June 30th Opportunity Fund Testing is Near - Here’s What You Need to Know to Pass!

Posted on Mon, Jun 10, 2019 ©2021 Drucker & Scaccetti

chris-catarino-largeThe most recent set of proposed Opportunity Zone (OZ) regulations, issued by Treasury in April, provide the clarity many OZ Fund sponsors need to begin doing deals. However, early-adopters formed funds in 2018 and the beginning of 2019 despite the uncertainty in the law. For these courageous few, a critical IRS testing date is fast-approaching on June 30, 2019. Today, we discuss what you need to know to pass your OZ Fund’s mid-term test.


Back-up... there’s a test my fund needs to pass to get all of its really neat benefits? What’s up with that?!


As you know, the OZ program provides significant tax incentives to capital investments made into certain low-income areas (Qualified Opportunity Zones). The law requires these investments be made through Qualified Opportunity Funds (OZ Funds). To ensure tax benefits are only accruing to OZ Funds playing by the rules and investing into Qualified Opportunity Zones, OZ Funds are tested semi-annually to ensure at least 90% of their assets qualify. OZ Funds that fail the 90% test are subject to a monetary penalty.


Fair enough. When exactly is the OZ Fund tested?


OZ Funds are tested semi-annually, with the initial testing date on the last day of the sixth month after the fund’s taxable year begins and the second testing date on the last day of the fund’s taxable year. An OZ Fund with a calendar year for tax purposes is generally tested June 30th and December 31st each year.


However, in an OZ Fund’s initial tax year, its first testing date isn’t until six months after it elects to be an OZ Fund. For example, assume a fund is formed in March of 2019, but doesn’t receive its first eligible equity investment until June of 2019. In this case, the fund could elect to be an OZ Fund in June 2019. This would delay its initial testing date until November 30, 2019 (six months after the June election date). The OZ Fund would again be tested on the last day of its tax year, December 31, 2019. Going forward, the OZ Fund’s semi-annual testing dates would be June 30th and December 31st.


An OZ Fund that makes its OZ Fund election after June has only one testing date in its first tax year, December 31st.


The procrastinator in me is curious... Why wouldn't an OZ Fund just wait until after June to make its initial election?


While delaying the election may push back or eliminate an OZ Fund's first testing date, a fund must initially elect to be an OZ Fund by the time it receives its first eligible equity investment. If not, the investor would not be considered to have made an investment in an OZ Fund and would not be eligible to receive any of the related tax benefits.


Typical IRS... Just figuring out when an OZ Fund is tested requires mental gymnastics and a quarter of your blog. Any chance this mid-term is a take-home exam?


Actually, it kind of is... While the OZ Fund must report the results of both its interim and final tests to the IRS annually on Form 8996, this form isn’t due until the OZ Fund’s income tax returns are due for that year. This means a calendar-year OZ Fund taxed as a partnership may not need to report the results of its initial test until 9/15/2020, the extended due date of its 2019 partnership income tax return.


You must be kidding me! Why am I wasting my time reading this now?


Even though the results of the test aren’t reported to the IRS until much later, it’s based on the OZ Fund’s financials on the testing dates. While most private investors are familiar with year-end tax planning, it's unusual to focus much on interim financials for tax purposes. This isn’t the case for OZ Funds. A critical review and analysis of an OZ Fund’s balance sheet prior to its mid-year testing date is crucial, as well as having records to support the results of the mid-year test.


Ugh! Two Tax Seasons for OZ Funds? What a pain! Can I just fail the mid-term and make it up with an ‘A’ on the final?


You're preaching to the choir on this… But if an OZ Fund fails its mid-year test, it only has a chance to make up a full letter grade with its final. Let me explain. While an OZ Fund is tested semi-annually, the penalty only applies if the average of the results of its semi-annual tests for the year is below 90%.  This means an OZ Fund with qualifying assets of only 80% on its initial testing date may not necessarily fail for the year if 100% of its assets qualify on its final testing date. However, a mid-year score of less than 80% will all but ensure the OZ Fund is subject to a penalty, unless it can prove reasonable cause.


Tell me about this penalty, how much are we talking here?


The penalty rate is published monthly by the IRS and is 5% for 2018 and 6%, so far, for 2019. The penalty rate is multiplied by the OZ Fund’s qualifying asset shortfall. For example, a Fund with $1M of total assets and only 70% of qualifying assets after both test results are averaged for 2018 would be subject to a $10,000 penalty [($900k of assets needed to pass test - $700k of average qualifying assets) * 5%].


The penalty calculation is actually done month-by-month , but the exact calculation is beyond the scope of this “study guide.”


As far as we know, failing the 90% test will NOT cause an OZ Fund to lose its tax benefits. However, the penalty can be substantial for funds that significantly miss the mark and can eat into investor returns, even with slight misses.


Enough build-up already. What must I know to pass the test?


An OZ Fund’s balance sheet must be closely reviewed prior to a testing date to determine which property qualifies. Unfortunately, this determination is not straight forward. Significant portions of the law and regulations are dedicated to defining qualifying property and, as with all tax law, there are general rules, exceptions, and exceptions to the exceptions. However, below are a few key points that may be useful.



Cash is generally NOT a qualifying asset, unless:

  • It was received as an equity contribution by the OZ Fund within the last six months; or
  • It is held by a Qualified Opportunity Zone Business (QOZB), which is a corporation or partnership owned by an OZ Fund, and that QOZB has a written plan to use the cash for the acquisition, improvement and development of Qualified Opportunity Zone Business Property (QOZBP) within the next 31 months.


This is a hugely beneficial safe harbor that only applies to QOZB's - OZ Funds cannot use this safe harbor if they hold cash directly. This is why many have structured their OZ investments using a Two-Tier Structure, which you can learn more about here.


Tangible property owned

Tangible property owned by an OZ Fund must meet these requirements to qualify:

  • Used in a trade or business in a Qualified Opportunity Zone;
  • Acquired by purchase from an unrelated party after 12/31/2017; and
  • Either its original use in the zone must commence with the OZ Fund or it must be substantially improved (commonly known as basis-doubling).


Tangible property is generally valued for the 90% test based on its undepreciated cost. However, if an OZ Fund has an Applicable Financial Statement (AFS), the value of the property as reported on the AFS may be used by the OZ Fund for its 90% test.


Leased property

Leased property used by an OZ Fund must also be considered in its 90% test even though leases and leased property are generally not valued or reported as assets for tax purposes.


The value is determined based on the present value of the future lease payments, discounted using the IRS Applicable Federal Rate (AFR). Once the lease is initially valued (when the lease is entered into), its value remains unchanged for all future testing dates. If an OZ Fund has an AFS that reports leased property as assets, the AFS value can be used if it is also used in calculating the value of tangible property owned.


Additionally, to qualify, leased property must meet the following requirements, among others:

  • Acquired under a lease signed after 12/31/2017;
  • The lease must be market rate; and
  • Substantially all of the use of the leased property is in a QOZ.


Oh, is that all there is to it? Thanks for the tutoring session but I’ve been around the block before. Are you just trying to say I either must be, or hire, an Opportunity Zone expert to pass this test?


Bingo!  The Tax Warriors® at Drucker & Scaccetti are well versed in the Qualified Opportunity Zone program and can help you with planning - Contact us today.  You can also visit our comprehensive online QOZ Resource Center.

Topics: Regulations, Philadelphia, IRS, Qualified Opportunity Zones, Qualified Opportunity Funds, QOZ, QOF, Testing, Opportunity Fund Experts, OZ fund, Form 8996

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