The cash conundrum for Qualified Opportunity Zone Funds
The Qualified Opportunity Zone (QOZ) program may offer investors temporary tax deferral, but they bring with them cash challenges for fund managers.
Introduced as part of the Tax Cuts and Jobs Act of 2017, the Opportunity Zone program‡ is a tax incentive designed to encourage investment and job creation in economically distressed communities, designated as “opportunity zones” throughout the United States. Through the program, investors can defer tax recognition of capital gains by re-investing those gains into qualifying opportunity zone funds. The funds put the investors’ capital to use in funding opportunity zone businesses, or property.
In addition to deferring tax – until 2027 – on prior gains when investing in a Qualified Opportunity Fund (QOF), investors’ longevity is incentivized. If the investment is held for longer than five years, there is a 10% exclusion of deferred gains. After seven years, that 10% becomes 15%. And once the investment is held for at least 10 years, the investor becomes eligible for an increase in basis of the investment to its fair market value on the date it’s sold.
But the long-term benefits of QOFs don’t come without challenges. While investors invest cash in the fund, cash is generally a bad asset for OZ qualification. The fund must invest the cash in qualifying property to maintain its qualifying status. Then, the investor may need their cash back in 2027 when their tax bill comes due. Therefore, the fund will eventually need to provide cash to investors to facilitate payment of their deferred tax without compounding the tax due with an additional taxable event—hence, the conundrum.
Here are five rules for holding cash in a QOF:
- 90% rule: A QOF may have up to 10% of its assets in cash or other nonqualifying property. These funds measure their compliance with QOZ qualification standards twice annually. The amount of non-qualifying assets on the two measurement dates is averaged, and must be less than, or equal to, 10% of total assets for the fund to qualify.
- 6 months rule: A QOF may hold newly invested cash for up to six months. The 90% test can be applied without regard to any investment received in the preceding six months.
- 12 months rule: The fund is allowed 12 months to reinvest cash received as proceeds from the sale of qualifying property. During the 12-month period, the proceeds are treated as qualifying property for compliance with the 90% test.
- 5% nonqualified financial assets rule: A QOZ business may hold up to 5% of its property as cash or other nonqualified financial assets.
- Working capital exception: A QOZ business is allowed an exception to the rule regarding nonqualified financial assets for working capital. The business can hold cash in excess of the 5% rule for up to 31 months provided the cash is held, and deployed, under a qualifying written plan.
Given that investors in QOFs will need cash in 2027 to pay their deferred taxes, and that cash is generally a disqualifying asset under the QOZ rules, funds should plan accordingly regarding retention, deployment, and receipt of cash.
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