Bloomberg Tax
Dec. 30, 2019, 2:01 PM

INSIGHT: Opportunity Zones—Final Regulations and Outlook for 2020

Libin Zhang
Libin Zhang
Fried Frank

The opportunity zone tax benefit is divided into three parts: (1) deferral of any capital gains invested in a qualified opportunity fund (QOF) generally until 2026, (2) exclusion of up to 15% (or more) of the deferred gains from gross income, and (3) tax-free gain for a QOF interest sold or exchanged after 10 years (through 2047). Substantially all of the tens of billions of dollars of QOF investments has been deployed to revitalize certain designated low-income communities and adjacent census tracts (collectively, opportunity zones).

Treasury and the Internal Revenue Service released proposed regulations in November 2018 and May 2019, which were followed by 544 pages of final regulations on Dec. 19, 2019. Although the final regulations do not address all taxpayer concerns, such as FIRPTA withholding, when a QOF can be disqualified, and what happens when the opportunity zone regime ends in 2047, the regulations do provide plenty of favorable and unfavorable guidance and must be carefully taken into account before making QOF investments.


As an example of a QOF investment following the final regulations, an investor receives $100,000 of mutual fund and REIT capital gain dividends throughout 2019. The investor defers all the gain by investing $100,000 into a new QOF on Dec. 31, 2019. The QOF makes qualifying investments by acquiring a building that’s been vacant ever since its census tract was designated as an opportunity zone in early 2018.

The investor is making her QOF investment in 2019 and therefore can obtain a full 15% basis step-up in its QOF interest after seven years. The investor recognizes only up to $85,000 (85%) of the deferred capital gain in 2026. When she sells her QOF interest or the QOF sells its assets for $400,000 in late 2029, she can elect a basis step-up and pay zero federal income tax on the $300,000 of appreciation.

Alternatively, the QOF may have diversified investments in opportunity zone businesses, including startups in life sciences, artificial intelligence, blockchain technology, and other popular opportunity zone industries. The businesses must comply with certain income and asset requirements, such as ensuring that generally at least 40% of their intellectual property is used to generate gross income in the opportunity zone. The QOF sells some of its stock investments after five years for up to $10 million of tax-free gain qualifying under the Section 1202 small business stock rules, and the QOF sells its remaining investments after 10 years for an unlimited amount of tax-free gain under the opportunity zone rules. The QOF’s tax-free gain after 10 years includes depreciation recapture and other ordinary income from dispositions of any assets, except for ordinary income from the disposition of inventory in the ordinary course of business.


A QOF investor’s deferred capital gain is recognized when there is an “inclusion event,” such as a disposition of the QOF interest. A gift of a QOF interest is an inclusion event that accelerates the deferred gains and terminates any future opportunity zone tax benefits. Since 1984, a transfer of assets to one’s spouse or former spouse (incident to a divorce) is treated as a gift under Section 1041 for all income tax purposes. Updated prenuptial agreements can confirm that, in the event of a divorce, investors can at least keep their QOF interests and not lose any opportunity zone tax benefits.

In contrast to divorce, death is not an inclusion event. The heirs have no basis step-up, recognize the deferred gain in 2026 just like the decedent, and can obtain opportunity zone tax benefits. The final regulations provide for no basis step-up even if the decedent’s QOF interest has appreciated since the initial investment of deferred gains, because the opportunity zone statute generally provides that the tax basis of a QOF interest must be zero and supersedes any basis increase under Section 1014. It is not apparent how that position reconciles with the treatment of partners in QOF partnerships, who have additional tax basis in their QOF interests under Section 752 equal to their share of the QOF’s liabilities.

Section 1231 Gains

The November 2018 proposed regulations provide that only “capital gains” may be deferred with a QOF investment. Commentators promptly pointed out certain issues with gains from Section 1231 property, such as real property used in a trade or business and held for more than one year. Generally a taxpayer’s net Section 1231 gains are capital gains, while any net Section 1231 losses are ordinary losses, and there was debate over how the amounts can be deferred with a QOF investment. See, e.g., Libin Zhang, Qualified Opportunity Zones and Select Partnership Issues, 35 Tax Management Real Estate Journal 235 (Nov. 11, 2018).

Other commentators opined that it is potentially abusive and too good to be true for a taxpayer to defer its Section 1231 gains with a QOF investment while being allowed to deduct Section 1231 losses as ordinary losses in the same year. It is unclear why the same concerns do not apply to like-kind exchanges and installment notes, which have allowed taxpayers to defer Section 1231 gains and deduct ordinary Section 1231 losses in the same year since 1942.

In response, Treasury and the Internal Revenue Service provided in the May 2019 proposed regulations that only a taxpayer’s net Section 1231 gains may be deferred with a QOF investment, and furthermore that such net gains may only be invested beginning on the last day of each year. In other words, a taxpayer who sold rental real estate at any time in 2019 must generally wait until the very end of 2019 to make a qualifying QOF investment, which has delayed much critical capital deployment into opportunity zones. Tuesday, Dec. 31, 2019, became the Great Opportunity Fund Investment Closing Date, as it is the first date that most 2019 Section 1231 gains can be invested in QOFs and also the last date that investors can potentially obtain the 15% reduction of the deferred gains.

