What Happens If a Fund Is Disqualified?
Opportunity Zones are a tax incentive that brings much-needed funds to economically distressed or low-income areas. When used properly, Opportunity Zones benefit everyone. Those who live in the community benefit from the influx of investment funds, business, and opportunities. Those who invest get a variety of tax benefits.
Unfortunately, however, a high number of illegitimate Opportunity Funds have caused the IRS to place additional scrutiny on these investments. To crack down on abuse, the IRS is heavily auditing Qualified Opportunity Funds (QOFs) and their investors. If you’re involved with QOFs on any level, it’s important to be aware of the risks and what to expect. To get representation now, contact us at Wiggam Law today.
Key takeaways
- IRS examinations of Qualified Opportunity Fund’s tax returns can lead to scrutiny of fund managers and audits of investors’ returns.
- If the fund is decertified, fund managers may face penalties and legal charges.
- Investors will lose their tax benefits and face back taxes and penalties.
How an Opportunity Zone Dispute Begins
The dispute process often begins when the IRS sees an issue with a fund’s tax return. The IRS examines the return to ensure that the QOF is compliant with tax regulations. If the examiner sees issues, they initiate an audit of the fund’s tax returns and its certification status. If they decide to decertify the fund, they then turn their attention to individual investors.
In some cases, the process starts by looking at individual investors’ returns. If taxpayers don’t report their QOF investments properly, the IRS may audit their returns, which can lead to scrutiny of the fund’s returns.
The IRS Process for Opportunity Zone Disputes
Opportunity Fund disputes involve fund- and investor-level audits as explained below.
Qualified Opportunity Fund QOF-Level Audit
Typically, the IRS audits the fund’s tax returns before looking at individual investors’ returns. During the exam, the IRS will examine the fund’s Form 8996 filings, its assessments, and any other relevant details.
If the auditor sees any of the following, they may disallow the fund:
- Fails the 90% asset test: The Opportunity Zone Fund must have at least 90% of its assets in an Opportunity Zone area.
- Fund engages in fraud: The person operating the fund uses it to launder money or otherwise cover up illegal activity. Some funds have also been caught paying distributions in the same way as a pyramid scheme might function, involving fabricated documents and other fraudulent activities.
- Doesn’t meet substantial improvement requirements: Business property must be substantially improved by the Qualified Opportunity Zone. The IRS considers property to be substantially improved if additions to the property during a 30-month period are greater than the adjusted basis at the start of the 30-month period.
- Business is not an Opportunity Zone Business: For a business to be considered a Qualified Opportunity Zone business, it must earn at least 50% of its gross income from activities within the Opportunity Zone. They can meet this requirement by showing that half of the hours of service received by the business were in the Opportunity Zone, that half of the amount the business paid for services was in an Opportunity Zone, or that tangible property and business functions were in an Opportunity Zone. If a business does not hit this threshold, the investment itself may be illegitimate.
- Out of compliance with IRS requirements: The entity must file tax forms every year to show that it continues to meet the requirements to qualify as a Qualified Opportunity Fund. Failing to file may put the investment out of compliance.
Investor-Level Audit
After auditing the fund, the IRS generally turns to individual investors’ tax returns, but in some cases, the audit may start by looking at an individual’s return. The IRS auditor will verify whether or not the investment was reported properly and secured within the 180-day window from the original capital gain or section 1231 gain.
The IRS will send you a letter if there are issues with your claim. Letter 6501 (Qualified Opportunity Fund (QOF) Investment Standard) indicates that the annual certification is missing or invalid, and you need to take steps to self-certify. In other cases, the IRS may send Letters 6502 (Reporting Qualified Opportunity Fund (QOF) Investments) or 6503 (Annual Reporting of Qualified Opportunity Fund (QOF) Investments). If you receive these notices and you believe that your claim was legitimate, you should file an amended return and make sure that the Form 8997 is filled out correctly. Or you may need to file an administrative adjustment request (AAR) in response.
