Daily Tax Report ®

INSIGHT: Navigating Opportunity Zones—Making the Myriad of Legal Requirements Work in Practice

Oct. 11, 2019, 1:00 PM

Qualified opportunity zones, or “QOZs,” were established as part of 2017’s so-called Tax Cuts and Jobs Act, which provides three tax benefits to encourage economic growth and investment in these low-income communities: (1) deferral of capital gain recognition until the end of 2026 to the extent a taxpayer elects to invest a corresponding amount in a qualified opportunity fund, or “QOF,” (2) exclusion from income of up to 15% of that gain—10% after five years and an additional 5% after seven years, and (3) exclusion from income of certain post-acquisition gains on investments in the QOF held for at least 10 years.

The Department of the Treasury and the Internal Revenue Service have issued two sets of proposed regulations that provide guidance on a number of questions that were not answered by the statute. Although both sets of proposed regulations generally permit taxpayers to rely on them, more than 300 comments have been filed on the two regulations, and final regulations have not yet been issued. Thus, unanswered questions remain, but because the QOZ benefits are time limited (no election may be made after Dec. 31, 2026), taxpayers must act now if they want the full tax benefits.

This article provides a brief overview of the requirements under the QOZ rules, and looks at some of the solutions that have evolved to work within the requirements of the statute and proposed regulations, as well as some areas where QOF sponsors and their advisors are still in the process of developing solutions. In the process, we will highlight some of the key differences between QOFs and traditional investment funds, which add to the difficulty in navigating these rules.


The QOZ statute and the proposed regulations establish a general framework for investment into a QOZ through an investment vehicle—the QOF—that is required to meet certain requirements. Applying these requirements can be complicated in practice and involves terminology that is easily confused. For example, the statute has three closely-related defined terms—“qualified opportunity zone property,” “qualified opportunity zone business,” and “qualified opportunity zone business property”—that all have their own distinct requirements. It is critical to have a basic understanding of this terminology and the framework set up by the QOZ rules in order to successfully navigate those rules.

Initial Investment

After recognizing capital gain from the sale or exchange of an asset to an unrelated party, investors have up to 180 days to make an investment in a QOF that will qualify for QOZ tax benefits. Qualifying investments must either be made by making a direct contribution of cash or property into a top-level investment entity that elects to be treated as a QOF or by purchasing a direct interest in a QOF from another party. An investor is also permitted to make a “mixed-funds investment” in a QOF—an investment that is qualifying in part and nonqualifying in part—but these portions must be accounted for separately, which may be burdensome.

90% Assets Test and QOZ Property

In order to avoid monetary penalties, at least 90% of the assets of a QOF must be treated as “QOZ property” (the “90% assets test”). QOZ property may consist either of direct investments in “QOZ business property” (tangible assets located in a QOZ that satisfy certain other requirements, described below) or investments in an entity known as a “QOZ business” that, in turn, invests in QOZ business property.

The 90% assets test generally is measured at the half-way point and end of a QOF’s taxable year. However, the proposed regulations permit QOFs to ignore cash, cash equivalents, and short-term debt for six months, effectively giving QOFs between 6-12 months to invest the equity capital it receives in QOZ property. There is a technical issue of whether a QOF can qualify if it has only cash, cash equivalents, and short-term debt, as its asset ratio would be zero, which will hopefully be clarified in the final regulations.

In order for an equity interest in a QOZ business to be treated as QOZ property, it must be acquired by the QOF: (1) after Dec. 31, 2017, (2) from the business at its original issue, and (3) solely in exchange for cash. This means that a QOF cannot purchase a qualifying interest in a QOZ business from a third party, and cannot receive a qualifying interest by contributing non-cash property to a QOZ business. This rule significantly limits the ways in which a QOF may acquire its interest in qualifying investments.