The final regulations, released less than two weeks before Dec. 31, 2019, is more informed about Section 1231 and provides that the gross amount of Section 1231 gains may be deferred with a QOF investment, regardless of the taxpayer’s Section 1231 losses in the same year that offset other ordinary income. The 180-day investment period for Section 1231 gains begins on the sale or exchange date, instead of year end. Due to the timing, taxpayers who followed the proposed regulations and waited until the end of 2019 are sometimes unable to use the final regulations, under which the 180-day period may have already ended.

The final regulations apply to a taxpayer’s taxable years beginning after February 2020, i.e., in 2021 and subsequent years for calendar year taxpayers. A taxpayer may choose to apply the final regulations to earlier years, but only if applied in a consistent matter for all such earlier years. In other words, before 2021, a taxpayer generally cannot selectively use the proposed regulations in some circumstances (such as the 180-day investment period begins at year end for Section 1231 gains recognized early in the year) and use the final regulations in other circumstances (such as investing other gross Section 1231 gains mid-year, within 180 days of sale, or any other favorable rule in all the final regulations).

Excluded Businesses

A QOF’s lower-tier subsidiary may not engage in certain excluded businesses: golf course, country club, massage parlor, hot tub facility, suntan facility, gambling facility, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises. (The more judgmental and anti-golf term of “sin businesses” is sometimes used.) The excluded business prohibitions do not apply to a QOF’s direct assets, such as QOF-owned casinos, health spas, and golf courses in opportunity zones.

The final regulations confirm in an example that a QOF may directly own a golf course. The QOF’s lower-tier subsidiary may not own an excluded business or lease its properties to an excluded business, other than a de minimis amount. The prohibition on leasing to an excluded business is consistent with the nearly identical new markets tax credit (NMTC) rules, which has banned such leases to excluded businesses since 2005.

There are some congressional bills to make the excluded business prohibitions actually apply to QOFs, and also to discourage a QOF and its subsidiaries from owning any airplane, private luxury box, health club facility, self-storage facility, stadium and certain other sports facilities, parking facility, or residential property where less than 50% of the housing units are rent-restricted and occupied by individuals with less than 50% of area median income. The proposed legislation will generally have retroactive effect and may negatively affect many QOFs’ plans to develop children’s athletic centers, moderate income housing, any development with significant parking, and other enterprises. See Libin Zhang, Clearing the Air About Marijuana in Qualified Opportunity Zones, 35 Tax Management Real Estate Journal No. 4 (2019).


Many states conform to the federal QOF tax benefits, but not all. California and Massachusetts residents cannot defer their capital gains for state tax purposes and must pay full state income tax when they sell their QOF investments. Similarly, out-of-state investors in a QOF with a California project are potentially subject to full California income tax when they sell their QOF investments, even after 10 years, which likely negates any QOF tax benefits provided by their home states. California has temporarily extended its top 13.3% tax rate through 2030.

California-related QOFs may have some difficulties with fundraising, especially after they disclose material state tax issues to their prospective investors. California could enact QOF conformity legislation in the future, but the major proposed bills so far would provide California tax benefits only to renewable energy and affordable housing investments, only for limited investment amounts, and only in California opportunity zones.


Although the final regulations provide favorable timing rules for REIT shareholders to invest their REIT capital gain dividends in QOFs, the regulations are less favorable for public REITs that would like to themselves invest in QOFs. A well-known issue is whether a REIT’s earnings and profits (E&P) are increased by the tax-free gain (basis step-up) after 10 years, as well as the 10% or 15% basis step-ups after five or seven years. If those step-ups increase E&P, the REIT’s tax-free gain becomes taxable ordinary dividends when distributed to the REIT’s shareholders.

The final regulations followed one commentator’s recommendation that the basis step-ups be treated as tax-exempt income that increases E&P of REITs and other corporations. New York State Bar Association, Report No. 1418—Report on Proposed Qualified Opportunity Zone Regulations under Section 1400Z-2, at 68 (July 1, 2019). The practical consequence is that the opportunity zone tax exemption benefit may become merely a tax-deferral benefit for REITs and their shareholders, and may further convert what would otherwise be capital gain into ordinary income. A vast source of available investment capital may be dissuaded from opportunity zone investments.


The final regulations address other important points that can facilitate opportunity zone investments in 2020 and beyond, including the ability to treat inventory as optionally a good asset or a disregarded asset for the various asset tests, fewer requirements for properties leased to a QOF or its subsidiary, allowing an opportunity zone business to use the working capital safe harbor for up to 62 months, clarification of discrepancies in the proposed regulations about properties that straddle opportunity zone boundaries, and expanded rules for the growing use of opportunity zone benefits by multinational corporations and their consolidated groups.

Over the past two years, many QOFs have provided capital, housing, jobs, and other desirable development benefits for opportunity zones and their local stakeholders. Substantially all funds and their opportunity zone advisers have been sensitive to community concerns, in part by using teams with diverse cultural backgrounds and experiences. Opportunity zone projects are long-term investments. QOF interests can be held through 2047 and give rise to tax-free gain compounded over three decades, as long as no inclusion event occurs, which requires careful tax planning and thoughtful tax guidance in order to ensure that the investments are made properly and continue smoothly.

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

Author Information

Libin Zhang is a partner in Fried Frank’s New York office.