IRS Publishes Final Opportunity Zone Regulations: Putting It All Together

Ah…opportunity zones. Not since my private message pursuit of Kristen Bell have I invested so much time and effort into something only to receive nothing in return.

To be honest, the whole opportunity zone thing has been a bit of a phenomenon. Once an overlooked eight pages of sloppily-written text buried deep within the Tax Cuts and Jobs Act, over the last two years, the opportunity zone tax break – or at least talking about the opportunity zone tax break – has become big business. Not a week goes by that there isn’t an conference or three on the topic somewhere in the country. Over the summer, I arrived home from work one day to find the inaugural issue of Opportunity Zones Magazine in my mailbox. And to top it all off, in the past year, I’ve been interviewed by two opportunity zone podcasts, which is worthy of note only because it establishes that there are multiple opportunity zone podcasts.

I’ve gotten caught up in the excitement as much as anyone. This is now the sixth time I’ve published an article detailing the tax benefits afforded by Section 1400Z-2, and I’ve taught the topic more times than I can count. But rather than explain from my own perspective why this time has proved fruitless, allow me to share the words of a guy who stood – yes stood – in the back of my four hour workshop on opportunity zones for the AICPA this past November. About two hours into my class, as I explained the critical differences between QOZB, QOZP, and QOZBP, he’d finally heard enough. His hand shot up, and I asked if he had a question. He did.

“I gotta’ be honest,” he said, “Why should I care about any of this stuff?”

Now, given that I was charged with teaching 75 people how these rules worked, you would think I’d find his apathy frustrating. But the thing is, I got it. In knew exactly what he meant. Because for all the time I’ve spent learning, writing and teaching about the opportunity zone rules, I haven’t found more than a client or two that’s actually excited about them. The rest worry about the confusing rules. The long required holding period. The inability to enjoy losses or take distributions in the early years.

As a result, when I look back at the past 24 months, I’m struck by the realization that for all the effort I’ve put in to learning these rules, putting that education into practice has barely earned my firm enough in revenue to pay for a shiny new printer for our Nashville office.

And I know I’m not alone. This frustration has been shared with me by countless members of the tax industry who have spent hours trying to understand how opportunity zones work, only to be met with indifference by clients and prospects. But because accountants are not exactly the free-thinking type, we carry on. New rules come out, and we simply can’t resist the primal, Pavolvian response to dive into the guidance and make sense of it all, even if it ain’t paying the bills.

Which brings me to this, article #6 on opportunity zones. Last Thursday, the IRS released final regulations under Section 1400Z-2 that tie together many of the loose ends remaining after the publishing of two sets of proposed regulations, one in October 2018 and another in May 2019. This article will attempt to put it ALL together: the statute, the two proposed regulations, and last week’s final regulations — on the off chance that 1) this is the first time you’re tackling these rules, and 2) you’re got clients that are ready to pull the trigger on an opportunity zone investment.

Because you may already be familiar with many of these concepts, however, throughout the article I’ll be sure to highlight those areas where changes were made by the final regulations. That way, if you’re only interested in perusing the latest developments, you can do that quickly and easily.

Here goes….

Opportunity Zones, In General

As part of the Tax Cuts and Jobs Act, Congress enacted two companion provisions designed to encourage investment and economic growth in certain low-income communities. First, Sec. 1400Z-1 paved the way for nearly 9,000 such low-income communities to be designated as “qualified opportunity zones” (QOZs). In turn, Sec. 1400Z-2 offers three federal income tax incentives to a taxpayer who invests in a business located within one of these zones: (1) the temporary deferral of capital gains, to the extent the gains are reinvested into a “qualified opportunity fund” (QOF); (2) the partial exclusion of previously deferred gains when certain holding period requirements in a QOF are met; and (3) the permanent exclusion of post-acquisition gains from the sale of an investment in a QOF held longer than 10 years.

Sec. 1400Z-2 entails a specific process, complete with critical definitions, deadlines, and quantitative tests that must be satisfied before the promised tax benefits become a reality. Before we get into the nuances of the law, we need to establish three things:

1.     The life cycle of an opportunity zone investment,

2.     The acronyms we’ll use throughout the article, and, perhaps most importantly,

3.     The “spirit” of the incentive.

Life Cycle

The life cycle of an opportunity zone incentive can be represented at a high level as follows:

A taxpayer realizes “eligible gain” taxed as capital gain —> The taxpayer reinvests the gain within 180 days into a QOF and defers the gain for the year of sale —> The QOF conducts a “Section 162 business,” either directly by holding qualified opportunity zone business property (QOZBP) or indirectly by holding QOZ stock or a QOZ partnership interest, provided the subsidiary meets the definition of a qualified opportunity zone business (QOZB) —> After holding the interest in the QOF for five years, the taxpayer excludes 10% of the original deferred gain —> After an additional two years, another 5% of the original deferred gain is excluded —> Any remaining deferred gain is recognized on Dec. 31, 2026 unless an “inclusion event” occurs prior to that date —> After holding the interest in the QOF for a total of ten years, the taxpayer may sell the investment in the QOF — or, in limited circumstances — the QOF or QOZB  may sell its assets — at any time before 2048 and the taxpayer can exclude all — or most of — the gain resulting from the sale.

Acronyms

As you probably just noticed, the opportunity zone life cycle is rife with acronyms. Let’s establish a brief glossary before we dig in any deeper:

QOZ: qualified opportunity zone. These are the designated areas in which a business must be conducted for any of the tax benefits to come to fruition.

QOF: qualified opportunity fund. A taxpayer who wishes to defer eligible gain must invest an amount equal to that gain into a QOF within 180 days of the sale. A QOF can be a C corporation, S corporation, or partnership.

QOZP: qualified opportunity zone property. A QOF must conduct a business in a QOZ, either directly or indirectly. This standard is tested every six months, and at each testing date, at least 90% of the assets of the QOF must be QOZP. QOZP can either be qualified opportunity zone business property (discussed below), or an interest in a subsidiary corporation or partnership that conducts a qualified opportunity zone business (QOZB, also discussed below).

QOZB: qualified opportunity zone business. A QOF can conduct a business directly, or through a corporate or partnership subsidiary. If done through a subsidiary, the subsidiary must meet the definition of a QOZB.

QOZBP: qualified opportunity zone business property. As discussed more fully below, QOZBP is property purchased after 2017 from an unrelated party, and, in general, either 1. the “original use” of the property in the QOZ begins with the QOF or QOZB, or 2. the QOF or QOZB “substantially improves” the property.

Spirit of the Incentive

The opportunity zone incentive is a simple bargain: taxpayers will invest deferred gain into designated areas in need of revitalization, and in exchange, the taxpayer will receive a heap of tax benefits. But in order to realize those benefits, the cash invested by the taxpayer into a QOZ – with the QOF acting as conduit — must improve the lives of those living in the opportunity zone, either by 1) bringing a new business into the zone that creates jobs or expands the options available to the zone’s residents, or 2) improving the availability, aesthetics and value of the zone’s housing options by engaging in development projects. This is why the statute requires that all qualifying assets be purchased after 2017 and either 1) satisfy the original use test – which as we’ll see below, means the asset was never before placed in service in the zone, ensuring that new assets are being brought in, or 2) substantially improved, which means existing assets are being renovated or rebuilt.

More important, however, is what the spirit of the law doesn’t allow for. For example, if you’re required to improve the lives of the local residents, an investor can’t simply buy raw land and hold it for ten years before selling the land and excluding all the gain. After all, who does that benefit other than the investor? Similarly, because of the “original use” and “substantial improvement” requirements, an investor can’t simply buy an existing rental property and continue the status quo: that real estate was there before the investor bought it; if it’s not being renovating, than what value did the investor bring to the zone?

