shall be treated as due to reasonable cause and shall be disregarded. This means that a calendar year QOF would not be subject to a penalty because it failed its June 30, 2020, and Dec. 31, 2020 testing dates as a result of not converting a sufficient amount of invested cash received in December 2019 to equity in a QOZB. This change is a significant development since many taxpayers invested cash into QOFs in December 2019 in order to obtain the 15% partial exclusion with respect to their qualifying investment.
Notable Comments: It should be noted that this provision in the notice has a broader application than as described above. A number of letters sent to Treasury and the IRS requested changes to the situs requirement for the 50% gross income test for QOZBs. Under the 50% gross income test, at least 50% of the total gross income of a non-real estate QOZB must be derived from the active conduct of a trade or business of such entity in the OZ (or in multiple OZs).
The regulations provide three safe harbors for a QOZB to satisfy the 50% gross income test. Two of these safe harbors require 50% or more of the services for the QOZB to be performed in an OZ based upon either actual hours performed, or amounts paid for such performed services. This could be difficult to satisfy when employees are required to work remotely outside of an OZ as a result of the COVID-19 crisis. Because of the notice, any failure of a QOZB to satisfy the 50% gross income test thereby resulting in a failure by the QOF to satisfy the 90% requirement on testing dates occurring between April 1, 2020 and Dec. 31, 2020 should not subject the QOF to a penalty.
TOLLING OF THE 30-MONTH SUBSTANTIAL IMPROVEMENT PERIOD
Background: One of the numerous requirements for an entity to be considered as a QOZB is that the entity needs to be engaged in a trade or business in which at least 70% of its tangible property, owned or leased, by such entity is qualified opportunity zone business property (OZBP). OZBP is tangible property used in a trade or business of the QOZB that was acquired by the QOZB by purchase from an unrelated person after Dec. 31, 2017. Also, either the original use of such tangible property in the OZ must commence with the QOZB, or the QOZB must “substantially improve” the tangible property. Note that tangible property could also be considered to be OZBP where it is leased by the QOZB when certain requirements are met.
The original use of tangible property in an OZ starts on the date any person first places the property in service in an OZ for depreciation purposes (or first uses it in a manner that would allow depreciation or amortization if that person were the property’s owner). Used tangible property acquired by purchase by the QOZB can satisfy the original use requirement as long as the property was not previously used or placed in service in the OZ. If the tangible property had been used or placed in service in the OZ before it was acquired by purchase by the QOZB, then the property must satisfy the substantial improvement requirement. The substantial improvement requirement provides that, during any 30-month period commencing after the acquisition date of the tangible property, additions to the income tax basis with respect to such property in the hands of the QOZB exceed an amount equal to the adjusted income tax basis of such property at the beginning of the 30-month period in the hands of the QOZB.
The Notice: The notice provides that the 30-month period to substantially improve tangible property is tolled for the period that begins on April 1, 2020 and ends on Dec. 31, 2020. To the extent that a QOZB has acquired tangible property prior to Dec. 31, 2020 and cannot meet the original use requirement (such as acquiring an occupied building located in an OZ), the period of time commencing on the later of the acquisition date, or April 1, 2020, and ending on Dec. 31, 2020, will not count against the 30-month substantial improvement period.
AUTOMATIC ADDITIONAL 24 MONTHS FOR WORKING CAPITAL EXPENDITURES
Background: Another requirement for an entity to be considered a QOZB is that no more than 5% of the average of the aggregate unadjusted tax bases of the property of the business can be attributable to nonqualified financial property (NQFP). NQFP refers to cash and certain other assets but does not include reasonable amounts of working capital held in cash, cash equivalents, or debt instruments with a term of 18 months or less (collectively, Working Capital Assets), and certain other items.
The regulations provide a safe harbor for determining whether Working Capital Assets are considered to be reasonable working capital. Specifically, the working capital safe harbor provides that Working Capital Assets (i.e. cash, cash equivalents, or debt instruments with a term of eighteen (18) months or less) can be treated as reasonable working capital when the following requirements are satisfied:
The amounts are designated in a writing that identifies the Working Capital Assets being held for the development of a trade or business in an OZ, including when appropriate, the acquisition, construction, and/or substantial improvement of tangible property in an OZ;
There is a written schedule consistent with the ordinary start-up of a trade or business for the expenditure of such assets and the schedule demonstrates that such Working Capital Assets will be spent within 31 months of receipt by the business (the Working Capital Safe Harbor Period); and
The Working Capital Assets are actually used in a manner that is substantially consistent with the above-mentioned written designation and the written schedule (collectively, the Working Capital Plan).
