Opportunity Zones in 2022: End of Penalty Relief, Rising Interest Rates, and Year-End Reminders

As the year-end approaches, many investors and fund sponsors will be engaging with their professional advisors to discuss tax and planning strategies. Accordingly, we turn our attention to the compliance and testing exercises which will be undertaken by Qualified Opportunity Funds (QOFs).

December 31, 2022 marks the second semi-annual testing date on which a calendar year QOF must measure its investments in qualifying property to determine compliance with its 90% investment standard. Failure to invest at least 90% of its assets in qualified property may cause a QOF to incur penalties.

End of Notice 2021-10 Relief
Previously, in response to the COVID-19 pandemic, the IRS issued Notice 2021-10, which provided penalty relief for certain QOFs. Pursuant to this relief, the failure of certain QOFs to maintain their 90% investment standard was deemed to be due to reasonable cause, and QOFs eligible for the relief were not subject to the penalties normally assessed. Relief was generally provided through the 2021 taxable year, meaning 2022 taxable years are no longer eligible for penalty relief. As a result, QOFs that have delayed investing in qualifying property due to pandemic-related issues may be subjected to penalties in 2022.

Interest Rate Considerations
During the pandemic, interest rates reached new lows. The penalty rate assessed under Sec. 1400Z-2(f) was 3.0% during 2021. As we have observed the sharp rise in interest rates during 2022, the QOF penalty rate has also risen, now at an annualized rate of 6.0% – double the 2021 rate! Since this rate has steadily increased throughout the year, a QOF may be subject to higher penalties in 2022. The following summary illustrates how penalties would be applied to a QOF in 2022 whose only assets of $1,000,000* have not been invested in qualifying property:

• Q1 (January-March) penalty rate: 3%. Penalty = $6,750
• Q2 (April-June) penalty rate: 4%. Penalty = $9,000
• Q3 (July-September) penalty rate: 5%. Penalty = $11,250
• Q4 (October-December penalty rate: 6%. Penalty = $13,500
• Total annualized penalty in 2022 = $40,500

* Under Section 1400Z-2(f), penalties are assessed on 90% of the amount of assets not invested in qualifying property.

Key Takeaways

• The end of penalty relief and higher penalty rates create greater pressure for QOFs to fulfill their original business plans and deploy the capital they raised.
• The cost of continued delays in making investments in qualifying property may have a higher financial cost to QOFs and their investors.
• QOF sponsors and managers should engage with their tax advisors to determine strategies to minimize penalty exposure before reaching the December 31, 2022 testing date.