Understanding the spirit of the law is critical, because the final regulations contain a broad anti-abuse provision that can derail any investment that doesn’t adhere to that spirit. Don’t believe me? Check out this example from Reg. Section 1.1400Z2(f)-1:

Example 4.— Facts. Entity D is a QOF. Entity D owns a majority qualified opportunity zone partnership interest in a domestic partnership, Partnership D. Entity D organized Partnership D for the purpose of being a qualified opportunity zone business. Partnership D acquires a tract of land located in a qualified opportunity zone. At the time of the acquisition of that land, there was no plan or intent to develop or otherwise utilize the land in a trade or business that would increase substantially the economic productivity of the land. Instead, there was a plan to pave the land for use as a parking lot. Partnership D planned to install a gate to the paved parking area, a small structure that would serve as an office for a parking attendant, and two self-pay stations for use by customers. The parking lot was not reasonably expected to expand significantly, and the initial small number of employees was not reasonably expected significantly to increase. A significant purpose for the acquisition of the land was to sell the land at a profit and to exclude any gain from appreciation.

The acquisition of the land is a transaction carried out to achieve a tax result that is inconsistent with the purposes of section 1400Z-2 and the section 1400Z-2 regulations. Consequently, the land is not qualified opportunity zone business property and gain from the sale of the land will not be eligible to be excluded from gross income.

See what I mean? In the example, even though cash was used to operate a business within a QOZ – a parking lot – the spirit of the law wasn’t met; rather, the investor was looking to cash in on land speculation. Use this concept when assessing whether a proposed investment into a QOZ will work; if it doesn’t sound like the investment will improve the lives of the residents of the QOZ, it should give you pause.

OK, next on the docket is to break down each step of the opportunity zone life cycle. Let’s get started, and remember, as we go through the process, we’ll be sure to point out where the final regulations have changed things.

Eligible Gain 

The immediate benefit provided by Sec. 1400Z-2 is the deferral of “eligible gain” that is reinvested into a QOF within 180 days of the sale or exchange that gives rise to the gain. Eligible gain is gain that:

• Is “treated as capital” for federal income tax purposes;
• Would be recognized for federal income tax purposes before Jan. 1, 2027; and
• Does not arise from a sale or exchange with a related party (a 20% direct or indirect relationship either before or after the sale).

The use of the term “treated as capital gain” is important. It allows for gain arising from the sale of a Sec. 1231 asset — which by definition is not a capital asset but the net gain from which is taxed as capital gain — to qualify as eligible gain. Any depreciation recapture taxed as ordinary income under Secs. 1245 and 1250, however, is not eligible gain.

It’s at this point where we have our first significant change made by the final regulations:

Change in the Final Regulations: Treatment of Section 1231 Gains

Depreciable property and non-depreciable real estate used in a trade or business for longer than one year are not capital assets; rather, they are a special brand of property: Section 1231 assets. When a taxpayer disposes of Section 1231 assets, a netting process is required, with the resulting character of any net gain or loss being a bit of a chameleon. Net Section 1231 gain for the year is taxed as capital gain, while net Section 1231 loss is deducted as an ordinary loss. Because of this netting process, the proposed regulations required a taxpayer to wait until the last day of the tax year – when the netting process would be complete – before contributing any net Section 1231 gain into a QOF.

Thus, if a taxpayer had a $1,000,000 Section 1231 gain on January 5, 2019, and a $200,000 Section 1231 loss on December 3^rd, 2019, the taxpayer would be limited to contributing the net Section 1231 gain amount of $800,000 to a QOF — as this was the amount “treated as capital gain” — and that investment couldn’t take place until December 31, 2019. Alternatively, assume the same taxpayer had only the January 5^th gain of $1,000,000. Under the proposed regulations, even if the taxpayer knew he or she would not have any Section 1231 losses for the remainder of the year, they still had to wait until December 31, 2019 – when the netting process was complete – before contributing the $1,000,000 of gain into a QOF.  

The final regulations change these rules, allowing a taxpayer to immediately contribute a Section 1231 gain to a QOF, even though the taxpayer could have other Section 1231 losses during the year that reduce the net Section 1231 gain. To illustrate, if the taxpayer above recognized the $1,000,000 of Section 1231 gain on January 5^th, the 180-day investment clock would start on that day, and the taxpayer would be free to drop the $1,000,000 into a QOF despite the fact that the taxpayer later generated a $200,000 Section 1231 loss on December 3^rd. Stated another way, each Section 1231 gain now stands on its own, and may be immediately invested into a QOF without regard to other Section 1231 losses that may occur before or after the gain is recognized and that would – but for this rule — reduce the net Section 1231 gain for the year. This is obviously great news for taxpayers as it increases the amount of gain they may invest and defer and starts the investment window immediately. But it’s actually better than that…because Section 1231 gain may be immediately invested into a QOF and deferred, any Section 1231 loss for the year, which otherwise would have simply reduced gain taxed at favorable capital rates, will now become a net Section 1231 loss, giving rise to an ordinary deduction.

But that’s not all. As you may be aware, before any Section 1231 gain is afforded capital gain treatment, the taxpayer must “recapture” any net Section 1231 losses from the previous five years as ordinary income. To illustrate, if a taxpayer has net Section 1231 gain of $100,000 in 2019 but had a net Section 1231 loss of $20,000 in 2017, $20,000 of the 2019 gain of $100,000 is recharacterized as ordinary income.

But for those taxpayers investing in a QOF in 2019 or 2020, when the Section 1231 gain that is deferred becomes triggered in 2026 (assuming no inclusion event prior), any Section 1231 loss that was given ordinary treatment in the year of investment by virtue of the deferral of Section 1231 gain will be outside the 5-year recapture window.

Other Changes to Eligible Gain in the Final Regulations

Finally, the final regulations clarified two unresolved issues surrounding eligible gains; one clarification yielding good news, the other bad.

First, the regulations make clear that if a taxpayer sells an asset on the installment method that gives rise to eligible gain, the taxpayer may choose to defer each and every gain recognized over the period of years payments are received (until the end of 2026, that is). This is the case even if the initial sale occurred prior to 2018.

As for determining the 180-day reinvestment period for installment sale gain, the taxpayer has a choice: there can either be a separate 180-day period for each payment received by the taxpayer during the year, or there can be only a single reinvestment period beginning on the last day of the tax year. Thus, if a taxpayer receives payments in March, June, September of December of 2019, each giving rise to installment sale gain under Section 453, the taxpayer could elect to have four separate 180-day windows (starting in March, June, September and December), or instead a single period starting on December 31, 2019, during which all of the gain recognized during the year could be reinvested.

Now for the bad news. The regulations make clear that a taxpayer cannot sell an asset to a QOF and then reinvest those proceeds into the QOF and have that transaction give rise to eligible gain. This is because the cash started and ended at the QOF, and thus under general tax principles, the circular movement of the cash would be disregarded and the transaction would be recast as a contribution of property to the QOF in exchange for an ownership interest. Thus, there has been no “sale” giving rise to eligible gain. The same would hold true if a taxpayer sold an asset to a QOZB, then contributed the proceeds to a QOF that owned the QOZB, only for the QOF to contribute those proceeds back to the same QOZB from whence they came.

Eligible Taxpayers 

Any taxpayer that realizes eligible gain for federal tax purposes may elect to defer that gain. These taxpayers include individuals, C corporations (including RICs and REITs), partnerships, S corporations, and trusts and estates.

If a partnership or S corporation realizes eligible gain, it has a choice: It may elect to defer that gain at the entity level, or it may pass the gain through to its owners, who are then free to make their own decision on deferral.

If a partnership or S corporation elects to defer the eligible gain, the deferred gain is not included in the distributive share of the owners and does not increase the owners’ basis in the entity. When some or all of the deferred gain is subsequently recognized by the entity under the rules of Sec. 1400Z-2, the gain is included in the distributive share of the owners and increases the owners’ basis at that time.

