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The IRS announced (IR-2022-79) on April 12, 2022, that it is sending letters to some qualified opportunity funds (QOFs) and their investors regarding their compliance with the certification and investing requirements. The letters will be sent to taxpayers that have filed Form 8996, Qualified Opportunity Fund or Form 8997, Initial and Annual Statement of Qualified Opportunity Fund (QOF) Investments, with missing, invalid or incorrect information Failure to take action may result in the IRS referring QOFs or their investors for examination and disqualifying the investments.

Background

The Tax Cuts and Jobs Act (TCJA) created qualified opportunity zones by adding IRC Section 1400Z-1 and IRC Section 1400Z-2 to encourage investment in economically-distressed areas by giving tax incentives to taxpayers who invest and hold on to investments in qualified opportunity zones through QOFs. A QOF is a corporation or partnership that holds at least 90% of its assets in qualified opportunity zone property. Investors in QOFs must make an IRC Section 1400Z-2(a) election to defer eligible gain.

Investors can generally defer tax on eligible gains invested in a QOF until the earlier of the date on which the investment in a QOF is sold or exchanged, or December 31, 2026. If the QOF investment is held for longer than five years by the end of the deferral period, 10% of the deferred gain is excluded; a 15% exclusion applies if the investment is held for more than seven years by the end of the deferral period. If the investment is held for at least 10 years, the investor is eligible for a basis increase equal to the QOF investment's fair market value on the date that the QOF investment is sold or exchanged, thus excluding 100% of the gain that would have been realized from disposing of the appreciated QOF.

IRS letters

A QOF must file Form 8996 with its first tax return to certify its formation as a QOF and then with subsequent tax returns to demonstrate that it complies with the investment standard of holding 90% of its assets in opportunity zone property. The IRS announced it may send QOFs Letter 6501, Qualified Opportunity Fund (QOF) Investment Standard, if (1) the information on Form 8996 supporting the annual certification of investment standard (showing compliance with the 90% requirement) is missing or invalid; or (2) the calculation does not support the reported amounts.

QOF investors must file Form 8997 to report QOF investments held at the beginning and end of the current tax year, current-tax-year capital gains deferred by investing in QOFs and QOF investments disposed of during the current tax year. QOF investors may receive Letter 6502, Reporting Qualified Opportunity Fund (QOF) Investments, or Letter 6503, Annual Reporting of Qualified Opportunity Fund (QOF) Investments, if (1) the information regarding their investments is missing or invalid; or (2) they did not properly follow the requirements to maintain a qualifying investment in a QOF.

The IRS said in the announcement that QOFs or QOF investors that receive any of these letters should file an amended return or administration adjustment request (AAR). QOFs and QOF investors that do not take the appropriate action may be referred for examination and the QOF investments could be disqualified.

Implications

Tax compliance for QOFs and QOF investors is particularly important given the significant tax benefits tied to QOFs. Failure to file accurate Forms 8996 and/or 8997 could result in the disqualification of the investment, which could make QOF investors liable for back taxes on improperly deferred capital gains and/or ineligible for 10-year exclusion benefits. This IRS announcement should serve as a notice for QOFs and QOF investors to review previous and upcoming tax filings for accuracy and completion.

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