Treasury provides key—and much awaited—guidance on qualified opportunity zones in a second round of proposed regulations

On April 17, 2019, the U.S. Treasury Department and IRS released a highly anticipated second round of proposed regulations on qualified opportunity zones (QOZs). In it, they addressed questions regarding investment in and operation of qualified opportunity funds (QOFs) that had been left unanswered by a first round of guidance issued in October. Many investors have been waiting for further clarification before deciding whether to invest in QOFs. Following this generally taxpayer-friendly release, investors may feel better prepared to make a decision.

Opportunity zones include more than 8,000 low-income communities, certified by the Treasury Department, with investment in QOFs eligible for certain tax incentives. The program, which aims to connect private capital to struggling communities, was created as part of the Tax Cuts and Jobs Act of 2017.

Treasury will accept comments on the proposed regulations, most of which may be relied upon, over a 60-day period. Additional guidance regarding administrative rules and information reporting requirements for QOFs is expected in the next few months.

Here, we share some of the answers we now have to significant questions that were left open after the first round of Treasury guidance was issued in October 2018. We also explain additional clarifications and changes in the proposed regulations. 

Q | How will pre-December 31, 2026, distributions from a QOF affect the deferral of capital gains?

A | In general, distributions from QOFs will constitute an “inclusion event” (accelerating the recognition of deferred gains and loss of QOZ benefits) only to the extent they exceed basis. Distributions from QOFs organized as partnerships will be taxed to the extent the distributed property has a fair market value in excess of the partner’s outside basis (which initially is zero, but may be increased by the partner’s share of partnership liabilities, among other adjustments). Distributions from QOFs organized as C corporations will constitute an inclusion event to the extent they are treated as gain from the sale or exchange under corporate tax rules (i.e., they are non-dividend distributions in excess of the shareholder’s basis in his or her stock). A special rule applies to distributions made within two years of a taxpayer’s investment. Such distributions may be treated as a “disguised sale,” disqualifying a portion of the original QOF investment from the QOZ tax benefits. 

Q | What are the consequences of employing debt at the QOF-level?

A | Although the proposed regulations do not explicitly address the full scope of the consequences of fund-level debt, there is some good news for investors. A partner’s allocable share of debt increases his or her basis in a QOF investment.  That rule, coupled with the rule that distributions are taxable to a partner only to the extent they exceed basis, means that investors in a QOF organized as a partnership should be able to take advantage of tax-free leveraged distributions after the first two years. 

Losses (e.g., from depreciation) would be suspended until an investor (whose basis in the QOF investment is initially zero), acquires basis (e.g., through debt or the 5- and 7-year step-ups). 

Q | What happens if a QOF sells an investment in qualified property and reinvests in other qualified property?

A | A QOF’s sale of qualified property and reinvestment into other qualified property raised several questions: Could that be done without tax consequences for the QOF? For the QOF investor? Would it affect the QOF investor’s 5-, 7- and 10-year holding periods? Would interim proceeds compromise the 90% qualified property test for the QOF? The regulations provide guidance on all of these questions. (For explanations of concepts like the 90% test, see our previous alert here.)

Starting backwards, proceeds from sale or disposition of qualified assets by the QOF are treated as qualified property for purposes of the 90% qualified property test as long as the QOF reinvests the proceeds within one year (subject to a government inaction extension), and the proceeds are held in cash, cash equivalents, or debt instruments with a term of 18 months or less. On the other hand, Treasury did not feel it had the authority to make such dispositions of, and reinvestments into, qualified property tax-free (but has requested comments on this point). This means that a realization within the QOF would be subject to normal income tax recognition rules. But QOF realization and reinvestment into other qualified property will not affect a taxpayer’s 5-, 7- and 10-year holding periods in the QOF, or, seemingly, the deferral of the taxpayer’s original gain.

Q | What does “substantially all” mean in the various places it is used in the definition of qualified property? 

A | The term “substantially all” is used in multiple places in the definitions of qualified property. Qualified property can be QOZ stock, QOZ partnership interests or QOZ business property (see the full definitions on p. 3 of our previous alert here).  Below are relevant excerpts from each definition.

  • QOZ Stock
    • During substantially all (90%) of the QOF’s holding period for the stock, the corporation qualified as a QOZ business
  •  QOZ Partnership Interests
    • During substantially all (90%) of the QOF’s holding period for the interest, the partnership qualified as a QOZ business
  • QOZ Business Property (QOZBP)
    • During substantially all (90%) of the QOF’s holding period for the property, substantially all (70%) of the use of such property was in a QOZ
  •  QOZ Business (QOZB)
    • Substantially all (previously defined as 70%) of the tangible property owned or leased by the taxpayer is QOZ business property
    • A substantial (40%) portion of the intangible property is used in the active conduct of such business

The proposed regulations suggest that these layered quantifications are compounded. For example, a QOF could satisfy the QOZ requirements with as little as 40% of its tangible assets effectively in use within a QOZ. This would result from 90% of QOF assets being invested in a QOZB, in which 70% of the tangible assets of that business are in QOZBP, and that QOZBP is only 70% in use in a QOZ for 90% of the holding period for such property (0.9 x 0.7 x 0.7 x 0.9   0.4).