Ex. A, B, and C each own a one-third interest in PRS, a partnership. In 2019, PRS realizes eligible gain of $90,000. If PRS elects to defer the gain, no amount of the $90,000 gain is allocated to A, B, or C, and the basis of A, B, and C in PRS is not increased. If the partnership does not elect to defer the eligible gain, the gain is included in the distributive share of the partners and immediately increases each partner’s basis in the partnership. Each partner, in turn, may then elect to defer some or all of the eligible gain allocated from the partnership, but only if the sale by the partnership giving rise to the gain was to a taxpayer unrelated to the partner.

Ex. Assume the same facts as in the previous example, only PRS does not elect to defer the eligible gain realized in 2019. As a result, each of A, B, and C is allocated $30,000 of gain, and each partner increases his or her basis in PRS at that time. Any or all of A, B, or C may then elect to defer the gain at the individual level, provided all the requirements of Sec. 1400Z-2 are met.

Timing of Reinvestment

A taxpayer that wishes to defer eligible gain must reinvest the gain into a QOF within 180 days from the date of the sale or exchange that gives rise to the gain.

In the case of a partnership or S corporation that realizes eligible gain but does not elect to defer that gain, choosing instead to allocate the gain to its owners, the partner or shareholder has a choice as to when to start the 180-day clock. Final regulations only added to that flexibility. Let’s take a look:

Change in Final Regulations to 180-Day Window for Gain Allocated from Pass-Through Entity to Owners

Proposed regulations provided that a partner or shareholder’s 180-day period with respect to gains allocated from a pass-through entity would begin not on the date of sale, but rather on the last day of the entity’s tax year.

Ex. A is a one-third partner in PRS, a calendar-year partnership. On Jan. 8, 2018, PRS realizes $90,000 of eligible gain. PRS elects not to defer the gain and includes $30,000 in A’s distributive share. A does not receive the Schedule K-1 reflecting the $30,000 of gain until March 12, 2019, a date well after the 180-day period beginning on the Jan. 8, 2018, sale date. For the purposes of determining A’s 180-day period, however, the period begins on Dec. 31, 2018, the last day of PRS’s tax year. This extends A’s period for reinvestment until June 29, 2019.

Alternatively, the proposed regulations permitted a partner or shareholder to elect to treat the 180-day period with respect to the owner’s distributive share of that gain as being the same as the entity’s 180-day period, i.e., the date of sale by the pass-through entity. This would permit an owner to accelerate his or her reinvestment into a QOF.

Ex: Assume the same facts as in the previous example A may elect to treat the 180-day period with respect to his $30,000 of gain from PRS as beginning on Jan. 8, 2018, the date of the partnership sale.

The final regulations added additional flexibility for a partner or shareholder receiving an allocation of eligible gain from a flow-through entity. Under Reg. Section 1.1400Z2(a)-1(c)(8)(iii), the partner or shareholder may elect to start the 180-day period on the due date of the pass-through entity’s tax return, not including extensions. Thus, in the example above, A could elect to start the 180-day period on March 15, 2019, extending the period for reinvestment into September of 2019. This will obviously help taxpayers who may not get information regarding their allocable share of gain until late in the winter filing season.

Reporting and Amount of Investment

A taxpayer elects to defer eligible gain by filing Form 8949, Sales and Other Dispositions of Capital Assets with their tax return for the year of sale.

A taxpayer is not required to reinvest the entire proceeds from the sale or exchange giving rise to the eligible gain; rather, to defer the full amount of eligible gain, the taxpayer must reinvest only the gain amount. Thus, unlike a Sec. 1031 exchange, a taxpayer reinvesting in a QOF can both take cash off the table and defer the full amount of gain resulting from the sale.

Ex: A holds a building with an adjusted tax basis of $1 million and FMV of $2 million. If A does a Sec. 1031 exchange with B, receiving replacement property with an FMV of $1.7 million and $300,000 of cash, A must pay tax on the $300,000 of gain under Sec. 1031(b) and thus may defer only $700,000 of gain. Alternatively, if A sells the building for $2 million of cash, A can retain $1 million of cash, reinvest the remaining $1 million into a QOF within 180 days, and defer the full $1 million of gain.

If a taxpayer invests more than the eligible gain amount into a QOF, the taxpayer is treated as having made two separate investments. The first represents only the investment of eligible gain for which a deferral election has been made. The second consists of all other amounts. The subsequent exclusion provisions (discussed later in this article) apply only to the investment of the eligible gain.

Ex. A realizes $100,000 of eligible gain on June 7, 2019. On June 23, 2019, A invests $150,000 into a QOF and elects to defer the $100,000 of gain. A is treated as having made two separate investments into the QOF; the first is the $100,000 of deferred gain that will be eligible for future tax benefits under Sec. 1400Z-2, and the second is a $50,000 investment that represents the amount invested in excess of the eligible gain. This second investment is not eligible for future tax benefits under Sec. 1400Z-2 but rather is subject to general tax principles.

Make sure you appreciate that previous example, as it’s perhaps the most important thing you can learn about opportunity zones, and understanding and appreciating this fact will save you a LOT of time: ONLY AN INVESTMENT OF DEFERRED GAIN IS ELIGIBLE FOR ANY OF THE OPPORTUNITY ZONE TAX BENEFITS, INCLUDING THE TEN YEAR EXCLUSION. I’ve had more clients and prospects than I can count talk to me for hours about opportunity zones, only for me to realize that they had no gains they wanted to invest; instead, they hoped to invest after-tax cash in pursuit of the ten-year exclusion. That, however, is not possible.

Recognition of Previously Deferred Gains 

There are two advantages of an opportunity zone investment relative to deferring gain via a Section 1031 like-kind exchange:

1. Unlike a like-kind exchange, a taxpayer who sells property for a gain may both defer all of the gain AND take cash off the table by investing in an opportunity zone, and
2. A partnership that holds appreciated real estate can dispose of the property and let each partner decide whether they want to cash out or defer the gain. This type of flexibility isn’t available in the Section 1031 context.

There is, however, also one way in which an opportunity zone investment is less advantageous than a Section 1031 exchange: unlike a like-kind exchange, any gain deferred by investing in a QOF is not deferred indefinitely. Rather, the clock begins counting down on the date of the investment, and the gain will be recognized on the earlier of:

• The date on which the interest in the QOF is sold or exchanged (or any other “inclusion event”), or
• Dec. 31, 2026.

The amount of gain included in gross income is determined by subtracting the taxpayer’s basis in the investment in the QOF (for these purposes, it is zero before being increased as the 5 and 7- year holding periods are met) from the lesser of:

• The original amount of deferred gain, or
• The FMV of the interest in the QOF on the recognition date.

If a taxpayer sells an interest in a QOF that was previously subject to a gain deferral election, the taxpayer may in turn make a second election to further defer the recognition of the original deferred gain, if the taxpayer reinvests the gain amount within 180 days in the same or another QOF.

Change in Final Regulations to Reinvestment of Gain Upon Partial Disposition of QOF Interest

Under the proposed regulations, this opportunity for a second deferral applied only when the taxpayer sold the entire interest in the QOF. This is not the case under the final regulations, however. Now, a taxpayer may also choose to defer gain related to a partial disposition of a QOF by reinvesting those proceeds into another QOF within 180 days. While the preamble seems to indicate that the gain can only be reinvested into a DIFFERENT QOF, the example in the final regulations — in which the taxpayer disposes of their entire interest in the QOF — provides that the proceeds can go back into the original QOF as well. Perhaps the difference is that gain from a partial inclusion event must be reinvested into a new QOF while gain from a complete inclusion event may also go back into the old QOF?