QOZ Business Requirements

There are several, distinct QOZ business requirements:

  • 70% tangible assets test—At least 70% of the tangible property owned or leased by a QOZ business must be treated as QOZ business property.
    • For owned property, this generally means that the property must be acquired by purchase from an unrelated party after Dec. 31, 2017. In addition, the property must either satisfy the “original use test” by being first placed in service in the QOZ after is acquired, or satisfy the “substantial improvement test,” which requires that the QOZ business make improvements to the tangible property in excess of its basis (generally, the cost of acquisition) within a 30-month period. Finally, at least 70% of the use of the owned tangible property must be in the QOZ for at least 90% of the QOZ business’s holding period for the property.
    • For leased property, this generally means that the lease must be entered into after Dec. 31, 2017, must have arm’s-length terms, and there cannot be an intention for the lessee to purchase the property for an amount of consideration other than the fair market value determined at the time of the purchase. Leased property does not need to satisfy the substantial improvement or original use requirements. In addition, leases can be between related persons if they meet certain additional requirements: (1) the lessee cannot prepay more than 12-months’ rent, and (2) for tangible personal property where the original use of the leased property in the QOZ does not commence with the lessee, the lessee must acquire QOZ business property having a value not less than the value of that leased tangible personal property within 30 months.
  • Intangible property test—At least 40% of the QOZ business’s intangible property must be used in the active conduct of business in the QOZ.

  • Nonqualified financial property test—Less than 5% of the aggregate unadjusted bases of property used by a QOZ business can be attributable to “nonqualified financial property”—generally consisting of stock and other financial assets other than reasonable amounts of working capital held in cash, cash equivalents, or short-term debt.

  • Gross income test—At least 50% of the total gross income of the QOZ business must be derived from the active conduct of business in the QOZ. The proposed regulations provide three safe harbors for meeting the gross income test, as well as allowing taxpayers to rely on a more general, but less certain, facts-and-circumstances test.

  • Sin business limitation—The QOZ business cannot operate certain enumerated businesses: golf courses, country clubs, massage parlors, hot tub facilities, suntan facilities, racetracks or other facilities used for gambling, or any stores the principal business of which is the sale of alcoholic beverages for consumption off premises.

The proposed regulations established a “working capital safe harbor,” which is an important tool that QOFs can use to create additional flexibility in their timeline for deploying capital. In general, the working capital safe harbor allows a QOZ business to hold cash, cash equivalents, and short-term debt for a period not longer than 31 months if the QOZ business has a written plan to deploy the working capital for the development of a trade or business in a QOZ (including the acquisition, construction, and/or substantial improvement of tangible property in a QOZ) and actually does so within that time period. If these requirements are satisfied, then the working capital safe harbor protects the QOZ business from failing the nonqualified financial property test, the gross income test, the intangible property test, and the 70% assets test by reason of holding the working capital.

The proposed regulations have also clarified that a single QOZ business may rely upon multiple overlapping or sequential applications of the working capital safe harbor if it receives working capital at different times. It is not clear, however, whether additional working capital safe harbor periods can extend the period for satisfying the QOZ business requirements with respect to the first infusion of capital. In other words, an open question exists as to whether the QOZ business must be engaged in an active trade or business generating gross income and utilizing tangible and intangible assets after the first 31 months.

Interim Recognition of Gains

The proposed regulations describe certain events, called “inclusion events,” that will trigger recognition of an investor’s deferred capital gain prior to the end of 2026. Although the inclusion event rules are lengthy, they generally apply in situations where either: (1) a transfer of a qualifying investment reduces the taxpayer’s direct equity interest in the QOF for tax purposes, or (2) the taxpayer receives property from a QOF in a transaction treated as a distribution for tax purposes. In practice, these rules can create traps for the unwary, as transactions and distributions that ordinarily would be tax-free under general tax principles may trigger an inclusion event.

If a QOF disposes of QOZ property before investor has held the QOF interest for 10 years, the proposed regulations provide some relief. They provide that the QOF can avoid the penalty for failing to meet the 90% assets test, as long as the QOF reinvests the proceeds of a sale of QOZ property within 12 months. However, this rule does not protect investors in a QOF partnership from recognizing interim gains. This is because the statute and proposed regulations do not turn off ordinary partnership tax principles. Thus, any gain recognized by the QOF on the sale of the QOZ property (even if reinvested within 12 months) will flow through to the QOF investors on a current basis—whether or not the investors receive any distributions of cash. This “phantom income” is familiar to most investors in traditional investment funds, but some have argued that it is inconsistent with the expectation of QOF investors to defer their gains.