Q | How does a QOF satisfy the “original use” test?

A | Qualified property generally has to have either its original use in the QOZ commencing with the QOF (or QOZB), or the QOF (or QOZB) has to “substantially improve” the property.   The earlier round of Treasury guidance did not define “original use.”  The new guidance clarified that property will be considered to be original use when a person first places the property in service in the QOZ in a manner that would allow for depreciation/amortization.  Treasury received several comments about allowing property (such has buildings or structures) that had been vacant for some time to qualify as original use property.  The regulations grant that if property has been vacant for at least five years prior to its purchase by a QOZ or QOZB, the original use test will be satisfied. 

Q | How does the “substantial improvement” test apply to raw land? 

A | The substantial improvement test requires that, after a QOF acquires tangible property, it must double its adjusted basis in the property over any 30-month period. Earlier guidance had suggested that the basis of land could be excluded from this calculation, leaving open whether and how this test applied to raw land. The regulations clarify that Treasury did not want to impose a uniform substantial improvement requirement on unimproved land because of the differing degrees to which such improvements would be wise for different industries. Thus, there is no per se substantial improvement requirement for raw land. But anti-abuse rules will prevent tax benefits for QOFs that do not invest in any new capital improvement or increase any economic activity/output of the land (e.g., acquiring land currently utilized for crop production, without any improvements). 

The regulations also stipulated that the substantial improvement test for tangible property should be applied on an asset-by-asset basis, but Treasury is requesting comments on whether the test should be applied on an aggregate basis.

Q | How is “trade or business” defined?

A | A QOF must hold, directly or indirectly, assets used in a trade or business. “Trade or business” is a question of fact defined by a substantial body of case law and administrative guidance around Internal Revenue Code Section 162 (relating to trade or business expenses). Among other things, for an enterprise to be considered a trade or business, a taxpayer must: 1) undertake an activity with the intent to make a profit; 2) be regularly and actively involved in a considerable activity (by scope and extent); and 3) have business operations that have actually commenced. Holding land for investment does not constitute carrying on a trade or business and, therefore, such land is not QOZBP.

Q | What must a QOZB do to comply with the requirement that at least 50% of the business’s gross income be derived from the active conduct of the business?

A | The QOZB definition provides a requirement that 50% or more of the total gross income of the trade or business is derived from the active conduct of such business. Some language in the first round of proposed regulations made practitioners question whether that meant gross income had to be sourced from within the zone, as opposed to the business merely being operated in the zone. The regulations provide three safe harbors and one facts-and-circumstances test for this requirement. 

The safe harbor tests:

  1. At least 50% of services performed (based on hours) performed within the QOZ
  2. At least 50% of the services performed for the business (based on amounts paid for services) are performed in the QOZ
  3. The tangible property of the business in a QOZ and the business’s management or operational functions in the QOZ are each necessary to generate 50% of the gross income of the trade or business

If none of these safe harbors is met, there is an alternative facts-and-circumstances test. This test is satisfied, if, based on all the facts and circumstances, at least 50% of the gross income of a trade or business is derived from the active conduct of a trade or business in the QOZ. 

Q | Can an interest in a QOF be transferred?

A | Earlier Treasury guidance left unclear how a taxpayer’s lifetime gifts of QOF interests would be treated. It was also unclear whether beneficiaries of a taxpayer who died holding a QOF interest would be able to take advantage of the QOZ provisions. Second round guidance is unfavorable for lifetime gifts, but favorable for testamentary transfers. The regulations clarify that lifetime gifts of a QOF interest will trigger recognition of the taxpayer’s deferred gain and loss of the QOZ benefits for the recipient. This includes a gift to a charitable organization. There is an exception for gifts to grantor trusts, but if the trust ceases to be a grantor trust (other than by reason of death), tax will be recognized on the deferred gain at that time, and the QOZ benefits will be lost. There is a similar exception for transfers to disregarded entities (such as a single-member LLC). 

On the other hand, if a gift of a QOF interest is made upon a taxpayer’s death, it will not trigger immediate inclusion of deferred gain. Instead, the deferred gain becomes an “income in respect of decedent” (IRD) asset. That means gain would remain deferred (with no step-up in basis) until the earlier of December 31, 2026, or when the decedent’s estate or beneficiaries dispose of the QOF interest. Capital gains taxes would be due at that time, but the estate or heirs would be entitled to deduct any federal estate taxes paid on the IRD asset. Beneficiaries appear to be eligible for the QOZ tax attributes even though they did not originally defer gain, and beneficiaries can tack on to decedent’s holding period for purposes of the 5-, 7- and 10-year rules. 