Attributes of Deferred Gain When Recognized

When previously deferred gain is included in income — either upon an earlier inclusion event or on Dec. 31, 2026 — the gain has the same attributes in the year of inclusion that it would have had if tax on the gain had not been deferred. These attributes include those taken into account by Secs. 1(h), 1222, 1256, and any other applicable provisions of the Code. The final regulations make clear that investors are, however, at the mercy of whatever tax rate may exist in 2026 when the deferred gain comes due. As a result, a taxpayer seeking to defer gain must consider the possibility that tax rates on capital gains could be significantly higher than the 23.8% maximum rate imposed today.

Inclusion Events

The final regulations establish a general principle that deferred gain must be recognized any time a taxpayer either 1) reduces their direct equity investment in the QOF, or 2. “cashes out” a portion of their investment in the QOF by receiving a distribution of property with a FMV in excess of the taxpayer’s basis in the QOF. .”

This latter group of “inclusion events” includes any distribution from a QOF corporation or partnership that exceeds the owner’s basis and is thus taxed as a sale or exchange under either Section 301, 731 or 1368. These types of inclusion events will trigger deferred gain on a dollar-for-dollar basis.

Here are just a few of the inclusion events:

• A sale of a direct interest in a QOF.
• Termination or liquidation of the QOF,
• Liquidation of a corporate owner of a QOF (to the extent Section 336 treats the QOF investment as having been “sold” in the liquidation),
• Transfer of a QOF investment by gift,
• A conversion of an S corporation investor in a QOF to a partnership or disregarded entity.
• A redemption of an eligible interest by a QOF C corporation unless the redeemed shareholder was the sole shareholder.

And here are a few items that are NOT considered inclusion events:

• Liquidation of a corporate owner of a QOF if the liquidation is into a parent who owns 80% of the taxpayer, making the liquidation tax-free under Sections 332 and 337,
• Generally, transfer of an investment in a QOF at death,
• Contribution of a QOF interest to a grantor trust, provided the taxpayer is the deemed owner of the trust.
• Transfer of a QOF interest to a partnership in exchange for a partnership interest under Section 721,
• The making or revocation of an S election,
• Qualifying Section 381 transactions resulting from tax-free reorganizations.

Investors will want to get familiar with the list of inclusion events that will cause deferred gain to be recognized prior to the end of 2026 that is found in Reg. Section 1.1400Z2(b)-1, as a few triggering transactions are not intuitive. For example, a tax-free transfer of a QOF interest between spouses incident to a divorce under Section 1041 is an inclusion event, triggering deferred gain to the transferor.

Clarification in Final Regulations on Basis Rules for Inherited QOF Interests

Lastly, the final regulations addressed a question that had vexed a number of investors. The statute requires that all investments of deferred gain into a QOF begin with a basis of zero. The proposed regulations then made clear that the death of a holder of a QOF was not an inclusion event. And of course, upon death, Section 1014 provides beneficiaries with a stepped-up fair market value basis in property received from the decedent. Read together, would that mean that upon death, an investors zero basis in a QOF (assuming it had not yet been increased at the 5 or 7-year anniversaries) would increase to its fair market value? The final regulations answer that in the negative.

Example. Taxpayer A, an individual, contributed $50X to a QOF in exchange for a qualifying investment in the QOF in January 2019. This $50X was capital gain that was excluded from A’s gross income. A’s basis in the qualifying investment is zero. As of January 2024, A’s basis in the QOF is increased by an amount equal to 10 percent of the amount of gain deferred, so that A’s adjusted basis in 2024 is $5X. A dies in 2025 and A’s heir inherits this qualifying investment in the QOF. A’s death is not an inclusion event for purposes of section 1400Z-2. The heir’s basis in the qualifying investment is $5X.

Qualified Opportunity Funds 

A taxpayer may defer eligible gain only if, within 180 days of the sale or exchange, some or all of the gain is reinvested into a QOF. A QOF is a special-purpose entity that effectively acts as a conduit, achieving the policy goal of ensuring that invested capital is ultimately employed in a business located within a QOZ.

A QOF may be organized as a corporation or partnership and may be newly formed or a preexisting entity. A QOF does not need to be located within a QOZ.

A QOF must self-certify that it is a QOF by filing Form 8996, Qualified Opportunity Fund, with its tax return for each year the entity intends to operate as a QOF. In the first tax year the entity intends to operate as a QOF, the entity has the option of specifying the first month it wants to be a QOF. If no month is specified, then the first month of the entity’s initial tax year as a QOF is treated as the first month that the entity is a QOF. Designation of the initial year and month as a QOF is critical, because any eligible gain invested by a taxpayer into an entity before the entity’s first month as a QOF is not eligible for deferral.

As stated earlier, a taxpayer that elects to defer gain by reinvesting that gain into a QOF takes a basis in the QOF interest of zero. If a taxpayer invests money in a QOF and does not make an election to defer eligible gain with respect to that investment — or if the taxpayer invests more than the eligible gain amount into a QOF — this investment is treated as a separate investment in the QOF, and the taxpayer’s basis in that investment in the QOF is determined under general tax principles. Only investments attributable to deferred gains are eligible for the five-, seven-, and 10-year holding period exclusion provisions.

The 90% test

A QOF must hold at least 90% of its assets in QOZP (the “90% test”), determined by the average of the percentage of QOZP held in the fund, as measured on:

• The last day of the first six-month period of the tax year of the QOF, and
• The last day of the tax year of the fund.

If an entity’s self-certification as a QOF is effective for a month other than the first month of the entity’s tax year, then in the QOF’s first year, the first six-month period begins on the first day the entity is designated as a QOF, but only if its tax year is longer than six months.

If an entity’s first month as a QOF is the seventh month of its tax year or later, there is only one testing date for the year: the last day of the QOF’s tax year.

Ex. PRS, a calendar-year partnership, self-certifies that it intends to operate as a QOF beginning September. 1, 2019. Because there are not six months in PRS’s initial tax year as a QOF, there is only one measurement date for purposes of the 90% test: Dec. 31, 2019.

If a QOF has an applicable financial statement, then the value of each asset for purposes of the 90% test is the value of that asset as reported on the QOF’s applicable financial statement for the relevant reporting period. If a QOF does not have an applicable financial statement, the value of each asset of the QOF for purposes of the 90% test is the QOF’s cost of the asset.

If a QOF fails to meet the 90% test for any year, the QOF must pay a penalty for each month it fails to meet the requirement. No penalty is imposed, however, if it is shown that the failure to satisfy the 90% test was due to reasonable cause. The proposed regulations do not provide examples of reasons for failing to satisfy the 90% test that would satisfy the reasonable-cause exception.

The regulations provide that a QOF, when measuring it’s compliance with the 90% test, may choose to exclude from both the numerator and denominator of its assets the amount of any property received by the QOF as a contribution in exchange for a membership interest in the QOF during the six month period prior to the test, as long as during the period after the contribution and before the testing date, the contribution was continuously held in cash, cash equivalents, or debt instruments with a life of 18 months or less.

This means that a QOF that continuously receives contributions of cash from investors need not worry that a significant contribution shortly before a six-month testing date will jeopardize the QOF’s compliance with the 90% test.

But here’s what we DON’T know about the 90% penalty — when is enough, enough? At what point do we fail the 90% test so frequently and repeatedly that the entire deal is blown up and all the tax benefits to the investors are invalidated? The answer, incredibly, is that we STILL don’t know, even after promulgation of three sets of regulations. You would think that bit of information would be important, but maybe no one cares? Maybe the IRS just dumped 544 pages in our laps about how to conduct a qualifying business within a QOZ, when at the end of the day, the rules don’t really seem to matter because there’s no failure so egregious that it will prevent investors from reaping the considerable tax benefits being offered. I know that sounds crazy, but if the IRS were going to draw a line in the sand for repeated failures of the 90% test, wouldn’t they have by now?