Notices About the Dispute Process
As the dispute plays out, investors may receive the following notices:
- CP2000: The IRS sends this letter when information received from third parties does not match the information in your return. When they receive this information, they do their own investigation to uncover discrepancies. Should they find any, they send CP2000—a proposal to adjust your tax return to match what they uncovered in their investigation.
In this situation, you will typically receive a CP2000 if a fund has been decertified and the IRS is revoking the tax benefits from your tax return.
- Letter 566: IRS Letter 566 is sent when the IRS is investigating your tax return for a specific year and needs more information. You’ll need to provide information showing why you qualify for specific deductions or credits. Alternatively, the IRS may send Letter 525.
If you receive this letter in relation to an Opportunity Fund dispute, you should submit any documents proving the legitimacy of your claim. Contact a tax professional if you’re worried your claim is illegitimate.
- CP3219N: This is a Notice of Deficiency. The IRS has made changes to your tax return and is notifying you that you now owe money. With a QOF dispute, you will receive this notice if your capital gains deferral has been eliminated and the IRS wants to assess capital gains tax against you on a previously filed tax return.
What Happens If an Opportunity Zone Fund Is Disqualified?
In addition to receiving some or all of the above letter, here are the consequences you’ll face if the fund is disqualified:
Immediate Consequences for the Fund
If the auditor discovers that the fund doesn’t meet the legal criteria to be classified as a QOF, the IRS will revoke its status, negating its tax benefits. The fund will be subject to penalties if it does not meet the requirement to have 90% of its assets as Qualified Opportunity Zones. The fund manager may also face legal charges for tax fraud, evasion, or promoting an illegal tax shelter.
Impact on Investors:
Once the IRS decertified the fund, investors are required to pay deferred capital gains taxes on the amount invested in the fund. This alone can be a huge consequence for investors, especially since penalties and interest can make the final amount owed even larger if they are unable to pay immediately.
In addition, investors can no longer avoid capital gains on the appreciated value of the Opportunity Zone investment if they hold it for 10 years. Finally, the IRS may adjust the affected returns if the taxpayer held this investment for multiple years. This can result in a massive unexpected tax bill that includes several years’ worth of liabilities.
Example Scenario – Investor Consequences After a QOF Disallowance
Say a taxpayer had $500,000 in capital gains from selling real estate. They defer their capital gains tax by investing the money into a QOF. However, five years later, the IRS disqualifies the fund for noncompliance.
Now, the investor must pay capital gains tax on the $500,000 gain that was deferred. Plus, the IRS will generally backdate penalties and interest to the original due date for those taxes – that’s five years of interest and penalties. Additionally, any gains that came from the QOF will be subject to tax and will no longer be eligible for the special tax exemption rules for QOFs.
Tax Obligations After an OZ Disqualification
If your investment is disqualified, the auditor will make adjustments to your tax return and send you a Notice of Deficiency. In some cases, you may also need to amend your tax return. You have appeal rights during this process, but if you don’t use them or once they’ve been exhausted, you must pay the tax and penalties due immediately.
The IRS may allow you to set up an installment agreement if you can’t immediately pay in full. If your income and assets aren’t enough to pay the tax liability or make payments, you may qualify for an offer in compromise to settle for less than owed. In some cases, investors may be able to get penalty abatement for failure-to-file or failure-to-pay penalties based on first-time abatement. If the IRS applies accuracy-related penalties to your account, you may sometimes qualify for reasonable cause abatement. However, there is no relief option for the interest on the tax debt.
Impact on State Tax Obligations
On a state level, a disqualified Opportunity Zone investment may play out in several different ways. Some states conform with federal Opportunity Zone provisions, while others do not. If you filed a return in a conforming state and received additional tax incentives for your investment, you will lose those incentives if the OZ is disqualified, which means you’ll face a state tax liability on top of your federal tax bill.
How Investors Can Protect Themselves from OZ Disputes
To avoid OZ audits and disputes, investors should consider the following tips:
- Make sure the fund files the necessary forms. If the fund manager or other managing party does not file Form 8996 or other forms required for the OZ fund, they may be hiding something they don’t want the IRS to discover. They may also know that filing the required forms would reveal that the fund is not legitimate, which would likely require them to return funds to investors.