Exiting from Investments

On the face of the statute, it appeared that an investor was required to sell the investor’s direct interest in the QOF in order to benefit from the 10-year exclusion rule. Because traditional investment funds—especially multi-asset funds—typically structure exits by selling underlying equity or assets owned by the fund and then redeeming investors, this would have significantly impaired the ability of investors to take advantage of the 10-year exclusion rule in practice. The proposed regulations provide some relief by permitting an investor to elect to exclude from gross income capital gain from the disposition of QOZ property reported on the Schedule K-1 that the investor receives from the QOF. However, the rule only applies to capital gain and does not, by its terms, apply to dispositions of property by a QOZ business.

Another problem that had been identified by commenters was that it appeared that the so-called “hot asset rules” under general partnership tax law could effectively erase all or a portion of the benefit of the 10-year exclusion rule to the extent the partnership held hot assets, such as depreciation recapture, inventory, or accounts receivable. The hot asset rules would effectively transform zero gain at the time an investor sells an interest in a QOF partnership into a combination of ordinary income and a capital loss that, in most cases, could not actually be used by the investor. The proposed regulations provide some relief in the form of a special deemed adjustment to the inside basis of QOF partnership assets so as to mimic a cash purchase of the investment when a tax code Section 754 election is in effect. This prevents ordinary income from being recognized and, as such, mitigates the hot asset issue. However, the rule appears to only apply if the investor sells the QOF interest, not if the QOF sells the QOZ property or the QOZ business sells the QOZ business property.

Anti-Abuse Rule

The second set of proposed regulations contained a broad anti-abuse rule:

“[I]f a significant purpose of a transaction is to achieve a tax result that is inconsistent with the purposes of section 1400Z-2, the Commissioner can recast a transaction (or series of transactions) for Federal tax purposes as appropriate to achieve tax results that are consistent with the purposes of section 1400Z-2. Whether a tax result is inconsistent with the purposes of section 1400Z-2 must be determined based on all the facts and circumstances.”

The proposed regulations do not provide any safe harbors or examples of facts and circumstances showing activities that are or are not inconsistent with the purposes of Section 1400Z-2. However, the preamble cites an example of a QOF’s acquisition of a parcel of agricultural land without the QOF investing any new capital investment in, or increasing any economic activity or output of, that parcel as an example of where the anti-abuse rule might apply.


We now turn to some of the practical considerations for QOFs and QOF investors to navigate these complex QOZ rules. In some cases, the considerations for investors will be at odds with those for managers and sponsors of QOFs. The issues faced by managers and sponsors of a QOF also differ in many respects from those faced by managers and sponsors of traditional investment funds.

One vs. Two-Tier Structures

Because of the rules established under the proposed regulations, in most cases, a two-tier structure in which a QOF invests in QOZ business property through a QOZ business generally will allow for greater flexibility than if the QOF invested in the QOZ business property directly. Specifically, a two-tier structure allows greater flexibility to hold nonqualifying property: a QOF can own at most 10% nonqualifying property, while a QOZ business can hold up to 30%. In addition, a two-tier structure allows more time to deploy capital: a QOF has only 6-12 months, while a QOZ business benefits from the 31-month working capital safe harbor.

However, the requirements work in such a way to push taxpayers towards using investment structures with exactly two tiers: the QOF that holds interests in one or more QOZ businesses. First, the rules require direct investment by an investor into a QOF, and a QOF cannot own another QOF. Thus, an investor cannot make a qualifying investment by first making a contribution to a non-QOF feeder fund or blocker corporation that, in turn, invests into a QOF. This means that feeder funds will not be able to be used to bridge the gap between the investors’ and the QOF’s time limitations (discussed immediately below). It also imposes significant limitations for foreign and tax-exempt investors.

Second, the nonqualified financial property test generally makes it impractical for a QOZ business to hold equity interests in a subsidiary. However, the QOZ business could hold interests in disregarded entities without running afoul of the nonqualified financial property test.

Investment Timelines

Managers of traditional funds often receive capital commitments from investors that can be called by the fund manager as and when needed. Because qualifying investments in a QOF must match the 180-day period of the investor, this traditional model may frustrate the tax objectives of QOF investors. While investors have some ability to choose the date that a capital gain is recognized—for example, by holding on to an investment and only selling it at a particular time—this flexibility is not absolute. And QOF managers will not be able to give investors complete discretion over when they put in their funds because the QOF will have to be able to initially deploy capital in a timely fashion (typically within 6-12 months) in order to avoid tax penalties.

