Treasury and IRS Issue Second Installment of Opportunity Zone Guidance

April 2019

On April 18, 2019, the Treasury Department issued a long-awaited second installment of proposed regulations (the “Second Regulations”) addressing issues surrounding the Opportunity Zone tax incentive adopted as part of the Tax Cut and Jobs Act of 2017. The Second Regulations build on a first set of proposed regulations (the “First Regulations”) issued on October 19, 2018. The Second Regulations address many, but not all, of the questions that the First Regulations did not answer. Treasury has requested comments regarding several of the open questions.

The Opportunity Zone tax incentive allows a taxpayer to defer gains that are recognized before 2027 if such gains are re-invested, within 180 days after being recognized, in a Qualified Opportunity Fund (“QOF”). The gain is deferred until the QOF interest is sold, or, if earlier, December 31, 2026. If the taxpayer holds the QOF interest for 10 years, the taxpayer can elect to step-up the basis of the interest to fair market value upon disposition, thus eliminating the gain with respect to the investment in the QOF interest.

The QOF must invest its funds in a designated Qualified Opportunity Zone (a “QOZ”) in accordance with the rules described below. Each state nominated certain census tracts as QOZs. The Treasury Department later approved those designations, and a complete list of census tracts has been published by the Internal Revenue Service.

The Statutory Rules

An entity can qualify as a QOF if 90 percent of its assets consist of “QOZ Property” (the “90 Percent Test”) during substantially all of the entity’s holding period for such property. QOZ Property may be either:

  1. tangible property acquired after 2017 and used in a trade or business located in a QOZ (“QOZ Business Property”); or
  2. an interest in a corporation or partnership that is a “QOZ Business.” 

To be a QOZ Business, among the conditions a business must meet, substantially all—which the First Regulations defined as 70 percent—of the corporation’s or partnership’s tangible assets must consist of QOZ Business Property (the “70 Percent Test”) during substantially all of the business’s holding period for such property. In addition, a QOZ Business must derive at least 50 percent of its total gross income from the active conduct of a trade or business in the QOZ (the “Gross Income Test”). For property to qualify as a good asset for either the 90 Percent Test or the 70 Percent Test, it must be “original use” property or be “substantially improved,” subject to certain regulatory exceptions.

Second Regulations

The Second Regulations clarify that:

  • Tangible property will be deemed to meet the “original use” requirement if it has not previously been used in the QOZ, or if was previously used in the QOZ but has not been utilized or has been abandoned or vacant for at least five years prior to being purchased by the QOF or the QOZ Business. Under these rules, it is now clear that a QOZ Business can be structured using used property. The Second Regulations also reiterate that the “original use” requirement does not apply to land.
  • Certain types of transfers will constitute “inclusion events”—that is, events that will require the inclusion of income previously deferred by an investor in QOF investment—even though such transfers would not generally require the recognition of gain. Certain nonrecognition transactions are treated as inclusion events as are gifts of QOF interests. Having said this, distributions by QOF partnerships will constitute inclusion events only to the extent that they exceed the investor’s basis in its QOF partnership interest. This rule generally allows QOFs structured as partnerships to distribute refinancing proceeds to investors without triggering deferred gains.
  • Leased property can be a good asset for both the 90 Percent Test and the 70 Percent Test. Leased property is exempt from the “original use” and “substantial improvement” requirements. Additionally, while property purchased from a related party cannot constitute a good asset, property leased from a related party can qualify as a good asset if the property, the lease, and the lessee meet certain specified requirements. 
  • A trade or business can meet the Gross Income Test by satisfying the criteria of one of three safe harbor tests. Taken together, these safe harbor tests will allow a trade or business to qualify as a QOZ Business while maintaining significant operations outside the QOZ as long as the 70 Percent Test is met.
  • The proceeds from sales of QOZ Property will count as good assets for the 90 Percent Test so long as they are reinvested in other QOZ Property within 12 months, and, during the interim, are continuously held in cash, cash equivalents, and debt instruments with a term of 18 months or less. Treasury is seeking comments with respect to whether an analogous rule should apply for the 70 Percent Test. 
  • Inventory of a trade or business will not qualify as a bad asset for the purposes of the 90 Percent Test or the 70 Percent Test simply because on the testing date it is in transit from a vendor or to customers outside the QOZ.
  • If a QOF that is a partnership or an S corporation sells an asset used in a trade or business at a time when a QOF investor has held its interest in that QOF for at least 10 years, such investor can elect to exclude some or all of the capital gain arising from that disposition. A related rule provides that QOF REITs can make tax free distributions of capital gains resulting from their sales of QOZ Property. These rules effectively allow a taxpayer to exclude some gains from a QOF investment held 10 years even if it has not fully disposed of that investment. In so doing, they facilitate the use of a single QOF to make multiple investments.  Notably, there are no analogous rules applicable to QOFs that a structured as C corporations. Such QOFs will still be subject to corporate level tax on the sale of QOZ Property. 
  • Where the statute uses the term “substantially all” to indicate the period during which a fund’s or business’s assets must qualify as good property for the purposes of the 90 Percent Test or the 70 Percent Test, “substantially all” means 90 percent. However, where the statute uses the term “substantially all” to indicate the portion of the use of property that must have been within a QOZ, the term “substantially all” means 70 percent. 
  • A taxpayer acquiring a direct investment in a QOF from a third party rather than directly from the fund is treated as making an investment in a QOF in an amount equal to the amount paid for the interest. 
  • A QOF investment may be made in the form of property other than cash. If an investor contributes property to a QOF in a carryover basis transaction, such as a contribution to a partnership, the amount of the investment will be deemed the lesser of (i) the investor’s adjusted basis in the equity (e.g. partnership interest) received in the transaction or (ii) the fair market value of the equity received. For these purposes, where the investor is contributing to a QOF that is a partnership, basis is calculated without regard to any liability that is allocated to the investor under the partnership debt rules.

