On Aug. 4, the Treasury Department, and Internal Revenue Service (IRS) surgically nipped and tucked the regulations governing qualified opportunity zone funds (QOFs) which, while precise and limited to two specific sections, arguably results in a complete face lift to the way QOFs must operate. In general, a QOF is a corporation or a partnership that self-certifies to the IRS that it meets a litany of requirements set forth in the Internal Revenue Code (the code) and Treasury regulations promulgated thereunder. If the entity satisfies such requirements, it provides a taxpayer who timely invests in a QOF with two primary federal income tax benefits: such taxpayer can defer recognizing federal income tax on capital gains recognized by such taxpayer on an unrelated transaction until Dec. 31, 2025; and such taxpayer can avoid paying any federal income tax upon exiting the QOF if such taxpayer has held the investment for at least ten years. For the QOFs that are real-estate focused, these surgical cuts may jeopardize their qualifications as QOFs and the ability of taxpayers who invest in these QOFs to avail themselves of the foregoing tax benefits.

One of the many requirements to qualify as a QOF is that the QOF invests in a qualified opportunity zone business (QOZB). Among the requirements for a business to be a QOZB, at least seventy percent (or 90% in certain circumstances) of assets used by the business must be “qualified opportunity zone business property” (QOZBP) (referred to as the “Good Asset Test”) and less than 5% of the business’ assets are held in certain passive investment assets (the “Bad Asset Test”). The Good Asset Teste and Bad Asset Test are applied semi-annually. An exception to the Bad Asset Test, permitting passive assets to exceed 5%, is for reasonable working capital amounts. The IRS and Treasury Department promulgated regulations in January 2020 to clarify the application of the Bad Asset Test and working capital exception to QOFs by creating a working capital safe harbor (WCSH) specifically applicable to the opportunity zone rules. In short, where the WCSH is satisfied, cash and cash equivalents are deemed to be reasonable in amount and the business does not fail the Bad Asset Test. In addition, such regulations included a provision which (arguably) went one step further to provide that, where the WCSH is met, the Good Asset Test is also satisfied while the WCSH is in effect. However, in the haste to promulgate such regulations (together with all other regulatory packages IRS and Treasury were working on in the wake of the Tax Cuts and Jobs Act of 2017), a clear drafting error (in the form of an incorrect section cross-reference) was included in the WCSH which created some uncertainty as to when satisfying the WCSH would also satisfy the Good Asset Test.

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