The timing issue is made more acute in the context of Section 1231 property—which is generally depreciable property used in a taxpayer’s trade or business. Under the proposed regulations, a taxpayer’s 180-day period for capital gain from to the sale of Section 1231 property begins on the last day of the taxable year in which the property is sold. This rule provides investors with even less flexibility in timing qualifying investments that will defer capital gains from the sale of Section 1231 property.

Different fund managers have adopted different approaches to this potential conflict with investors. Some fund managers have required investors to commit to providing capital whenever it is called, regardless of whether the investor has eligible capital gain at that time. Other fund managers have allowed investors a “put” on their capital commitments that can be exercised if the investor’s 180-day period is about to expire. Fund sponsors could also consider establishing a QOF without eligible investors, and investors that recognize eligible gains could purchase interests in the QOF from the sponsor. This would enable the QOF to work within the 180-day time periods for many different investors.

Because investors may not always have sufficient eligible capital gains to cover their entire capital commitment in a QOF, they may want to be able to make mixed-funds investments. The proposed regulations allow for mixed-funds investments, but not all QOF fund documents do so. Some prohibit mixed-funds investments due to the complexity in accounting for the differing interests.

In order to qualify for tax benefits, QOFs generally will need to stick to relatively strict timelines for both the initial deployment of capital and the establishment of an active trade or business (either directly or by the lower-tier QOZ business). After receiving equity capital from an investor, a QOF generally has 6-12 months to contribute what it receives to a QOZ business to meet the 90% assets test. Once the QOF makes a cash contribution to a QOZ business, the QOZ business may rely on the 31-month working capital safe harbor in order to make investments in developing a qualifying business (including purchasing or improving QOZ business property). For large projects anticipated to take more than 31 months to complete, in the absence of additional guidance, managers should consider ways to establish an active trade or business after 31 months, such as by completing the project in phases.

The timeline for deploying capital in a traditional fund can be very different from a QOF. For example, a traditional private equity or venture capital fund may deploy capital quite quickly after a capital call to make an acquisition or investment, although there may be multiple distinct rounds of investment. A real estate development fund may deploy capital over a long period of time based on the needs of particular construction projects.

Acquiring QOZ Business Property

As discussed above, QOZ business property must be acquired by purchase from an unrelated party after Dec. 31, 2017. This means that QOZ business property cannot be contributed to a QOZ business. It also means that QOZ business property cannot be purchased from related parties (e.g., those owning more than 20% of the QOF). Related-party acquisitions can present difficult questions, but the rules for related-party leases are considerably more favorable and so can provide a potential solution.

In addition, the property acquired must be put to original use in the QOZ or substantially improved. However, an operating business may find it difficult to meet the substantial improvement test because it applies on an asset-by-asset basis. In addition, a business already operating in a QOZ would not be able to satisfy the original use test. The operating business might also consider using leases (which do not need to meet the original use or substantial improvement test), but the lease must be entered into after Dec. 31, 2017 (and meet the other requirements for leased property described above).

Further, QOZ business property must be used in an actively conducted trade or business in order to meet the gross income test and intangible property test. The proposed regulations do not define active trade or business, although they do indicate that a triple-net-lease of real property does not alone constitute the active conduct of business. While private equity and real estate funds actively involve themselves in business investments, they nevertheless often constitute passive investments from a tax perspective, and such funds often engage in triple-net-leasing with respect to real estate. That practice will need to change for real estate businesses conducted through QOFs.

Distributions and Deductions

The QOZ rules differ from traditional partnership tax rules in the amount of the investor’s basis in its QOF partnership interest. The investor starts with a zero basis in its interest in the QOF, because basis is the mechanism by which the QOZ rules measure the deferred gain. Without basis, the investor cannot deduct its distributive share of losses from, for example, excess depreciation deductions. In addition, distributions in excess of a partner’s basis in its partnership interest are considered inclusion events. The investor will receive a partial step-up in basis after holding an investment in the QOF for five years and seven years to reflect the portion of deferred gain that is made exempt from tax by the QOZ rules. The basis also can be increased if the investor receives a distributive share of taxable income from the QOF. In addition, the proposed regulations confirmed that basis can be increased by incurring partnership debt that is allocated to the investor. Debt financing is likely to be very common among QOFs, as a way to provide basis for depreciation and other deductions and to support distributions. For example, a substantial portion (up to 85%) of the deferred capital gains taxes of investors will become payable at the end of 2026. Investors will need cash in order to make these payments and may look to the QOF to make tax distributions at this time.

