Various tax deferral and tax exemption benefits are available for taxpayers who invest cash in qualified opportunity funds, which are often not “funds” in the traditional sense but more typically self-created LLCs or partnerships with two or more members or partners. The qualified opportunity funds must deploy their contributed cash by certain deadlines. In Notice 2021-10, the IRS extended the deadlines for cash deployment, but that relief is only available to funds formed in January 2021 or earlier. Such funds get a free pass for all of 2020 and 2021, and they typically need to make qualifying investments only by June 30, 2022.
For example, a taxpayer has $100 million of long-term capital gains recognized on November 1, 2020 from the sale of Tesla stock. The taxpayer invests $1 million on January 30, 2021 into her new qualified opportunity fund. The taxpayer can invest the remaining $99 million into the fund later, and all of that $100 million of cash may be deployed in lower-tier qualified opportunity zone businesses as late as June 30, 2022. The taxpayer uses the cash in the interim to make certain non-qualifying investments.
In contrast, if the taxpayer waits until February or March 2021 to form the qualified opportunity fund, the fund would have to deploy all of its cash by December 31, 2021. In other words, the formation of a qualified opportunity fund in late January 2021, with a relatively small amount of cash, allows greater flexibility and additional time to find the optimal qualified opportunity zone business investment with the best social impact and economic returns.
Specifically, the statute provides that each qualified opportunity fund generally has two testing dates—the last day of the first six months of its taxable year and the last day of its taxable year. A qualified opportunity fund formed at any time in January 2021 (or earlier) would have testing dates of June 30, 2021, December 31, 2021, June 30, 2022, and so on. Notice 2021-10 generally provides that if a qualified opportunity fund has a testing date on June 30, 2021, the fund is exempt from any investment requirements for the entire taxable year, i.e., all of 2021. The qualified opportunity fund formed in January 2021 therefore gets a free pass for all of 2021 and only has to make any qualifying investments by the next testing date of June 30, 2022.
In the interim and subject to certain anti-abuse rules, the fund could generally own any type of nonqualifying asset in 2021 and early 2022.
For comparison, a qualified opportunity fund formed in February 2021 would have testing dates of July 30, 2021, December 31, 2021, June 30, 2022, and so on. The fund’s first testing date is after June 30, 2021, which does not qualify for the Notice 2021-10 relief. The fund must irreversibly deploy its cash into a qualified opportunity zone business investment by its second testing date of December 31, 2021. The same restrictions apply to funds formed later during the first half of 2021. In addition, the funds are restricted in the types of investments they can own during that time.
For substantially all taxpayers, the attraction of forming a January 2021 qualified opportunity fund is that the fund does not need to be fully funded with all of the deferred capital gains. Notice 2021-10 gives a free pass for all of 2021 as long as the fund is formed as a real taxpayer in January 2021 with a non-nominal amount of equity, even if some capital gains are invested in the fund later in 2021 or afterwards.
Notice 2021-10 also extends the opportunity zone investment deadlines to March 31, 2021 for many 2019 capital gains and all 2020 capital gains. A taxpayer can form the January 2021 qualified opportunity fund with a small amount of gains or even non-gain cash, and decide later whether to defer and invest more eligible 2019 and later capital gains.
For example, a taxpayer has $1 million of long-term capital gains, $1 million of short-term capital gains, and $1 million of long-term capital losses from a hedge fund’s 2019 Schedule K-1. The taxpayer had $1 million of short-term capital gains in 2019 that were fully taxed at ordinary income rates. The taxpayer can retroactively defer the $1 million of 2019 long-term capital gains by making a $1 million qualified opportunity fund investment in March 2021. The taxpayer ends up with zero tax liability for 2019 and a full refund of any taxes paid for 2019, because the $1 million of 2019 long-term capital losses entirely offset the remaining $1 million of 2019 short-term capital gains.
The taxpayer effectively converts 2019 short-term capital gains into $2026 long-term capital gains. If the taxpayer first formed the qualified opportunity fund in January 2021, the $1 million of invested cash in March 2021 can be deployed to the opportunity zones by June 2022. Similar techniques apply to section 1231 gains and losses from the disposition of depreciable personal property or real property used in a trade or business and held for more than one year. The section 1231 gains may be deferred with a qualified opportunity fund investment and taxed as long-term capital gains in 2026, while the section 1231 losses can offset ordinary income and can be carried back as net operating losses (NOLs) for certain taxpayers.
Some opportunity zone commentators have read Notice 2021-10 as not providing any relief beyond the first half of 2021. The varying interpretations of Notice 2021-10 demonstrate the continuing importance of diversity and inclusion in the opportunity zone community to provide a diverse set of perspectives in understanding the rules. Diversity and inclusion should also be important for the funds making their investments in opportunity zones through June 2022, particularly in the country’s ethnically diverse areas such as California, Florida, Texas, and the rest of the southern United States.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Libin Zhang is a tax partner at Fried, Frank, Harris, Shriver & Jacobson LLP in the New York office. His mid-2018 research on hot tubs and other opportunity zone hot topics was cited in U.S. Senate Committee on the Budget, Tax Expenditures: Compendium of Background Materials on Individual Provisions, 115th Cong. 2d Sess., S. Print 115-28, at 601 (Dec. 2018).
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