During these times of unprecedented uncertainty, many Americans believe that President Joe Biden’s administration will introduce sweeping changes to our country’s tax code. After all, every president since Bill Clinton has signed into law a new tax bill within 12 months of the beginning of their first term. 

One area that many taxpayers and practitioners alike are keeping their eye on is the qualified opportunity zone (QOZ) incentive, which was part of the Tax Cuts and Jobs Act of December 2017. The concept of QOZs was very much a bipartisan idea even before the Tax Cuts and Jobs Act, but over time, the qualified opportunity zones’ incentive has been viewed by many as a Republican tax policy and has received more than its share of negative press as the incentive has unfolded over the past couple of years.

There a few areas in particular that QOZ stakeholders are focusing on when it comes to the potential for new tax-law changes.

Potential increase in capital-gains tax rate

For an investor to take advantage of the QOZ incentives, one must have realized a capital gain that is eligible to be contributed into a qualified opportunity fund. By doing so, you can avoid having to pay tax on that capital gain until as late as 2026. But if we see an increase in the tax rates that apply to capital gains, what rate must be used when computing the tax owed on those gains in a future year? 

In a perfect world, the equitable answer would be for those investors to recognize their capital gains at the same tax rate that was in place at the time they deferred such gains into a qualified opportunity fund. However, there is currently no such provision in the tax code.

On the other hand, if the capital-gains tax rates happen to increase in future years, the rate rise may serve as a catalyst for increased investment into QOZs, since taxpayers would be able to defer larger amounts of capital gains as a result. However, even if a QOZ project has investors deferring substantial capital gains into a qualified opportunity fund, other incentives and sources of capital — bank financing, New Markets Tax Credits, Historic Tax Credits, etc. — will still be necessary in order to make these projects possible. 

Potential for residential rental real estate to not qualify as a QOZ trade or business

In the previous session of Congress, Senator Ron Wyden (D–Oregon) had introduced the Opportunity Zone Reporting and Reform Act in the Senate as a proposed bill (S. 2787). The bill was never voted on in that session of Congress, but if it had been enacted as written, residential rental real estate would not qualify as eligible QOZ property unless a minimum of 50 percent of the units available for rent are rent-restricted and occupied by lower-income individuals. In addition, self-storage properties and stadiums would have also become ineligible QOZ property.

Since the enactment of the Tax Cuts and Jobs Act, the vast majority of qualified-opportunity-zone businesses we have seen have been residential rental real-estate projects. If specific types of businesses were to no longer be eligible QOZ businesses, further guidance would be needed for not only businesses, but investors as well. 

Increased reporting requirements

We have seen bipartisan support for more robust reporting requirements for qualified opportunity funds. In addition, the U.S. Government Accountability Office (GAO) recently issued a report indicating the need for additional oversight of the QOZ tax incentive. Such oversight would be accomplished in part by collecting data from qualified opportunity funds on an annual basis, by filing Form 8996 with their annual income-tax return. Some of these additional reporting requirements could include, but not be limited to, the following criteria:

• Number of jobs created

• Dollar amount of capital gains invested

• Dollar amount of improvements made to property

• Number of residential rental units available

If these reporting requirements were to be enacted as written, significant penalties could apply for noncompliance with these rules.

COVID-19 Opportunity Zone relief 

In addition to the potential changes described above, QOZ stakeholders should also take note of the changes being made due to impacts of the pandemic. On Jan. 19, 2021, the IRS issued Notice 2021-10 to provide additional relief for qualified opportunity funds, as well as their investors and other stakeholders. Key provisions of Notice 2021-10 include:

• More time to defer capital gains: The deadline to re-invest certain eligible capital gains into a qualified opportunity fund is extended to March 31, 2021. This applies to eligible capital gains where the 180-day deadline to defer the gain ends on or after April 1, 2020 and before March 31, 2021

• Additional relief from 30-month substantial improvement period: The period from April 1, 2020 through March 31, 2021 is automatically disregarded for purposes of measuring the time in which property must be substantially improved.

• Additional relief from 90 percent asset test for qualified opportunity funds: To the extent any semi-annual testing date falls on or after April 1, 2020 and through June 30, 2021, any failure by a qualified opportunity fund to meet the 90 percent asset test during 2020 or 2021 is automatically deemed to be a result of reasonable cause, and the penalty for such failure will be $0.

• Additional time for working-capital safe harbor: QOZ businesses are allowed a 24-month extension of the original 31-month working-capital safe-harbor period if they have working-capital assets whose safe-harbor period ends prior to June 30, 2021.

• Additional time for reinvestment period: a qualified opportunity fund that has an interim sale of qualified opportunity-zone property receives an additional 12 months to reinvest the proceeds from such sale into other qualified opportunity-zone property, as long as the original 12-month reinvestment period includes June 30, 2020.

There is still untapped opportunity in opportunity zones

When considering what the future may bring, investors and business owners should not overlook the many unique opportunities created by the QOZ incentive. The rules and regulations promulgated under the previous presidential administration have made it progressively less cumbersome for businesses and investors to use the QOZ incentive as a catalyst to spur additional economic development in many different communities that have not seen any meaningful economic investment in decades. 

While real-estate projects have dominated the conversation when it comes to qualified opportunity zones, careful planning can allow operating businesses, such as manufacturers, to see much greater after-tax returns on investment than can be achieved through investments in real estate alone. In addition, operating businesses will spur the creation of jobs and otherwise help promote positive social change within their respective communities.

While the QOZ incentive is certainly a once-in-a-generation opportunity afforded by the tax code, stakeholders should remember that the QOZ incentive will not magically make a bad project successful. Rather, it can potentially provide another source of funds to make a sound investment opportunity even more attractive.  

Joseph Wutz is a principal with The Bonadio Group. He is a member of the accounting firm’s real estate and construction teams and spends most of his time overseeing tax consulting and tax-compliance projects for businesses in these industries. Contact Wutz at jwutz@bonadio.com.