If the fund does not meet the test, it will be subject to penalties. The law nor the regulations provide explanation as to the impact to the investors.
Ask A Question
What happens if I invest in a QOF, but they don’t deploy my funds before the testing period?
Answers
If you invest in someone else's QOF and it's taxed as a partnership, you'll be responsible for your distributive share of all penalties, so do your due diligence carefully.
The QOF will not satisfy the 90% qualified asset test and penalties apply. Basically, interest in the tax deferred by rolling the gain into a QOF. However, there could be other issues depending on why the QOF did not deploy the money.
The next set of regulations is intended to address questions like this that are relating to disqualification and penalty considerations, but the short answer is that if the intended QOF does not qualify as a QOF, then the risk to you is that you will not receive the intended tax benefits. Thus, buyer beware.
Funds do not need to be deployed before the testing period necessarily. The regulations provide a 31-month working capital safe harbor that a QOF can manage by creating a reasonable written plan to deploy such capital, and if they follow that plan reasonably closely, the QOF status will remain intact. Generally, any testing failures result in penalties to the QOF and not to the investors if they are not one in the same. I would expect that if you did your due diligence on the QOF and are comfortable with their team, then your primary concern would be regard to the timing of your investment with regard to your capital gain event.
You need to make sure that doesn’t happen. Otherwise, there are penalties applied.
You would lose the Opportunity Zone incentive benefits.
Deferral ends at that point. You may have cause of action against them.
There is a six-month grace period prior to investor funds received by a QOF factoring into the asset test.
To make a long story short, you get fined. This was addressed in greater detail in the second tranche of guidance. You'll find links to lots of helpful information on the Arizona Commerce Authority's Opportunity Zones resources page, and, of course, an attorney could help you plan capital ingestion and use to minimize or avoid a fine.
If you timely invest in a QOF using eligible funds, then you will presumably not report the "original" capital gain on your 2019 tax return. Now, fast forward to something like a year from now, when the QOF didn't properly invest the money in accordance with the 180-day timetable, including the possible six-month waiver for most recent capital contributions. At this point, we have statutory language that says what happens, but we don't have any guidance from the IRS to interpret these rules. The statutory language would make the QOF, and pursuant to the Ccde provision, you (and your fellow investors), liable for a penalty for failure to properly invest, unless the QOF had "reasonable cause," in which case the penalty would not be imposed. Now, here's what no guidance means. One, we don't know exactly what the penalty is. It appears to be the Section 6621(a)(2) underpayment rate (currently 6% annually), although some have expressed concern that it might be that rate but applied each month. In my judgment, multiplying the rate by 12 because of poor drafting (i.e., a 72% rate?) is ridiculous; I can't imagine a court reaching that conclusion. Second, the rate is multiplied by the excess of 90% of the fund's assets over the amount properly invested. Some have expressed concern that if the fund borrowed money, this could be some astronomical number. It presumably that won't happen, since you are assuming that they didn't do anything. Third, we don't know what the IRS might consider to be "reasonable cause" or whether your QOF will fit that requirement, but this might get you out of any penalty anyway. Fourth, if the QOF really, really didn't do anything, or if it continues to not invest for some time longer, then the IRS might eventually say, "Enough! We don't think that this was a proper QOF in the first place, and you should pay the taxes you otherwise didn't pay from 2019." Finally, you may have an action against the people who put the fund together, depending on a lot of things: what they represented to you, what damages you agreed to waive, etc. I have certainly seen offerings where the QOF sponsors have said, "We don't promise to do anything; so don't come after us if we don't comply with the OZ requirements!" You should read your offering materials to find out what your sponsor has said.
The fund could be subject to a penalty.
If the fund fails to satisfy the 90% asset test, then you, as an investor, would be allocated a monthly penalty.
First off, if you establish an entity under the QOF to be a QOZ business and develop a business plan, you can fall under the 31-month working capital safe harbor rule and minimize any penalties. The penalty for not deploying the funds is currently 6.5% annually.
In the event you fail the self-certifying test, the fund is subject to a penalty on a monthly basis for the shortfall. The penalty is 0.417% a month for the shortfall in qualified assets. If the shortfall is $1 million, then there would be a penalty of $4,170 a month. The fund will incur this penalty. You as the investor will proportionately be subject to this penalty as an expense against income. The penalties will end once the shortfall is cured. In the event that the fund can never qualify, any tax deferral that was utilized will be clawed back and the deferred tax will be due. Any future gains if help 10 years will not get tax-free status.
This is a working capital safe harbor that allows for a QOF invested within an indirect method to qualify and meet the 70% tangible asset and 90% asset tests. If at any point the tests are not met, there is a penalty that is paid for failing the testing period. The penalty will vary depending on how severely the QOF missed the applicable test.
DISCLAIMER:the information found on this website is intended to be general information; it is not legal or financial advice. Specific legal or financial advice can only be given by a licensed professional with full knowledge of all the facts and circumstances of your particular situation. You should seek consultation with legal and financial experts prior to participating in any aspect relating to Opportunity Zones. Posting a question on this website does not create an attorney-client relationship. All questions you post will be available to the public; do not include confidential information in your question.