Qualified Opportunity Zone Property

By requiring that a QOF hold 90% of its assets in the form of QOZP, Section 1400Z-2 ensures that the QOF is investing in a business located within a QOZ. There are three types of QOZ property:

• QOZBP,
• QOZ stock, or
• QOZ partnership interests.

The first option permits a QOF to operate a business directly. The latter two options permit a QOF to operate a business indirectly through a subsidiary and have the value of that ownership interest count towards the 90% test, provided the subsidiary meets the definition of a QOZB for 90% of the QOF’s holding period of the interest. We’ll explain that latter concept more thoroughly below.

Qualified Opportunity Zone Business Property

A QOF that operates a business directly — and not through a subsidiary — must hold 90% of its assets as QOZBP. As we’ll see below, when a QOF conducts business through a subsidiary QOZB, the QOZB must hold 70% of its as QOZBP. Thus, the definition of QOZBP is extremely important.

To meet this definition, property acquired by a QOF or QOZB must satisfy a number of statutory and regulatory requirements.

1. Only tangible property used in a “trade or business” can count as QOZBP.
2. The property must have been purchased by the QOF or QOZB from an unrelated party after Dec. 31, 2017. This ensures that the QOF is making a new investment into a QOZ.
3. As a general rule, the original use of the property within the QOZ must begin with the QOF or QOZB (the “original use” requirement). This would prove problematic to a QOF or QOZB that planned, for example, to purchase and renovate a building within a QOZ, because the building will have already existed within the QOZ. The statute and initial proposed regulations provide an exception to this original-use requirement, however, if a QOF or QOZB “substantially improves” personal or real property acquired within the QOZ. 

Let’s dig a little deeper:

Trade or business requirement:

QOZBP must be used by a QOF or QOZB in a “Section 162 trade or business.” Section 162 is the provision that grants taxpayers the ability to claim a deduction for the ordinary and necessary operating expenses incurred while conducting a “trade or business.” The Supreme Court has established that to qualify as a Section 162 trade or business, the activity can’t be a sporadic amusement, but rather must be entered into for profit and conducted with continuity and regularity.

This requirement poses a problem to investors into a QOZ in two ways. First, as we discussed in the opening about the “spirit” of the opportunity zone, a QOF must conduct a meaningful business within a QOZ, and the IRS has at its disposal broad anti-abuse measures to make sure this happens. A great example of these measures is how the regulations deal with raw land.

By definition, raw land cannot satisfy the requirement that the original use of QOZBP begin in the QOZ with the taxpayer. The regulations provide, however, that land will qualify as QOZBP even if it is not substantially improved. 

This could lead to potential abuses where an investor engages in land speculation by purchasing raw land, sitting on it for ten years, and then selling it tax-free. The regulations combat this by requiring that land be more than “insubstantially improved” within 30 months in order to meet the definition of QOZBP. In addition, the land must be used in a Section 162 trade or business of the taxpayer. Thus, as the example previously cited in this article demonstrates, merely converting raw land into a parking lot won’t get the job done if the underlying purpose of the acquisition of the land was to benefit from its long-term appreciation.

The Section 162 trade or business requirement poses a second problem; this one with regard to property rentals; specifically, property rented on a “triple-net basis.” The IRS has historically viewed these types of rentals – where the tenant is on the hook for the maintenance, real estate taxes, and insurance costs of the space they occupy — as an investment rather than a trade or business, with the building thus failing to meet the definition of QOZBP.

The proposed regulations did little to assuage our concerns, as they provided that while the ownership and operation (including leasing) of real property is the active conduct of a trade or business, “merely entering into a triple-net lease with respect to real property owned by a taxpayer is not the active conduct of a trade or business.”

This caused no shortage of written comments and public testimony during the regulatory process. In crafting the final regulations, however, the IRS ignored calls for detailed guidance as to when a triple net lease constitutes a business, opting instead for two fairly useless examples. Example the first:

Example. (i) Facts. Company N constructs and places into service a new, three-story office building in a qualified opportunity zone and leases the entire building to tenant X, an unrelated person, which uses the building as office space for its software development firm. This building is the only property owned by Company N. The lease agreement between Company N and tenant X is a triple-net-lease under which tenant X is responsible for all of the costs relating to the office building (for example, paying all taxes, insurance, and maintenance expenses) in addition to paying rent. Company N also maintains an office in the building with staff members to address any issues that may arise with respect to the triple-net-lease.  Solely for purposes of section 1400Z-2(d)(3)(A), Company N is treated as not engaged in the active conduct of a trade or business with respect to the leased office building. Company N leases the building to tenant X under a triple-net lease, and therefore the employees of Company N do not meaningfully participate in the management or operations of the building. The fact that Company N maintains an office in the leased building with staff members to address any issues that may arise with respect to the triple-net-lease does not alter this result. Therefore, Company N does not conduct an active trade or business in a qualified opportunity zone.

This is what I have long thought of as a “pure” triple-net lease. One building. One tenant. The tenant bears all the burden of the carrying costs. The result, then, is a predictable one.

The regulations then add a second example, but again, it’s limited in its usefulness:

Example 2. (i) Facts. Company N constructs and places into service a new, three-story mixed-use building in a qualified opportunity zone and leases a floor to each of unrelated tenants X, Y, and Z, respectively. This building is the only property owned by Company N. The lease agreement between Company N and tenant X is a triple-net-lease under which tenant X is responsible for all of the costs relating to the third floor of the building (for example, paying all such taxes, insurance, and maintenance expenses) in addition to paying rent. The lease agreement between Company N and tenant Y is not a triple-net-lease and employees of Company N manage and operate the second floor of the building. Likewise, the lease agreement between Company N and tenant Z is not a triple-net-lease and employees of Company N manage and operate the first floor of the building. Company N maintains an office in the building, which the employees regularly use to carry out their managerial and operational duties with respect to the first and second floors, and address any other issues that may arise with respect to the three leases. Solely for purposes of section 1400Z-2(d)(3)(A), Company N is treated as engaged in the active conduct of a trade or business with respect to the leased mixed-use building. While Company N leases the third floor of the building to tenant X merely under a triple-net-lease, and therefore the employees of Company N do not meaningfully participate in the management or operations of that floor, the employees of Company N meaningfully participate in the management and operations of the first and second floors of the leased building. Therefore, in carrying out the overall leasing business of Company N with respect to the mixed-use building, employees of Company N conduct meaningful managerial and operational activities. As a result, Company N conducts an active trade or business in a qualified opportunity zone.

OK, great…this tell us that if we have one building, with multiple tenants, and one is a triple-net and the others are not, we have a trade or business. But what if we had one building with 12 tenants and they were all triple-net leases? Or what if the tenant were responsible for the interior maintenance costs but the landlord for the exterior improvements? This example doesn’t tell us when a lease ceases to be a triple-net lease, or when enough triple-net leases comprise a trade or business, which is what we really want to know. We’ll have to wait for future guidance on triple-net leases — either under Section 1400Z-2 or Section 199A — In the meantime, of course, investors into a QOF should steer clear of any type of “pure” triple-net arrangement.

Original Use Requirement

In general, to qualify as QOZBP, property must either satisfy the “original use” test — meaning the property had never before been used in the QOZ — or be “substantially improved.” When measuring compliance with the “original use” test, what if a taxpayer buys a building that is 97% complete, puts on the finishing touches, and places it into service for the first time? Is the original use test met? Or what if a taxpayer buys a building that has sat empty for several years? If the taxpayer gets it up and running — but doesn’t “substantially improve” it — would that satisfy the original use test? The final regulations made a few significant changes in this regard.

Changes in Final Regulations to Original Use Test

Here’s what hasn’t changed: the ”original use” of tangible property begins when any person first places the property in service for purposes of depreciation. Thus, a QOF could purchase a partially finished business, complete construction and place it in service for depreciation, and the building will satisfy the original use test because it has never before been depreciated within the QOZ.

