What is the 90% rule for Qualified Opportunity Zone Funds (QOFs)?

The 90% asset test is a key compliance requirement for Qualified Opportunity Funds (QOFs) that invest in Opportunity Zones (OZs). This rule mandates that a QOF must hold at least 90% of its assets in Qualified Opportunity Zone Property (QOZP) to maintain its tax-advantaged status. The rule is designed to ensure that QOFs actively invest in and improve distressed communities rather than merely holding cash or non-qualifying assets.

Below, we will break down what the 90% investment standard means, how it is calculated, how it is reported to the IRS, and what happens if a QOF fails to meet this requirement.

Understanding the 90% Investment Standard for QOFs

90% asset test

The purpose of the 90% rule is to ensure that a substantial portion of a QOF’s assets directly benefit Opportunity Zones. The rule requires that at least 90% of a QOF’s assets be invested in QOZP, which can include:

  • Qualified Opportunity Zone Business Property (QOZBP).
  • Qualified Opportunity Zone Stock.
  • Qualified Opportunity Zone Partnership Interests.

The 90% asset test is conducted semi-annually, typically on:

  • The last day of the first 6-month period of the QOF’s taxable year; and
  • The last day of the taxable year.

How to Calculate the 90% Investment Standard

The average of the percentages calculated on both testing dates must meet or exceed the 90% threshold. To calculate compliance:

  1. Determine the fair market value of all assets held on each testing date.
  2. Identify the value of assets that qualify as QOZP.
  3. Divide the value of QOZP by the total asset value.
  4. Average the percentages from both testing dates.

Example: If a QOF’s assets on the first testing date consist of $8 million in QOZP and $2 million in cash, the qualifying percentage is 80%. If, by the second testing date, the QOF has $9 million in QOZP and $1 million in cash, the qualifying percentage is 90%.

Average percentage: (80% + 90%) / 2 = 85%. Since the average does not meet the 90% threshold, the QOF would be subject to penalties.

How to Report the 90% Asset Test on Form 8996

The 90% asset test for Qualified Opportunity Funds (QOFs) is reported to the IRS using IRS Form 8996. This form is essential for certifying the fund as a QOF and demonstrating that it meets the 90% investment standard required under the Opportunity Zone (OZ) program.

Filing Form 8996 Annually

Form 8996 must be filed annually as part of the QOF’s federal income tax return. The form must be attached to the entity’s tax return (Form 1065 for partnerships or Form 1120 for corporations) and submitted by the due date of that return, including extensions.

Completing Part II of Form 8996

Part II of Form 8996 is specifically dedicated to the 90% investment standard.

  1. Line 6: Total Assets
    • Enter the total assets of the QOF on both testing dates (the last day of the first 6-month period and the last day of the tax year).
    • Total assets can be reported at cost or fair market value, but the chosen method must be consistent for both dates.
  2. Line 7: Qualified Opportunity Zone Property
    • Report the value of qualified OZ property held on each of the two testing dates.
    • This includes Qualified Opportunity Zone Business Property (QOZBP), Qualified Opportunity Zone Stock, and Qualified Opportunity Zone Partnership Interests.
  3. Line 8: Calculation of the Percentage
    • Divide the amount on Line 7 by the amount on Line 6 for each testing date.
    • Multiply the result by 100 to calculate the percentage of qualifying assets.
    • Record the percentage for each testing date.
  4. Line 9: Average of the Percentages
    • Add the two percentages from Line 8 (from both testing dates) and divide by 2.
    • The result should meet or exceed 90%.

Reporting Penalties

If the calculated average percentage falls below 90%, the QOF must complete Part III of Form 8996 to calculate the penalty.

  • Calculate the shortfall amount (the difference between 90% and the average percentage).
  • Multiply the shortfall amount by the IRS underpayment rate to determine the monthly penalty.
  • Enter the penalty amount on Line 15.

Signature and Submission

The authorized representative of the QOF must sign and date the form before submission. Ensure that Form 8996 is attached to the QOF’s annual tax return.

What Happens If a QOF Fails the 90% Rule?

If a QOF fails to meet the 90% investment standard, it must pay a penalty for each month it remains noncompliant.

Penalty Calculation

The penalty amount is determined by:

  • Multiplying the shortfall (difference between the 90% requirement and the actual percentage) by the IRS underpayment rate
  • Applying this rate to the value of the assets that fall short

Example
If a QOF’s average qualifying percentage for the year is 85%, it falls short by 5%. If the IRS underpayment rate is 3%, the penalty for a $10 million fund would be:

  • Shortfall amount: $500,000 (5% of $10 million)
  • Penalty: $500,000 x 0.03 = $15,000 per month

Reasonable Cause Exception

If the QOF can demonstrate that the failure was due to reasonable cause and not willful neglect, the IRS may waive the penalty. This is typically assessed on a case-by-case basis, and the fund must provide a reasonable explanation and supporting evidence.

Tips for Maintaining Compliance with the 90% Rule

  1. Plan Investments Strategically: Allocate capital efficiently to maintain the 90% threshold. Consider timing large acquisitions and improvements to align with testing dates.
  2. Monitor Asset Values: Track the fair market value of both qualified and non-qualified assets regularly. Be proactive in addressing potential shortfalls before testing dates.
  3. Utilize Safe Harbors: If holding substantial cash reserves, document the intended use under the 31-month working capital safe harbor to protect against penalties.
  4. Conduct Interim Compliance Checks: Perform internal calculations periodically to gauge compliance. This helps to identify potential risks well before the formal testing dates.
  5. Consult with Tax Advisors: Opportunity Zone compliance can be complex, and professional advice can help navigate the rules effectively. A qualified tax advisor can assist in structuring the fund to meet the 90% standard consistently.

Final Thoughts

The 90% rule is one of the most critical requirements for maintaining a QOF’s tax-advantaged status. By ensuring that at least 90% of assets are consistently invested in Qualified Opportunity Zone Property, funds can secure the significant tax benefits intended by the Opportunity Zone program.

Properly reporting the 90% asset test on Form 8996 is essential for maintaining compliance. By understanding how to calculate, report, and manage the 90% standard, QOF managers can minimize risks and protect the long-term benefits of their investments.