Additional 31-month Working Capital Safe Harbor Periods can be obtained for subsequent infusions of Working Capital Assets for an overall period of 62 months from the date of the original infusion of Working Capital Assets, but each infusion needs to separately satisfy the working capital safe harbor provisions. If the QOZB is located within a federally declared disaster area, the QOZB may receive not more than an additional 24 months to consume its Working Capital Assets, as long as it satisfies the working capital safe harbor provisions.
The Notice: It was not clear in the regulations whether obtaining the additional 24 months to the Working Capital Safe Harbor Period was automatic. The notice confirmed that the Working Capital Safe Harbor Period is extended by an additional 24 months for QOZBs located in a federally declared disaster area and holding Working Capital Assets intended to be covered by the working capital safe harbor before Dec. 31, 2020, as long as the working capital safe harbor provisions are otherwise satisfied by the QOZB. For example, it is possible for a QOF that makes a cash contribution to a QOZB on Dec. 30, 2020, to have a Working Capital Plan that expends such cash over a 55-month period. This is also helpful in a situation where a QOZB is currently holding cash subject to a Working Capital Plan. In such a case, the QOZB is able to expend those proceeds over an additional 24-month period.
It appears possible to extend the aggregate duration of the Working Capital Safe Harbor Periods up to an overall period of 86 months. The regulations allow for additional 31-month Working Capital Safe Harbor Periods for each subsequent infusion of Working Capital Assets to the extent that the aggregate duration of all of the Working Capital Safe Harbor Periods do not exceed 62 months from the date of the first infusion of cash. The regulations provide that each single infusion needs to independently satisfy the working capital safe harbor provisions. Accordingly, a subsequent infusion of cash to the QOZB occurring no later than the end of the 55-month period (taking into account a previous infusion of cash that obtained the additional 24-months under the notice) and subject to a Working Capital Plan could extend the aggregate Working Capital Safe Harbor Periods by an additional 31 months (and beyond the 55-month period).
Notable Comments: One requested change that does not appear to be addressed relates to the ability to amend or modify Working Capital Plans that were created prior to the COVID-19 crisis. Many investors that had eligible gains allocated to them by pass-through entities on Dec. 31, 2018 invested in QOFs in June 2019 (prior to the end of their 180-day investment period). Those QOFs were required to invest such proceeds in QOZBs no later than Dec. 31, 2019 and such investments required Working Capital Plans. As a result of the COVID-19 crisis, some of these Working Capital Plans can no longer be fulfilled. For example, a Working Capital Plan may have designated an amount of Working Capital Assets for the construction of a hotel project at a certain address in an OZ. The financing for this hotel project may no longer be available and the QOZB may want to amend the Working Capital Plan to change the project to the construction of a multifamily building. The notice does not appear to address this issue.
THE REINVESTMENT PERIOD FOR THE QOF EXTENDED 12 MONTHS
Background: If a QOF receives cash proceeds from the return of capital or the sale or disposition of some or all of its OZP and the QOF reinvests some or all of such proceeds in OZP by the last day of the 12-month period beginning on the date of the distribution, sale, or disposition, then the proceeds, to the extent that they are so reinvested, are treated as OZP for purposes of the 90% requirement. This prevents the QOF from incurring penalty for holding such cash on the QOF testing dates for the 90% requirements during these 12 months. However, the QOF must continuously hold the proceeds in cash, cash equivalents, or debt instruments with a term of 18 months or less. If the reinvestment is delayed as a result of a Federally declared disaster, then the QOF may receive up to an additional 12 months to reinvest such proceeds as long as the QOF invests such proceeds in the manner originally intended before the disaster.
The Notice: The notice provides that a QOF’s 12-month reinvestment period (to reinvest in QOZP) for the proceeds from the QOF’s sale or disposition of QOZP or a redemption of qualified opportunity zone stock is extended by an additional 12 months where the original 12-month reinvestment period included Jan. 20, 2020, as long as the proceeds are invested in a manner originally intended by the QOF prior to Jan. 20, 2020.
This provision has limited applicability. This is due to the fact that the QOF needed to be in the 12-month reinvestment period on Jan. 20, 2020 in order to receive the additional 12 months described above.
This notice has been welcomed by the OZ industry. As we continue to deal with the COVID-19 health crisis, federal income tax incentives for businesses will likely be necessary for economic recovery efforts. The OZ incentive could be a critical economic and community development tool to assist in these efforts by incentivizing equity investments for real estate projects and operating businesses. This notice may be a first step in these efforts.