Under the proposed regulations, the “original use” test would also be satisfied if a taxpayer placed back into service property that had sat vacant for at least five years. The final regulations, however, reduce this vacancy requirement to three years, provided the property were vacant for three years AFTER the surrounding area were designated as a QOF. A further reduction to one year is permitted if the property had been vacant for that long on the date the area surrounding the property were designated as a QOZ.

To illustrate, if a QOF purchases property that had sat vacant for one year on the date the area were designated as a QOZ and remains vacant until the QOF places it into service, the property will satisfy the original use test and need not be substantially improved. If instead, the property were vacated two months after the area were designated as a QOZ and sat vacant for three years after that date, a QOF could purchase the property and immediately place it into service and satisfy the original use test.

Finally, the latest regulations clarify that if a QOF manufactures or constructs its own property, the property can meet the original use test if the construction began after 2017 and the property will be used in a trade or business of the QOF.

Substantial Improvement

To ensure that the spirit of the incentive is being met and new investment is funneling into a QOZ, a taxpayer generally cannot acquire existing property within the zone and continue the status quo. Instead, because that property will fail the original use test, in order to meet the definition of QOZBP the property must be “substantially improved.”

Property is substantially improved by a QOF or QOZB if during any 30-month period beginning after the date of acquisition of the property, the QOF or QOZB spends as much to improve the property (measured by additions to basis) as the QOF or QOZB’s original basis in the property at the beginning of the 30-month period.

If a QOF purchases a building located on land wholly within a QOZ, the “substantial improvement” requirement is measured only by reference to the QOF’s original basis in the building; as a result, the QOF is not required to separately substantially improve the land upon which the building is located. As we discussed earlier, the land, despite not satisfying either the original use or substantial improvement test, will be treated as QOZBP under the final regulations.

Ex. A QOF acquires land and a building in a QOZ on Jan. 1, 2019, for $10 million; $4 million of the basis is allocated to the land, with the remaining $6 million of basis allocated to the building. Because the land and building were previously located within the QOZ, they do not satisfy the original-use requirement. On Jan. 1, 2019, the QOF begins to improve the building, and those improvements add $6 million to the basis of the building during the 30-month period beginning Jan. 1, 2019. The building has been substantially improved, and both the land and the building will be treated as QOZBP.

Changes in Final Regulations to Substantial Improvement Rules

The final regulations clarify a few things about the general substantial improvement rules. First, it is the adjusted tax basis of the property that must be doubled during the 30-month period, not the original cost. While this might motivate some taxpayers to take some time before beginning the improvement process to allow for depreciation to reduce the property’s adjusted basis, it is important to remember that the final regulations provide that substantially improved property will count as QOZBP during the 30-month period it is being improved. Thus, it stands to reason, the property will NOT meet the QOZBP test prior to the start of the 30-month period, and would not count towards the QOF’s 90% test.

In addition, if a taxpayer makes improvements to non-qualified property – for example, a building purchased by a QOF from a related party or contributed to the QOF by an investor —- the improvements are NOT QOZBP, even though they would satisfy the “original use” requirement. In the preamble to the final regulations, the IRS explained that it didn’t want taxpayers to have to bifurcate improved non-QOZBP property between its original basis (which would not help the taxpayer satisfy the 90% test) and the subsequent improvements (which would help the taxpayer satisfy the 90% test if it were permitted to be treated as QOZBP).

New “Substantial Improvement” Rules in the Final Regulations

The final regulations allow additional latitude in several respects when determining whether property has been substantially improved. First, a taxpayer can improve property by purchasing OTHER property that satisfies the original use test as long as that property improves the functionality of the property being improved. Here’s an example illustrating this point:

Example. On January 1, 2019, QOF A purchases the assets of a hotel business located in a qualified opportunity zone for $5 million. The purchased assets include land, a building, linens, furniture and other fixtures attached to the building. $1 million of the purchase price is allocated to land and the remaining $4 million is allocated to the building, furniture and fixtures. During the course of renovations over the 30-month substantial improvement period, the QOF spent $1 million replacing linens, mattresses and furniture, $500,000 on the purchase of new exercise equipment for a gym located in the hotel building, $1 million on renovations for a restaurant (including restaurant equipment) attached to the hotel, and $1.5 million on structural renovations to the hotel.

In order for the hotel to be considered qualified opportunity zone business property, QOF A must substantially improve the hotel as the hotel had previously been placed in service in the qualified opportunity zone. (QOF A was not required to substantially improve the land on which the hotel was located.) Because the amount of basis allocated to the hotel was $4 million, QOF A must expend $4 million to improve the hotel within the 30-month substantial improvement period. The new linens, mattresses and furniture, new exercise equipment, and new restaurant equipment all qualify as original use assets. QOF A also substantially improved the hotel, which was the asset that needed to be improved. QOF A chose, at the start of the 30- month period, to include the costs of the newly purchased assets that improve the functionality of the hotel to the basis of the hotel. Thus, the cost of these items is eligible to be added to the hotel’s basis. Therefore, QOF A has met the substantial improvement requirement by doubling its basis in the hotel and its fixtures within the 30- month substantial improvement period.

The regulations also allow, in limited circumstances, a QOF or QOZB that owns several buildings within a QOZ to aggregate the basis and improvements made to the buildings for purposes of measuring substantial improvement.

Leased Property as QOZBP

While the statute states that property must be “purchased” by a QOF or QOZB to qualify as QOZBP, the regulations allow for leased property to satisfy the requirement in certain situations. For leased property to meet the definition of QOZBP, however, the lease must be entered into AFTER December 31, 2017 and its terms must be arms-length. In general, two VERY favorable rules apply to leased property:

1. A lease does not need to satisfy the “original use” requirement, and
2. The QOF or QOZB is not required to “substantially improve” the lease.

Thus, a QOF can generally lease a building that has long existed in a QOF and need not substantially improve the property. This would enable a start-up company to lease its office space and have that lease meet the definition of QOZBP.

If a lease is between a QOF (or QOZB) and a related party, however, there are additional safeguards put into place by the new regulations. First, the lessee cannot make a prepayment on the lease relating to a period of use that exceeds 12 months. Then, in an exception to the general rule that the original use test does not apply to leased property, in order for personal property leased from a related party to count as QOZBP, the property must either 1. satisfy the original use requirement, or 2. during the 30-month period beginning with the inception of the lease, the QOF or QOZB must acquire other tangible QOZBP with a value equal to the value of the leased property. There is an important distinction here: the QOF or QOZB does not need to substantially improve the lease in any way, it simply must acquire other QOZBP with a value equal to the value of the lease, and that property can be completely unrelated to the leased property. For these purposes, leased property can be valued at either the value on an applicable financial statement, or by taking a present value of all lease payments on the date the lease is entered into. Be warned, however, that the latter value is determined on the date the lease is entered into and is used for the entire length of the lease; thus, this alternative valuation would not accurately capture a downturn in the market that reduces the value of the leased property.

Finally, if at the time a lease for real property is entered into (with a related or unrelated party) there is a plan or expectation for the leased property to be purchased by the QOF or QOZB for an amount other than the FMV determined at the time of purchase, the property is not QOZBP.

QOZ Stock and Partnership Interests

As an alternative to holding property directly, a QOF may satisfy the 90% test by conducting a business in a QOZ through a subsidiary by holding QOZ stock or a QOZ partnership interest.

Stock in a corporation is treated as QOZ stock if:

• It was acquired by a QOF after Dec. 31, 2017, directly from the corporation or through an underwriter, solely for cash;
• At the time the stock was issued, the corporation was a QOZB or, in the case of a new corporation, was organized for purposes of being a QOZB; and
• During 90% of the QOF’s holding period for the stock, the corporation is a QOZB.