- Before investing, ask for information on the fund’s real estate or business investments. Remember, OZ funds have to invest a certain amount of the money they collect in businesses in the Opportunity Zone. You should be concerned if information on these alleged investments is never given to investors, or the fund manager gives vague updates that are impossible to verify.
- Be cautious if other investors have pulled out due to rumors or concerns. You may want to start investigating if other investors choose not to invest or pull their funds completely. While they may have just chosen to invest elsewhere, there’s a chance that there are issues they discovered.
- Stay up to date on IRS actions related to Opportunity Funds. If OZ funds are being disqualified at high rates, legitimate funds will also be subject to scrutiny. Stay abreast of IRS actions and make sure that you’re ready to protect yourself. If you know your investment was legitimate, have the paperwork to back that up.
In all cases, working with a tax professional is the best way to protect yourself. An experienced tax pro can help you substantiate your investment and deal with IRS auditors. If the fund is decertified, a tax attorney can help you set up payments and apply for penalty abatement if relevant to your situation.
What to Do If the IRS Challenges an OZ Investment?
Here’s what you need to do if you get an audit notice, a letter about a return adjustment, or any other info suggesting that your investment is being challenged.
Step 1: Review the IRS notice and determine the specific issue – Make sure you understand exactly what the IRS wants to know. In some cases, you may need to back up information that you reported on a form, while in other cases, you may need to make a plan to deal with a disallowed claim, plus penalties and interest.
Step 2: Gather supporting documents if you want to appeal – If you know that the investment was legitimate, it’s time to gather all your documents and mount an appeal. You need QOF records, tax filings, investment agreements, and proof that you invested with the proper funds in the right timing. An experienced tax attorney can help with this process.
Step 3: Make payment arrangements if you don’t want to appeal – If you agree with the IRS’ disallowance of the investment, your only option is to pay the tax. Look into monthly payments if you can’t afford to pay in full, and always ask for penalty abatement even if you think it’s a long shot.
Get Help Navigating an Opportunity Zone Tax Dispute
Dealing with an audit is never fun, but it’s even worse when a tax-saving investment is on the cutting block. To protect yourself, be proactive and reach out for representation as soon as you receive the first IRS notice – or even sooner, if you know there’s a disqualification risk.
The IRS’ scrutiny of QOFs puts both fund managers and investors at risk. We can help. Contact Wiggam Law today to learn more about your rights and to discuss the best steps forward in this situation.
Opportunity Zone Fund Frequently Asked Questions
Can the IRS disqualify an entire Opportunity Zone Fund?
Yes, the IRS may disqualify an entire QOF. If that happens, the fund managers may face legal and civil consequences, and individual investors will also lose their tax benefits.
What happens if my QOF loses its tax status?
If the QOF loses its tax status, you could owe a substantial amount in back taxes, penalties, and interest. Your attorney can help you calculate this number and decide your next steps. If you believe the IRS’ decision was made in error, your attorney can help you navigate the appeals process.
How do I know if my Opportunity Zone investment is at risk?
The first sign that your investment is at risk is generally a notice from the IRS. However, if you’re worried that your QOF may not be legitimate, request documentation from the fund manager showing that the fund meets each of the requirements set out by the IRS. These requirements are very specific, so you may wish to bring the documentation to a tax attorney to figure out if your fund qualifies.
Can I dispute an IRS denial of my Opportunity Zone tax benefits?
You have the right to appeal in certain situations, but unfortunately, if the IRS decertifies the QOF, you will lose your tax benefits. The tax benefits for a Qualified Opportunity Fund are only for those who invest in a qualifying fund. If your fund loses that status, you no longer receive tax benefits.
What steps should I take if I need to pay back deferred capital gains?
If you can’t afford to pay in full, contact the IRS as soon as you can to request payments. If you have a history of compliance, you should easily be able to set up payments on up to $50,000 in back taxes. If you owe more, you will generally need to provide financial details to the IRS. Reach out to a tax attorney for help.