Outstanding Questions

Notwithstanding the Second Regulations, some important questions remain unanswered. These include:

  1. “Land Banking”. The Second Regulations indicate that, although land can qualify as a good asset for the purposes of the 90 Percent Test and the 70 Percent Test without meeting the original use or substantial improvement requirements, it will not qualify as a good asset unless it is used in a trade or business and the mere holding of land for investment will not qualify as use in a trade or business. The regulations also indicate that where treating land as a good asset could lead to “tax results that are inconsistent with the purposes of” the Opportunity Zone statute, Treasury will use general anti-abuse provisions to treat unimproved land as a bad asset even where it is being used in a trade or business. Treasury has requested comments on possible additional approaches that it can use to prevent QOZ benefits from applying to “land banking.”  Unless and until such guidance is provided, it is not clear precisely which land-intensive business models might be at risk of running afoul of them.
  2. Treatment of Inventory Generally. Although the Second Regulations make clear that inventory in transit outside the QOZ will not qualify as a bad asset for the purposes of the 90 Percent Test and the 70 Percent Test, they do not make clear under which circumstances inventory in general will be treated as a good or bad asset. Treasury has requested comments as to whether inventory can be deemed to be used in a QOZ, whether the location of where inventory is warehoused should be relevant, and whether inventory should be categorically treated as neither a good nor bad asset. 
  3. Aggregation of Property for the “Substantial Improvement” Test. The Second Regulations confirm that, in general, the determination of whether tangible property has been “substantially improved” will be made on an asset by asset basis, but also indicate that Treasury is considering allowing at least some tangible property to be grouped together for the purpose of determining whether it has been substantially improved.


The Second Regulations go a long way to facilitate the formation and operation of QOFs. These rules address pressing issues, such as how to treat leased property, whether refinancing proceeds can be distributed by partnership QOFs without triggering gain, how operating businesses can qualify on an ongoing basis, and how to viably structure multi-property QOFs. Although questions remain, this new guidance should accelerate the pace of formations of QOFs and related businesses and facilitate investment in them. Herrick’s team is eager to answer your questions in this area and help you realize your plans for a successful QOZ investment.

For more information on this issue or other tax matters, please contact:

Patrick J. O'Sullivan at +1 212 592 1503 or [email protected]
Louis Tuchman at +1 212 592 1490 or [email protected]

© 2019 Herrick, Feinstein LLP. This information is provided to keep clients and interested parties informed of legal developments that may affect or interest them. The information is not intended as legal advice or legal opinion and should not be construed as such.