WHAT HAPPENS WHEN YOUR QOF FAILS TO FIND A SUITABLE INVESTMENT ?
87 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 .
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 .
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 days1 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 liquidationreincorporation 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
OPPORTUNITYZONE . COM