Opportunity Zones offer investors an attractive way to defer and even reduce their capital gains tax liability while also making a positive difference in economically distressed communities. Despite the complexity of how these investments work, it’s relatively easy for unsophisticated investors to invest in Opportunity Zones.
This can increase the number of investments in geographical areas of need, but it also makes it easier for investors to suffer from losses due to fraud or poorly managed Qualified Opportunity Funds (the financial vehicle investors use to invest their money in Opportunity Zones). The goal of this article is to provide an overview of what can go wrong and what those problems could mean for taxpayers who invest in Opportunity Zones.
Key Takeaways
- Risks of Opportunity Zone (OZ) investments – high risk of audits and scams.
- Consequences if the Qualified Investment Fund is found to be illegitimate
- For the fund – loss of Qualified Investment Fund certification and monetary penalties.
- For the investor/taxpayer – loss of capital gains tax deferral, interest and penalties, and loss of QOF investment benefits.
- What to do – If you suspect a problem with a QOZ or QOF, consult with a tax attorney about options.
Potential Mistakes with Opportunity Zone Investments
There are numerous ways taxpayers could run into problems with their Opportunity Zone (OZ) investments – simply due to the complexity of these investment vehicles. The vast majority of these problems are financial and can include consequences such as:
- The Qualified Opportunity Fund (QOF) losing its certification.
- The QOF incurring monetary penalties.
- Taxpayers incurring tax penalties and interest for underpayment of taxes when they lose their capital gains tax deferment.
- Taxpayers losing out on the tax benefits that come with QOF investments.
Why the IRS Is Cracking Down on Opportunity Zone Investments
Opportunity Zones are relatively new and were created by the Tax Cuts and Jobs Act (TCJA) of 2017. But it’s been a few years since taxpayers have started taking advantage of these tax benefits, so the time is right for IRS audits to begin. But why does the IRS focus on taxpayers who invest in OZs using QOFs? There are several reasons:
Reason #1: Anyone Can Invest in a QOF (Although Not Everyone Should)
Despite the complexity of OZs, it’s relatively easy for individuals to invest in them. In theory, only accredited and sophisticated investors should invest in QOFs, but in practice, almost anyone can do so.
In some cases, it’s as simple as doing an online search for a Qualified Opportunity Zone, requesting information about the QOF, claiming to be a qualified investor, and then writing a check. With so many taxpayers investing in QOZs without fully understanding what they’re doing or what’s required of them, mistakes are bound to exist. And the more mistakes there are, the easier it is for the IRS to recover money in an audit.
Reason #2: Lack of Sufficient Advice
Many QOZ investors lack proper tax guidance, whether coming from a tax attorney or financial advisor. These taxpayers not only invest in a QOF without consulting with a financial or tax professional, but they often decide to handle things themselves when they get contacted by the IRS for more information about their OZ investment or are informed about an audit.
Reason #3: Financial and Legal Requirements Are Complex
The requirements to set up QOZs and QOFs are complicated, and if steps are not met to comply, hefty penalties can result. These penalties have defenses, but IRS guidance isn’t clear on how they will be applied. For example, a QOF can avoid a penalty if it can demonstrate “reasonable cause.” Yet no IRS or U.S. Treasury regulations explain how reasonable cause applies to QOFs.
Reason #4: There Are Holding Requirements for QOFs and QOZs
In order to reap the benefits of a QOF, you must hold the property for a certain period of time. The longer the property is held, the better the tax benefit. However, not all taxpayers hold as long as they need to and may pay more in taxes.
Potential Problems or Mistakes When Investing in a QOF or QOZ
Here’s a list of some (but not all) of the potential mistakes that taxpayers and QOFs can make that could lead to penalties, loss of tax benefits, and/or decertification of QOF status.
- The QOF’s formation documents didn’t contain the proper language indicating it would be investing in a QOZ.
- The investment in the QOF wasn’t an equity investment.
- The taxpayer didn’t reinvest their capital gain funds within the 180-day window.
- The taxpayer didn’t file IRS Form 8997, Initial and Annual Statement of Qualified Opportunity Fund (QOF) Investments, or they filed it late.
- The QOF didn’t file IRS Form 8996, Qualified Opportunity Fund, or it was filed late.
- The QOF or QOZ was in possession of too much cash for too long and wasn’t eligible for the applicable cash safe harbor.
- A QOZ business didn’t create a proper written plan.
- The property is not held for investment long enough to reap favorable tax benefits.
- The taxpayer didn’t have sufficient liquidity to pay the deferred capital gain tax when it became due.
- The taxpayer misunderstood the special rule for K-1s, such that the taxpayer missed the 180-day reinvestment window.
- The QOF failed to meet the 90% asset test.
- The taxpayer miscalculated the 180-day window because they wrongly assumed the clock started when they received the cash.
- The taxpayer shopped around for an appraiser willing to provide more favorable real estate appraisals when trying to get the right numbers for allocating basis between the land itself and structures on the property.
- One of the QOF creators divorced, potentially resulting in an inclusion event (an event that terminates a taxpayer’s qualifying investment in a QOF).