With regard to transfers for value, an investor can acquire a QOF interest from an existing investor rather than from the fund. For purposes of the opportunity zone tax attributes, the investment is equal to the amount paid for the eligible interest. 

Q | Does a QOZ have to own qualified property, or can it be leased? 

A | Treasury wanted to achieve parity among different business models, whether they involved owning or leasing property. Therefore, the regulations provide that leased property can be treated as satisfying the 90% test and QOZB “substantially all” test if it meets certain criteria: 1) leased tangible property must be acquired by lease entered after December 31, 2017; and 2) substantially all of the use of the leased property must be in a QOZ during substantially all of the period for which the business leases the property. 

The original use and substantial improvement tests do not apply to leased property (although improvements to leased property by the lessee satisfy the original use requirement). An alternative test provides that the lease must be at arms-length market rates. 

There is also no related party test for leased property, but leased property will not be QOZBP if a related party makes a prepayment of rent (relating to use more than 12 months out). Also, leased tangible property will be considered QOZBP only if, within a certain period, the lessee acquires additional QOZBP at least equal to the value of the leased property. 

The regulations contain an anti-abuse rule to prevent the use of leases to circumvent the substantial improvement requirement for purchases of real property. This rule applies if there is a plan, intent, or expectation for the real property to be purchased by the QOF under certain circumstances. 

For purposes of a QOF’s 90% qualified property asset test, leased property is valued in one of two ways: 1) at the value reported on applicable financial statement prepared in accordance with GAAP; or 2) at the present value of the leased property. 

For purposes of qualifying as a trade or business, ownership and operation, including leasing, of real property used in a trade or business are treated as qualifying.


Investments of in-kind property

The regulations appear to allow for non-cash (i.e., in-kind contributions) to QOFs. Based on the regulations, these investments appear to qualify for the QOF benefits. The amount of the qualifying investment, however, would generally be limited to the basis of the contributed property (or its fair market value, if lower), with the remaining amount being ineligible for the QOZ benefits (resulting in a mixed investment). The regulations seem silent on whether such contributions of property in-kind would be “good assets” for purposes of the 90% test. (The statute generally requires that “good assets” be acquired by purchase from an unrelated party.) 

More flexibility on exit for 10+ year investors

Until now, it appeared that a taxpayer had to sell his or her QOF interest (not the underlying property in a QOF), or receive a liquidating distribution from the QOF, which had to terminate, in order to be eligible for the forgiveness of new gain after 10 years. Because it would be more difficult to get “top dollar” for several properties bundled in a single QOF interest, fund managers have considered isolating each project in its own QOF. That may not be necessary (but may still be preferable). New guidance provides additional flexibility on exit for taxpayers in QOFs organized as partnerships in which taxpayers have held their interest for at least 10 years. Those taxpayers can make an election, subject to the finalization of these proposed regulations, to exclude some or all of the capital gain from the sale of underlying QOF property, and can elect the 10-plus year forgiveness on separate capital assets. The added flexibility reduces the need to isolate each property in its own QOF. There may still be benefits to so segregating projects, however, including isolating the 10-year clock for each fund/project and considerations around depreciation recapture. 

Also, the regulations provide that taxpayers in QOFs organized as REITs in which taxpayers have held their interest for over 10 years may receive tax-free capital gain dividends. 

Other changes related to the 90% test

Other changes in the regulations include a change that expanded the 31-month working capital exception to be friendlier to businesses. Whereas previously that exception required a written plan relating to the acquisition, construction and substantial improvement of tangible property, there is now also an option for a written plan for the use of working capital in the development of a trade or business. 

There has been concern that recently invested money, for which there was not adequate time to deploy, could hurt a QOF under the 90% qualified property asset test. The regulations provide relief for such newly contributed assets. The 90% test is applied without regard for investments received by the QOF in the six-month period in advance of a testing date (if the investments are held in cash, cash equivalents or debt instruments with a term of 18 months or less). 

Potential reporting requirements

Treasury also released a request for information on what data would be useful in tracking the effectiveness of the QOZ provisions in bringing economic benefits to distressed communities. We can expect information reporting requirements for QOFs in the future.


Anti-abuse rules—included in the 2017 tax law and reaffirmed in Treasury guidance on QOZ regulations—apply to all QOF investments. If a significant purpose of a transaction is to achieve a tax result inconsistent with the purposes of the QOZ provisions, the Commissioner of Internal Revenue can recharacterize the transaction to achieve appropriate tax results. 

The proposed regulations examine a great deal more than we have detailed here, including comments about carried interest and various inclusion events. Treasury and the IRS may publish two more rounds of guidance. We will continue to keep you informed of any important developments in the new field of opportunity zone investment. In the meantime, if you have any questions, please reach out to your J.P. Morgan advisor.