Enough time has passed since the IRS issued its first substantive round of draft regulations and guidance on the federal Opportunity Zone program for certain Qualified Opportunity Fund (“QOF”) managers to begin their capital raise.  Some Funds are still working through structuring concepts and documentation, while many others remain on the sidelines in light of the outstanding questions and potential issues that remain for Opportunity Zone investments and projects.  While the remaining issues and areas of confusion should not be taken lightly, there is also a bit of a race against the clock element in play due to the December 31, 2019 deadline for an investor to invest in a QOF and receive the maximum level of tax benefits afforded under the program.

The first issue that QOF managers need to consider is the timing of seeking certification through the filing of IRS Form 8996.  Under the draft regulations, a QOF may designate its first month as a QOF for certification and asset testing purposes.  However, the QOF must be certified (through the Form 8996 filing) for the month when investment capital is taken in from investors with capital gains. Otherwise, the QOF risks the investor not receiving any of the tax benefits for investing in a QOF.  A significant issue arises under the statute and draft regulations for a QOF that wants to begin taking investments this month, December 2018, and that operates with a calendar year tax filing period.  If the QOF files the Form 8996 in December and takes investor capital in the same month, it will have to have invested 90 percent of its assets (investment proceeds) in Qualified Opportunity Zone Property by December 31, 2018 or risk being penalized.

This problem is mitigated in part by the 31-month working capital flexibility provided to investments in Qualified Opportunity Zone Businesses by a QOF and the potential for penalty relief if there is reasonable cause.  However, it does require that a QOF have a project lined up immediately and may involve special structuring to accommodate making the qualified investment before the end of December.

Another significant question or area of uncertainty is the investor’s exit from a QOF.  A multi-asset Fund typically provides investors with an exit strategy that involves selling the assets of the Fund and distributing the proceeds to investors.  Under the current Opportunity Zone tax rules, a QOF’s sale of assets could trigger a taxable gain.  This gain would be passed through to investors if the QOF is a pass-through entity.  Absent guidance or a statutory change extending the fair market value basis step-up to a QOF’s sale of assets, there will be an influx of single asset funds. In the alternative, complex structures are being contemplated to allow QOFs to hold a diverse class of assets without triggering a taxable event for investors.  The discussion and planning continues on this subject.

Finally, there is the issue of making investments in operating businesses based in Opportunity Zones. Under the proposed regulations, 70 percent of that businesses’ property must be qualified property—meaning acquired in 2018 or later; first used in a zone or substantially improved.  This essentially limits the universe of potential investee businesses to companies that may be relocating or building a new site.  However, what about a service company that leases space in an OZ or a start-up that is working in a co-working/incubator space?  How will the 70 percent test be applied in these contexts or in the case of an existing business that may be making significant capital investments?  Until there is more clarity in this area and potentially a more flexible standard for a business’s qualified property holding requirements, this new program may initially only have a focus on real estate projects.

As regulators, practitioners and advisers all struggle with these complexities, the clock is still ticking on the deadline for investing.  All while QOF managers and sponsors anxiously await additional guidance and weigh the benefits and risks of being first (or early) to market.