Similarly, an interest in a partnership is treated as a QOZ partnership interest if:

• It was acquired by a QOF after Dec. 31, 2017, directly from the partnership solely for cash;
• At the time the partnership interest was issued, the partnership was a QOZB, or in the case of a new partnership, was organized for purposes of being a QOZB; and
• During 90% of the QOF’s holding period for the partnership interest, the partnership is a QOZB.

If corporate stock or a partnership interest held by a QOF satisfies these requirements, then all of the assets of the subsidiary partnership or corporation are considered QOZ property for purposes of applying the 90% test to the QOF. There is no prohibition on a QOF investing in a preexisting corporation or partnership, but from a practical perspective, if the subsidiary owns significant assets that were acquired prior to 2018, it will be difficult for the subsidiary to satisfy the 70% test (discussed below).

Qualified Opportunity Zone Business 

When a QOF operates a business through a subsidiary, for all of the assets of the subsidiary to count toward the 90% test, at the time the subsidiary’s stock was issued or its partnership interest was acquired by the QOF, and during 90% of the QOF’s holding period for the stock or partnership interest in the subsidiary, among other requirements, the subsidiary must meet the definition of a QOZB. To be a QOZB, the subsidiary must satisfy a “70% test,” an “income-and-assets test,” and a “qualifying-business” test.

The 70% test

At least 70% of all of the tangible property owned or leased by the trade or business of the subsidiary must meet the definition of QOZBP. As previously discussed, QOZBP is property that meets the following requirements:

• The property must have been acquired by the subsidiary by purchase or lease after Dec. 31, 2017;
• The original use of the property in the QOZ must have commenced with the subsidiary, or in the alternative, the subsidiary must substantially improve the property; and
• During 90% of the subsidiary’s holding period of the tangible property, 70% of the use of the tangible property was in a QOZ.

The income-and-assets test

For each tax year, a QOZB must satisfy the following requirements set forth by Sec. 1397C(b).

• At least 50% of the gross income must be derived from the active conduct of a trade or business in the QOZ (the “50%-of-income test”);
• A substantial portion of the intangible property must be used in the active conduct of a trade or business in the QOZ (the “intangible test”); and
• Less than 5% of the aggregate unadjusted bases of the property of the trade or business is attributable to nonqualified financial property (the “5%-of-assets test”).

Fifty Percent of Income Test

What remained unclear after the initial proposed regulations was how a QOF or subsidiary could invest in an operating business. The root of the problem was the requirement that to meet the definition of a QOZB, at least 50% of the income of a business would be required to be earned in a QOZ in each year. But how was this requirement measured when customers reside both within and outside the QOZ? Did the original regulations contemplate that more than 50% of the store’s customers must reside within the QOZ? Or would the test be satisfied if the store is located within the QOZ, regardless of where the customers reside?

The final regulations put an end to the confusion. They provide three safe harbors and a facts and circumstances test that will enable a QOZB to satisfy the 50% test.

1. If at least 50% of the hours spent by employees and independent contractors are within the QOZ, the test is satisfied. Thus, if a company’s employees are all located in a QOZ, it doesn’t matter where the customers are located, the business will meet the test.
2. If at least 50% of the amount paid paid by a business to employees and independent contractors are for services performed within a QOZ, the test is satisfied. Thus, a taxpayer can have employees outside the QOZ, provided at least half of the total compensation is paid to employees performing services within the QOZ.
3. If the tangible property located in a QOZ and the management or operational functions performed in the QOZ are each necessary for the generation of at least 50% of the gross income of the business, the test is met.

For the purposes of the first two safe harbors, services provided by a partner in a partnership are counted towards the tests.

It’s also important to note that, as discussed more fully below, the regulations expand a 31-month working capital safe harbor, which previously bought a QOZB time to convert cash into real property without violating the 70% test. Now, that same 31-month safe harbor can be used for the “development of a trade or business.”

Nonqualified Financial Property Test

To meet the definition of a QOZB, less than 5% of the aggregate unadjusted bases of the property of the trade or business may be attributable to nonqualified financial property. Nonqualified financial property includes debt, stock, partnership interests, options, futures contracts, forward contracts, warrants, notional principal contracts, annuities, and other similar property. Excluded from the definition of nonqualified financial property are reasonable amounts of working capital held in cash, cash equivalents, or debt instruments with a term of 18 months or less.

The 5%-of-assets test would prove problematic for QOZBs that receive a large influx of investment capital but need time before they can convert that capital into tangible property. To illustrate, a QOF may invest significant cash into a subsidiary partnership that intends to build affordable housing. Absent an exception, while the subsidiary partnership is seeking approvals and beginning construction, the cash would be treated as nonqualified financial property. Fortunately, the proposed regulations contain such an exception in the form of a safe harbor.

Working capital assets are considered reasonable — and thus are not treated as nonqualified financial property — if the amounts are designated in writing for the acquisition, construction, and/or substantial improvement of tangible property in a QOZ. In addition, there must be a written schedule consistent with the ordinary startup of a trade or business for the expenditure of the working capital assets within 31 months of the business’s receipt of the assets; and the working capital must actually be used in a manner that is substantially consistent with the written plan. For certain qualifying start-up businesses, the working capital exception can be extended to as much as 62 months.

If these requirements are met, any gross income earned on the working capital throughout the 31-month period counts toward the satisfaction of the 50%-of-income test. Likewise, throughout the entire 31-month period, the business is treated as having satisfied the intangible test. Perhaps most importantly, tangible property purchased, leased, or improved by a business with cash covered by a working capital safe harbor will count as QOZBP.

Ex. In 2019, Taxpayer H realized $10 million of capital gains and within the 180- day period invested $10 million in QOF. QOF immediately acquired from Partnership P a partnership interest in P, solely in exchange for $10 million of cash. P immediately placed the $10 million in working capital assets, which remained in working capital assets until used. P had written plans to acquire land in a QOZ on which it planned to construct a commercial building. Of the $10 million, $4 million was dedicated to the land purchase, $5 million to the construction of the building, and $1 million to ancillary but necessary expenditures for the project. The written plans provided for purchase of the land within a month of receipt of the cash from QOF and for the remaining $5 million and $1 million to be spent within the next 30 months on construction of the building and on the ancillary expenditures. All expenditures were made on schedule, consuming the $10 million. During the tax years that overlap with the first 31-month period, P had no gross income other than that derived from the amounts held in those working capital assets. Prior to completion of the building, P’s only assets were the land it purchased, the unspent amounts in the working capital assets, and P’s work in process as the building was constructed.

P met the three requirements of the safe harbor. P had a written plan to spend the $10 million received from QOF for the acquisition, construction, and/or substantial improvement of tangible property in a QOZ. P had a written schedule consistent with the ordinary startup of a business for the expenditure of the working capital assets. And, finally, P’s working capital assets were actually used in a manner that was substantially consistent with its written plan and the ordinary startup of a business. Therefore, the $4 million, the $5 million, and the $1 million are treated as reasonable in amount. Because Phad no other gross income during the 31 months at issue, 100% of P’s gross income during that time is treated as derived from an active trade or business in the QOZ for purposes of satisfying the 50%-of-income test. For purposes of satisfying the intangible test, during the period of land acquisition and building construction, a substantial portion of P’s intangible property is treated as being used in the active conduct of a trade or business in the QOZ.

The disqualified-business test

A QOZB may not be a business described in Sec. 144(c)(6)(B) (a so-called sin business). This includes: 

• Any private or commercial golf course;
• Country club;
• Massage parlor;
• Hot tub facility;
• Suntan facility;
• Racetrack or other facility used for gambling; or
• Any store, the principal business of which is the sale of alcoholic beverages for consumption off the premises.

The final regulations provide a de minimis rule whereby a small amount of “sin business” will not invalidate all the activity of a QOZB. In addition, because by definition the requirements of Section 1397C apply only to a QOZB and not a QOF, there is no prohibition on a QOF operating a sin business.

