The Essential Guide to Opportunity Zone Compliance
April 29, 2022 •Jonathan Ewert, CapZone Impact Investments
With contributions by Auyon Rahman of Summit Consulting
This is the first in a series of four posts in collaboration with CapZone Impact Investments discussing Opportunity Zone (OZ) updates in 2022. As the program develops, so does scrutiny on OZ investors. In this post, we review the watchdog report by the Treasury Inspector General for Tax Administration, which zeros in on inaccurate or inconsistent filings by OZ taxpayers.
As part of the Tax Cuts and Jobs Act enacted in 2017, geographical areas for capital investment were identified throughout the U.S., which allowed investors to receive tax incentives in return for making investments in real estate and business property. These are called Qualified Opportunity Zones (QOZs), and the purpose of the tax incentive is to encourage the creation of jobs and economic growth in low-income communities.
There are now more than 8,700 OZs in both rural and urban areas, with 35 million residents, 7.5 million of which live below the poverty line. According to the accounting firm Novogradac, the Qualified Opportunity Funds they track raised almost $7 billion in equity in the second quarter of 2021 alone.
How Do Investors Take Advantage of Qualified Opportunity Funds?
To invest in designated OZs, investors must place eligible capital gains into a Qualified Opportunity Fund (QOF) within 180 days of realizing these gains from the sale of stocks, bonds, real estate, or a private business in exchange for cash. Presently, the incentive is intended to continue until the end of 2026.
While these investment vehicles can be a win-win for all concerned, they come with vital legal reporting requirements. In addition, any QOF must file as a partnership or corporation and must invest at least 90% of its assets in an OZ or risk being disqualified from the program and subject to a penalty. Yet to date, a recent report regarding OZ tax noncompliance issued by the Treasury Inspector General for Tax Administration (TIGTA) demonstrated that the Internal Revenue Service (IRS) does not have a complete process to accurately identify QOFs that do not meet key program requirements.
As of December 31, 2020, an analysis of IRS tax records by TIGTA evaluated 6,198 QOFs with total assets of nearly $26.9 billion in the 2020 tax year. Although the TIGTA report is heavily redacted, 28.8% of QOF tax filings reported potentially inaccurate investment information. (The IRS does not transcribe all key data fields from paper-filed Forms 8996 and 8997, and TIGTA based their analysis primarily on e-filed Forms 8996 and 8997. For the 2019 tax year, 13.9% of Forms 8996 and 13.6% of Forms 8997 were paper-filed.)
Furthermore, despite clear and unmistakable regulations that a QOF cannot invest in another QOF, the TIGTA report found that almost $13 billion was invested by QOFs into other QOFs, including $585 million worth of investments that QOFs made in themselves.
In light of the TIGTA report, IRS management is designing an Opportunity Zone Compliance Plan to include post-filing compliance processes to review similar QOFs and investor noncompliance. The IRS stated that its Office of Chief Counsel has received recommendations to address QOFs that intentionally do not comply with program requirements.
What Are the Mandatory Reporting Requirements of a QOF?
There are three required IRS forms to be filed disclosing OZ investments alongside a taxpayer’s regular returns. The first two are for individual investors, and the third is for a QOF’s directors or partners:
- Individual investors must file IRS Forms 8949 and 8997 alongside their annual tax return.
- QOF directors or partners must return Form 8996 annually for the QOF to self-certify as a qualifying fund.
The tax forms are relatively short and clear, yet it is evident from the TIGTA report that mistakes are frequently made. At a minimum, this error rate is potentially very costly for QOFs and their investors. It could lead to additional inquiries from the IRS or the state into the tax filings of QOFs and their investors.
What Are Forms 8949, 8997, and 8996?
Form 8949 allows investors to describe the sale and other disposition of capital assets. It’s a relatively simple form where investors list the properties they have sold, with sale price, costs, other deductions, and their final capital gains or losses.
Form 8997 is where investors list the QOFs they have invested in, plus the number or percentage of shares they hold in each fund and the amount of deferred gain invested. Investors must also list events such as share transfers and gifts made during the relevant year.
On the QOF directors’ and partners’ side, Form 8996 is an annual certification filing, through which the QOF indicates whether it met its eligibility requirements during the tax year.
On February 7, the IRS granted an additional 60 days to file to two taxpayers who failed to do so because neither they, nor their accountants, were aware of the Form 8996 requirement. While this leniency was welcome, taxpayers involved in a QOF should not expect the IRS to grant this leeway indefinitely in such cases.
What Are the Penalties for Noncompliance with IRS Reporting Requirements?
Reporting requirement oversight can be costly. Generally, failure to file penalties equal 5% of unpaid tax per month, or partial month, that taxes remain unpaid, up to a maximum of 25% of taxes due. In addition, the IRS charges interest on penalties.
If in any month the QOF did not invest at least 90% of its assets in eligible properties, then there are penalties to pay. According to the TIGTA report, “...when the QOF fails the 90 percent test during the tax year, it is required to pay a penalty for each month in which it fails to meet the requirement equal to the amount of its investment shortfall multiplied by the underpayment rate. The penalty is equal to the excess of 1) the amount equal to 90 percent of its aggregate assets, over 2) the aggregate amount of QOZ property held by the fund, multiplied by 3) the underpayment rate for the month.”
The COVID-19 Pandemic and Failure to Demonstrate QOF Eligibility
The IRS has instituted penalty relief for QOFs that were negatively impacted by the COVID-19 pandemic and failed to meet the 90% investment standard. This applies to any affected QOF whose last day of their first 6-month tax period fell between April 1, 2020, and June 30, 2021. Whether this provision will be carried over into the 2021–2022 tax year remains to be seen.
Both individual QOF investors and eligible QOF directors and partners have mandatory IRS reporting requirements on an annual basis alongside their personal tax returns. It pays to factor in these additional returns when planning accounting schedules and costs.
While OZ investment continues to be both lucrative for investors and instrumental in helping drive economic development velocity in low-income communities, it requires fiscal diligence and may carry additional risk if mandatory IRS reporting requirements are not met. Compliance with existing regulations could become more complex if further reporting requirements are added under new legislation aimed at increasing transparency in OZ investments.
The TIGTA made a total of eight recommendations to address the QOZ fund and investor noncompliance, six of which were agreed to by the IRS. In the next post, we’ll cover each of the recommendations and the response from IRS management.
For more information about evolving QOF compliance and reporting requirements, investors may reach out to CapZone at firstname.lastname@example.org.
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