The proposed regulations provide that any distribution of cash or property will disqualify an investor’s original transfer to a QOF partnership from beneficial QOZ treatment to the extent the overall transaction would be recharacterized as a disguised sale. For this purpose, the proposed regulations broaden the definition of disguised sale to treat cash contributed to a QOF partnership as non-cash property, and to ignore the exception from disguised sale treatment for certain debt-financed distributions. Thus, distributions of cash to QOF partnership investors within two years of the contribution typically will trigger deferred gain. This serves as an anti-abuse rule of sorts—preventing investors from pulling their money out of the QOF within two years.

Although traditional funds also have constraints on the ability to make tax-free distributions to investors, the tax cost can be significantly greater for QOF investors. Thus, QOF managers will need to carefully monitor distributions to navigate the inclusion event and disguised sale limitations, while providing sufficient liquidity for investors to pay taxes when due.

Structuring Exits of Investments

QOFs may aim to adhere (although likely not contractually commit) to a minimum 10-year investment horizon in light of the election to step up the QOF basis to fair market value after 10 years. In practice, the 10-year exclusion rule generally is the most important tax benefit provided by the QOZ statute. Private equity and real estate funds often have shorter investment time horizons.

Traditional funds have significant flexibility in structuring exits from investments to optimize tax efficiency. Often, this is achieved by a sale of an underlying portfolio company (or assets held in a portfolio company), followed by a cash redemption of investors. While the proposed regulations provided some additional flexibility on exit, as described above, some constraints still remain and may not be resolved by the final regulations.

In particular, if the investor sells its QOF interest, the proposed regulations preserve the benefits of the 10-year exclusion rule. The gain is excluded from income, and the special deemed Section 754-type adjustment mitigates the hot asset issue and prevents ordinary income from being recognized from depreciation recapture or other ordinary assets. However, if the QOF sells the QOZ business, the proposed regulations treat capital gain as excluded from the investor’s income if it is reported on the Schedule K-1. However, the rule only applies to capital gain, not ordinary income, so it would not apply to the extent of depreciation recapture or sales of inventory or accounts receivable as part of an operating business. In addition, the hot asset rule provides no relief because it does not, by its terms, apply. Thus, ordinary income could still be triggered to investors upon the sale of the portfolio company. Finally, if the QOZ business sells its assets, neither of the rules in the proposed regulations by their terms apply.

These constraints are particularly important in the context of multi-asset funds and funds with hot assets, including depreciation recapture. It may be impractical for investors to sell their QOF interests to qualify for full benefits of the 10-year exclusion rule, as a third-party buyer is unlikely to want to purchase all of the underlying QOZ businesses simultaneously.

Traditional funds typically invest in multiple different portfolio companies or properties under a single fund structure. Because of the constraints on exit described above, among other reasons, multi-asset QOFs may continue to be disfavored. Instead, parallel fund structures (including series partnerships), with each investment having its own top-level QOF vehicle, may continue to be preferable.

Anti-Abuse Rule

The breadth of the anti-abuse rule may cause some uncertainty, particularly for land deals, such as brownfields remediation or farming or timber activities. Commenters have asked for more clarity on these activities, although the expenditure of substantial capital to improve land and the use of such land in a trade or business should not run afoul of the anti-abuse rule. More traditional real estate developments and operating businesses have not seemed to present similar concerns.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Lisa Zarlenga is a partner at Steptoe & Johnson LLP in Washington. She represents public and private companies on federal income taxation issues, with a focus on tax policy issues with respect to tax legislation and Treasury guidance as well as on corporate transactional and planning matters.

John Cobb is an associate in Steptoe’s Washington office and advises domestic and international clients on federal and state income tax aspects of corporate and partnership transactions.

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