United States: New QOZ amendments area mixed bag, giving both clarification and ambiguity

In brief

On 5 August 2021, the IRS published a second set of amendments to the Final QOZ Regulations that apply retroactively.  These amendments contain a favorable provision regarding the ability of “start-up businesses” to acquire qualifying property under a safe harbor. A disconnect between the Preamble and the amendments may continue to pose difficulties for entities that intend to rely on the Final Regulation’s working capital safe harbor (WCSH) provisions, however.



Introduced as part of the Tax Cuts and Jobs Act of 2017, the federal qualified opportunity zone (QOZ) program is designed to provide tax incentives to encourage long-term investments in certain economically distressed communities.

Investors that satisfy the numerous requirements of the QOZ program enjoy several tax benefits, including (i) deferral of recognition on eligible capital gain that is invested in a QOZ project, (ii) a potential time-limited write-off of an amount of invested eligible capital gain, and (iii) write-off of the post-investment appreciation in value of the investment, if the investment is held for at least ten years.  Final Treasury Regulations under the QOZ program were originally published in January 2020 ("Final Regulations").  On 1 April 2020, the Internal Revenue Service (IRS) published a first set of corrective amendments to the Final Regulations ("2020 Corrections").  Recently, on 5 August 2021, the IRS also published a second set of amendments to the Final Regulations ("New QOZ Amendments") which will be retroactively applicable on and after 13 January 2020.

The New QOZ Amendments also amended and restated certain parts of the preambles to the Final Regulations ("Preamble"). Although the New QOZ Amendments contain a favorable provision regarding the ability of “start-up businesses” to acquire qualifying property under a safe harbor, a disconnect between the Preamble and provisions of the The New QOZ Amendments also amended and restated certain parts of the preambles to the Final Regulations ("Preamble"). Although the New QOZ Amendments contain a favorable provision regarding the ability of “start-up businesses” to acquire qualifying property under a safe harbor, a disconnect between the Preamble and provisions of the New QOZ Amendments may continue to pose difficulties for entities that intend to rely on the Final Regulation’s working capital safe harbor (WCSH) provisions.

The New QOZ Amendments

As an initial matter, one simple change was made by the New QOZ Amendments on how a qualified opportunity fund (QOF) may voluntarily decertify itself as such. The QOZ rules essentially state the same: the IRS will provide guidance regarding the form and manner in which a QOF may decertify.  Although the IRS previously issued draft instructions regarding QOF decertification, these instructions were not included in the final revised IRS Form 8996.  Accordingly, as of the publication of the New QOZ Amendments, no final guidance has yet been published on this point.

In addition, clarification was provided with regard to the WCSH and property acquired thereunder.  As a general matter, a QOF must structure its investments such that at least 90% of its total assets are considered as “qualified opportunity zone property” ("QOZ Property"), with detailed QOZ rules providing what may constitute QOZ Property.  The statutory scheme of the QOZ rules generally favor the use of a lower-tier entity to help a QOF meet this investment standard, which entity is called a “qualified opportunity zone business” (QOZB).  A QOZB is subject to several requirements to qualify as such, one of which is that the QOZB is restricted from holding more than 5% of its assets in the form of cash and other cash-like assets, referred to as “nonqualified financial property” (NQFP). However, the WCSH provisions provide that a QOZB may hold an amount of NQFP over this 5% threshold if the QOZB has a written plan that sufficiently describes how such capital will be held and used to eventually acquire qualifying property or be deployed in the QOZB’s line of business. The New QOZ Amendments provide that tangible property purchased, leased, or improved with working capital in accordance with the taxpayer’s WCSH plan is treated as “good” property during the WCSH period. In practice, this means that a QOZB can timely use working capital to acquire and hold assets in accordance with its WCSH plan and treat property so acquired as “good” property during the WCSH period.

The third and final change set forth in the New QOZ Amendments relates to the WCSH’s application to QOZB qualification.  Under the New QOZ Amendments, the relevant QOZ provision now reads that “start-up businesses” (and only “start-up businesses”, which itself is a term that is not defined) can utilize the WCSH to temporarily shut off one of the required QOZB compliance tests; specifically, the “70% Asset Test”, which requires that at least 70% of the tangible property owned or leased by the QOZB must be “good” qualifying property.  This is a welcomed confirmation of the position many QOZBs and their advisors have taken under the Final Regulations and the 2020 Corrections.

The Disconnect

However, the Preamble accompanying the New QOZ Amendments adds confusion. Whereas the express language of the relevant QOZ provision seems to turn off the 70% Asset Test, the Preamble states that the 70% Asset Test is satisfied “with regard to such property.” But if the New QOZ Amendments amend the relevant QOZ provision to read as shutting off the 70% Asset Test entirely during the WCSH time period, it is unclear why the Preamble would provide that working capital could effectively be treated as a “good” asset for purposes of the 70% Asset Test. Treating working capital as “good” property in this limited instance implies that the 70% Asset test isnotturned off, because otherwise such clarification would serve no purpose. Accordingly, we read the New QOZ Amendments as creating a disconnect between the actual language of the QOZ provisions and the Preamble which seeks to explain them.

Why does this disconnect matter? QOZ projects that have been or will be structured based on the assumption that the WCSH turns off the 70% Asset Test during the period covered by a WCSH plan may now need to consider the possibility that this is not the case, adding a layer of uncertainty to their QOZ compliance.

To see how this may be an issue, consider a new entity that was formed after promulgation of the Final Regulations but prior to the New QOZ Amendments. Suppose that this entity intended to rely both on the WCSH to hold working capital and on the inapplicability of the 70% Asset Test during the time that the WCSH was to be in place. Based on these intentions, the QOZB initially acquired property treated as “bad” for purposes of the 70% Asset Test, but planned future transactions and operations such that the QOZB would satisfy the 70% Asset Test on or prior to the WCSH’s expiration. Assuming the QOZB’s plans come to fruition and other qualification tests are met, the QOZB should qualify as such at the end of the WCSH period with no penalties in the interim.

However, under the New QOZ Amendments, this plan may not work as intended. If the New QOZ Amendments function as implied the Preamble, such that the 70% Asset Test is not turned off and instead working capital qualifies only as “good” property, then the QOZB may have to hold enough working capital and “good” property to satisfy the 70% Asset Test. Considering the high potential value of the initially-acquired “bad” asset, this poses an issue in the timing of funds, loans, and improvements for a QOZB.

Practical Considerations

In light of the above ambiguity, QOF sponsors should consider the timing of their investments and whether any subsidiary QOZBs might be affected by the new potential applicability of the 70% Asset Test during the WCSH period. Although this could be a drafting oversight in the Preamble, QOF sponsors should seek advice on how to best prepare in the event that such changes are indeed intended.

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