- Wrongly valued assets within the QOF or QOZ.
- Failed the 20% relatedness test
What Happens If There’s a Problem With the Qualified Opportunity Zone Investment?
In most cases, the consequences include fund decertification and/or monetary penalties. Who pays these penalties varies depending on the nature of the infraction or error.
The Taxpayer Pays
For example, if the QOF’s formation documents aren’t sufficient, the IRS might disqualify the QOF, and the taxpayer then faces late and underpayment penalties (plus interest) for the capital gains taxes not paid when they were originally owed. This occurs because the taxpayer no longer enjoys the capital gains tax deferral they assumed they were getting with the QOF investment. Generally speaking, there’s no special defense or safe harbor for this type of taxpayer penalty.
The Qualified Opportunity Fund Pays
Monetary penalties levied on the QOF are most common when the QOF fails the 90% investment asset test. The QOF proves it meets this test when it files Form 8996. When completing this form, the QOF will have to show that on two yearly testing dates, there was a sufficient percentage of property value on its balance sheet that was attributable to QOZ property. This percentage must be at least 90%. The goal of this rule is to ensure the QOF is investing sufficient funds in a QOZ.
If the QOF fails this test, the penalty is equal to the amount of assets that must be transferred to meet this 90% asset test and multiplied by the underpayment interest rate set out in Section 6621(a)(2) of the Internal Revenue Code. This is equal to the federal short-term rate plus 3%.
So, if a fund needed to reallocate $500,000 to meet the 90% test and the underpayment interest rate is 4%, then the penalty for that tax year is $20,000. This doesn’t sound like much, but if this mistake isn’t found until the IRS audits the taxpayer or QOF, then this problem likely existed for multiple years.
When added up, most, if not all, of the QOF’s return on investment could be wiped out. To add insult to injury, because this problem exists (or should have existed) on the QOF’s Form 8996, late and accuracy-related penalties (plus interest) will also apply. Learn more about how Opportunity Zone disputes play out.
Potential Red Flags for QOFs and Taxpayers with QOZ Investments
In some cases, you won’t learn of a problem with your QOZ or QOF until the IRS audits you, a QOZ business, or your QOF. That being said, if you notice any of the following, it could be a sign of possible trouble:
- The QOF can’t provide a copy of its tax filings, such as Form 8996.
- You hear about the QOF or QOZ in the media as a result of possible investigations or legal actions.
- The QOF isn’t investing in real estate developments or active businesses within the Opportunity Zone community.
- The QOF isn’t filing the necessary documents with the IRS and/or is filing them late.
- The financial “advisor” who brought the QOF investment to your attention seems to lack sufficient knowledge about QOZs and how QOFs work.
- The IRS is sending you letters and notices asking for information relating to your OZ investment.
Opportunity Zone FAQs
What should I do if the IRS disqualified my Opportunity Zone investment?
You should get ready for a significant and unexpected tax bill. If you think you’ll have trouble paying this bill, you may be able to make arrangements with the IRS to pay the tax balance over time with a payment plan or installment agreement. In similar cases, you might be able to have the IRS reduce the amount you owe. You may need the help of a tax pro to negotiate this settlement with the IRS.
Can I get back my money if I am the victim of a QOZ fraud scheme?
It’s possible, but it will be difficult. And if you did, you shouldn’t expect to fully recover all of the money lost. If the parties guilty of scamming you are convicted in criminal court, part of their sentence will probably include paying back the investors they stole money from. In most cases, they won’t be able to do this, or if they can do it, they’ll be paying back pennies on the dollar.
How do I know if my OZ investment is legitimate?
It can be difficult to know for sure, but one way to protect yourself is to make a QOF investment through a reputable financial firm. If you decide to invest on your own, make sure any QOF you’re considering is up-to-date with its Form 8996 filings, and these filings include a valid census tract number for the OZ.
Will I have to pay penalties for problems with my QOF or QOZ investment?
It depends on the mistake or noncompliance. If your QOF loses its certified status, late and underpayment penalties, plus interest, are likely, as the IRS will consider your capital gain tax payment late because you no longer enjoy a deferral for that payment.
Can I still benefit from tax incentives if my investment loses its QOF status?
Probably not. The two main benefits are capital gains tax deferment and not paying taxes on any QOF investment gains after 10 years. Both of these will be lost with a decertified QOF.
What legal actions can be taken against fraudulent OZ fund managers?
Criminal charges and civil causes of action, such as breach of contract, theft, and fraudulent misrepresentation, may be possible. Regulatory action, such as through the U.S. Securities and Exchange Commission, might also be an option.
What If You’re Worried About Your Opportunity Zone Investment
The best thing to do is to contact a tax professional with experience handling Opportunity Zone tax issues and investments. The bad news is that the consequences of mistakes with OZ investments can be somewhat unforgiving. The good news is that the legal landscape is relatively new, so there’s still room for legal interpretation by the IRS and courts.
However, the sooner you act, the more effective your tax presentation will be. If you’re thinking about an OZ investment or have questions about your QOF, contact Wiggam Law to set up a consultation. We can be reached by calling (404) 233-9800 or through our online consultation form.