Tax Benefits Resulting from an Investment of Eligible Gain into a QOF

So why are we doing all of this?

A taxpayer who invests eligible gain within 180 days into a QOF is eligible for four distinct tax benefits, provided the taxpayer holds the investment in the QOF for at least 10 years. The first three benefits relate to the reinvested eligible gain, while the final benefit relates to gain realized on the disposition of the investment in the QOF.

To illustrate the application of these benefits, assume that on April 21, 2019, A sells publicly traded stock in which A has a basis of $1 million for $2 million, realizing $1 million of eligible gain. On May 9, 2019, A reinvests $1 million into a QOF.

Tax benefit No. 1: Deferral of eligible gain

A may elect to defer the recognition of the $1 million of gain. If she makes this election, A will not report the gain on her 2019 tax return. A’s basis in the QOF is zero.

Tax benefit No. 2: Exclusion of 10% of the deferred gain

If A holds the investment in the QOF for five years (May 9, 2024) the basis of the investment is increased by 10% of the deferred gain, or $100,000. Stated another way, 10% of the deferred gain is now permanently excluded and will never be recognized.

Tax benefit No. 3: Exclusion of additional 5% of the deferred gain

If A holds the investment in the QOF for an additional two years, the basis of the investment is increased by an additional 5% of the deferred gain, or $50,000. As a result, 15% of the deferred gain is now permanently excluded.

The seven-year basis increase creates a sense of urgency for investing in opportunity zones. For investments made in 2020, it will be impossible to achieve the seven-year holding period prior to the deferred gain’s being automatically triggered on Dec. 31, 2026. Thus, to maximize the tax benefits available under Sec. 1400Z-2, taxpayers should reinvest deferred gain into a QOF before Dec. 31, 2019.

Recognition of deferred gain

Any remaining deferred gain must be recognized by Dec. 31, 2026 unless an inclusion event occurs prior to that date. The amount of gain to be recognized is determined by subtracting the taxpayer’s basis in the investment — zero before being increased in years 5 and 7, if applicable— from the lesser of (1) the amount of eligible gain originally deferred, or (2) the FMV of the investment in the QOF on Dec. 31, 2026.

If A continues to hold the investment in the QOF at Dec. 31, 2026, at a time when the investment has an FMV of $1.4 million, A must recognize the remaining $850,000 of deferred gain. This is the lesser of the FMV of the investment ($1.4 million) or the original deferred gain ($1 million), less A’s basis in the investment ($150,000, zero before being increased at the five- and seven-year anniversaries). A then increases her basis in the investment by the amount of deferred gain recognized, or $850,000. A’s basis in the investment in the QOF is now $1,000,000.

It is important to remember that if a taxpayer holds an interest in a QOF until the end of 2026, the deferred gain becomes due without a liquidating event. Thus, it is critical that taxpayers reinvesting deferred gain into a QOF plan accordingly and set aside cash to pay the 2026 tax liability.

Tax benefit No. 4: Exclusion from gain on the sale of a QOF interest held longer than 10 years

If a taxpayer holds an interest in a QOF for 10 years that is attributable to a previous election to defer eligible gain, upon the sale of that investment, the basis of the investment is treated as being equal to its FMV. In simpler terms, this means that no gain is recognized upon the sale of the investment in the QOF. This represents the ultimate benefit offered by Sec. 1400Z-2: the ability to exclude all gain upon the subsequent disposition of an interest in a QOF that has been held for 10 years. To receive the benefit of the tax-free gain, however, the taxpayer must sell the investment in the QOF before Jan. 1, 2048.

In 2035, A sells her investment, with a basis of $1 million, for $6.4 million. Because the investment has been held longer than 10 years, the basis of the investment is treated as being equal to the sales price of $6.4 million, and no gain is recognized on the appreciation of the investment after Dec. 31, 2026.

I know I said this once, but it’s so important I’ll stress it again: only gain from the sale of an investment in a QOF that was originally attributable to the investment of eligible gain for which a deferral election was made is eligible for the gain exclusion upon sale of the investment.

Ex. Assume the same facts as in the previous examples, except in addition to the investment of $1 million of eligible gain for which a deferral election was made into the QOF, A also invested an additional $500,000 into the QOF that was not related to eligible gain. Upon the subsequent sale of the investment in the QOF in 2035, only the gain attributable to the $1 million investment is eligible for the basis increase and related gain exclusion.

Disposition of the Investment after Ten-Year Holding Period is Met

The real carrot being dangled by Section 1400Z-2 comes after an investor holds an interest in a QOF for ten years. After that holding period has been reached, the taxpayer may exclude the gain from the sale of an investment in a QOF that is attributable to an investment of previously deferred gain. The use of the word “investment” in the original proposed regulations implied that to benefit from the exclusion, a taxpayer must sell the equity interest in the QOF. On this matter, the proposed and final regulations differ significantly.

Changes in Final Regulations to Exclusion of Gain From Asset Sales After Ten Years

The proposed regulations provided partial relief from a forced equity sale. The regulations provided that if a QOF formed as a partnership or S corporation sells its assets, a partner or shareholder who has held an interest in the QOF may elect to exclude any capital gain allocated to the partner or shareholder on Schedule K-1 resulting from the sale of QOZBP.

There is a quirk, however. If a partner or shareholder sells his or her interest in the QOF after 10 years, all of the gain may be excluded from income. If instead, however, the QOF sells its assets, only capital gain generated from the sale of QOZBP that is allocated to a partner or shareholder may be excluded. Thus, if the partnership or S corporation sells inventory, cash basis receivables, or assets subject to ordinary income depreciation recapture, a sale of the assets by the QOF after ten years will result in some degree of ordinary income recognition to the investors. Likewise, if the QOF were to sell non-QOZBP assets, any gain would be required to be recognized by the investors. Also note, there is no protection for an asset sale made by a QOF that is a C corporation.

The final regulations broaden the scope of the available exclusion upon the sale of assets, rather than equity, after ten years. First, the exclusion is expanded to asset sales by a QOZB as well as a QOF. In addition, only ordinary income from the sale of inventory is required to be recognized. Other types of ordinary income – such as depreciation recapture – as well as gain from the sale of non-QOZBP, will be protected under the exclusion. The final regulations also make clear that a taxpayer can make multiple elections to exclude flow-through asset sale gain if, for example, a QOF or QOZB sold off its assets piece by piece over several years.

Final Thoughts

If you’re contemplating an investment into an opportunity zone and have read this entire article (you haven’t), one thing has probably become clear: unless you plan on running a sin business, you’re going to want to conduct your business in a subsidiary QOZB rather than a QOF. This is because due to a combination of sloppy statutory language and intentional disparate treatment by the IRS, it is generally much more advantageous to drop everything down one level into a subsidiary. For example:

• A QOF that operates a business directly is required to hold 90% of its assets as QOZBP. If, however, the same QOF were instead to operate a business through a subsidiary, for the subsidiary to meet the definition of a QOZB, the subsidiary would be required to hold only 70% of its assets as QOZBP. This, obviously, allows a lot more flexibility for the occasional failure to qualify an asset as QOZBP.
• Only a QOZB is subject to the rules of Sec. 1397C. This creates several important distinctions. First, the good news: the 31-month working-capital safe harbor applies only to a QOZB. Then, the bad news: only a QOZB may not be a “sin business” as defined under Sec. 144. As mentioned previously, there is no prohibition on a QOF’s directly conducting a sin business, however.

The IRS has done a remarkable job with the opportunity zone incentive, publishing two sets of proposed regulations and 544 pages of final regulations within two years of the addition of Section 1400Z-2 to the statute. While a few unanswered questions remain, investors should have enough guidance to more forward with confidence; fortunate timing giving a major deadline looms less than ten days away.

Now if you’ll excuse me, I’ve got to wish Kristen Bell a Merry Christmas via Instagram. I don’t give up that easy.