Importance of Semiannual and Annual OZ Testing

Importance of Semiannual and Annual OZ Testing

Fund managers must ensure their qualified opportunity funds (“QOF”) meet the requirement that 90 percent of the QOF’s assets are held in qualified opportunity zone (“QOZ”) property.  Failure to meet the test can result in significant penalties to the QOF that can have a significant impact on the investment return to its investors. 

Opportunity Zones offer tax benefits to investors who elect to temporarily defer tax on capital gains if they timely invest the capital gains in a QOF.  Investors can defer tax on the invested gain amounts until there is an event that reduces or terminates the qualifying investment in the QOF (an “Inclusion Event”) or by December 31, 2026, whichever is earlier.  The length of time the investor holds a QOF investment determines the tax benefits they receive:

  • If the investor holds the QOF investment for at least five years, the basis of the QOF investment increases to 10 percent of the deferred gain.
  • If the investor holds the QOF investment for at least seven years, the basis of the QOF investment increases to 15 percent of the deferred gain.
  • If the investor holds the investment in the QOF for at least 10 years, the investor is eligible to elect to adjust the basis in the QOF investment to its fair market value on the date that the QOF investment is sold or exchanged.

Since capital gains that were deferred through the QOF investment must be recognized by 2026, the 10 percent and 15 percent basis increases discussed above are not applicable to new QOF investments, however, the remaining benefits are still applicable.

Whether a QOF holds at least 90 percent of its assets in QOZ property is determined based on the average of the percentage of QOZ property holds on two semiannual testing dates: the last day of the first six-month period of QOF’s tax year, and the last day of its tax year.  At the QOF level, the following are good assets for purposes of the 90 percent investment standard:

  • QOZ business property owned by the QOF;
  • An equity interest in an eligible entity classified as a partnership that meets the QOZ business requirements; and
  • An equity interest in an eligible entity classified as a corporation that meets the QOZ business requirements.

From both a statutory and regulatory perspective, the way in which the opportunity zone rules are drafted create a strong incentive for a two-tier structure where the QOF owns QOZ businesses instead of directly owning or leasing QOZ business property.  Some of the advantages include that QOZ businesses are able to hold unlimited amounts of intangible property as long as a substantial portion (40%) of that property is used in the active conduct of a trade or business in a QOZ while all intangibles at the QOF level are treated as bad assets; and the numeric test applicable to QOZ businesses is 70 percent and applies only to tangible personal property, whereas, a QOF must meet a higher 90 percent standard.

If a QOF fails to meet the 90 percent investment standard (“Investment Standard”) for a given taxable year and does not establish reasonable cause, the QOF is required to pay a monthly penalty for each month that it fails the standard.  The penalty is an amount equal to the product of: (1) the excess of the amount equal to 90% of its aggregate assets over the aggregate amount of QOZ property held by the QOF; and (2) the annualized applicable Internal Revenue Code (“IRC”) underpayment rate.  For example, lets assume 90% of the QOF’s aggregate assets is $10 million, the QOZ property is $4 million, and the underpayment rate is 3 percent, the monthly penalty for the QOF failing to meet the Investment Standard would be $15,000 or $180,000 annually. 

The testing can be completed under the Applicable Financial Statement (“AFS”) Method or the Alternate Valuation “(“AV”) Method.  It is important that the professionals who handle the compliance testing understand the differences between the AFS and AV method in order to select the best method.  This is even more important when the QOF or QOZ businesses have multiple locations with assets both inside and outside Opportunity Zones. 

To efficiently test for the semiannual Investment Standard and the annual 70 percent QOZ business test, the testing should be completed by both legal advisors who understand the technical requirements of the statutory and regulatory authority and CPAs who can efficiently implement the testing, which is how the testing is completed at Praestans.  Getting the testing wrong can result in both the loss of deferral of gain to the investors (not likely) and implication of penalties that reduce the returns to investors.

Praestans Global Advisors is neither a law firm nor a CPA firm.

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