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IRS Releases Round Two of Proposed Regulations for Qualified Opportunity Funds

On Behalf of | May 6, 2019 |

On April 17, 2019, the Internal Revenue Service (“IRS”) issued the second round of proposed regulations with respect to qualified opportunity funds (“QOFs”). While the first round of proposed regulations, issued in October of 2018, established a solid basis on which to build, this second round addresses many of the questions that had remained open and unclear since last October.

As background, Congress created opportunity zones, enacted under new Subchapter Z of the Internal Revenue Code (the “Code”), to boost investment in certain economically distressed communities. There are more than 8,700 census tracts designated as opportunity zones across all 50 states, the District of Columbia, and several U.S. territories, including nearly all of hurricane-ravaged Puerto Rico. Qualifying investments in opportunity zones must be purchases of equity interests in QOFs, generally defined as a corporation or partnership that self-certifies and holds at east 90% of its assets in qualified opportunity zone (“QOZ”) property.

Under Code Sec. 1400Z-2(d), qualifying assets of a QOF include QOZ business property, QOZ stock, or a QOZ partnership interest. QOZ stock and partnership interests must be acquired after Dec. 31, 2017, and be original issue of a corporation or partnership that is a qualified opportunity zone business (“QOZB”) at the time of acquisition and during “substantially all” of the QOF’s holding period of the interest. A QOZB is a trade or business in an opportunity zone in which:

  • “Substantially all” of the tangible property owned or leased by the business is QOZ business property;
  • At least 50% of gross income is derived from the active conduct of the business in the opportunity zone;
  • A “substantial portion” of the intangible property is used in the active conduct of the business;
  • Less than 5% of the average of the aggregate unadjusted basis of the entity’s property is attributable to nonqualified financial property; and
  • The business is not a golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack, casino, or liquor store.

QOZ business property must fulfill three requirements:

  • The property must be acquired by the QOF after Dec. 31, 2017;
  • The original use of the property in the opportunity zone must commence with the QOF, or the QOF must substantially improve the property; and
  • Substantially all of the use of the property must be in the opportunity zone during substantially all of the QOF’s holding period.

Here are six of the key takeaways from this new round of proposed regulations:

I. Qualified Opportunity Zone Businesses

Under the first round of proposed regulations, perhaps the greatest area of flexibility offered can be found within the definition of “substantially all” with regard to the tangible property requirement for a QOZB in an opportunity zone. The proposed rules provide that “substantially all” in this context is 70%. Thus, if 90% of a QOF’s assets are QOZ stock or partnership interests in businesses that hold 70% of their assets in QOZ business property, the QOF could effectively invest as little as 63% of its assets in QOZ business property. It is important to note that this definition of “substantially all” does not extend to other instances of the term. Under this second round of proposed regulations:

  1. With respect to QOZ business property in a QOZ, “substantially all” in terms of “use” is 70%. The definition of “substantially all” in this context was vague and not defined with specificity in the prior round of proposed regulations with respect to intangible property.
  2. “Substantially all” in the context of the holding period is 90%.
  3. With respect to the 50% gross income test, the safe harbors are as follows:

a. 50% or more of the services performed for a business by its employees or independent contractors (based on hours worked) are performed within the QOZ;

b. 50% or more of the services performed for a business by its employees or independent contractors (based on amount paid for the services) are performed within the QOZ; or

c. The management and operations and the tangible property of the business are all necessary to generate at least 50% of the gross income of the business.

II. Substantial Improvement

Under the first round of proposed regulations, substantial improvement of tangible property was defined in the statute as the doubling of its basis over 30 months. Rev. Rul. 2018-29 provides that land does not need to meet the “original use” or “substantial improvement” tests to qualify as opportunity zone business property. In addition, the proposed regulations and the revenue ruling state that the basis of any land is not included in the basis of a building for the substantial-improvement test. The IRS declined to offer further guidance on “original use,” instead asking for comments on pertinent issues, indicating a willingness to provide flexibility under the original-use requirement for property that is underutilized, vacant, or abandoned. The second round of proposed regulations clarified that the test for “substantial improvement” is conducted on an asset-by-asset basis.

III. Land

The second round of proposed regulations clarified that land is treated as QOZ business property only if it is utilized in a trade or business of a QOF or QOZ business.

IV.  Ten-Year Fair Market Value (“FMV”) Step-Up

The second round of proposed regulations also clarified that a taxpayer who holds a qualifying investment in a QOF partnership or subchapter “S” corporation may elect to exclude from gross income some (or all) of the capital gain from the sale of QOZ property (reported on the taxpayer’s K-1) if the sale occurs after the ten-year holding period.

V.  Original Use

With respect to determining when the original use of purchased tangible property may be deemed to have commenced, the second round of proposed regulations provides that original use begins on the date when the buyer or a previous owner first places the property in service in the QOZ for depreciation/amortization purposes. However, in situations where a building or structure is vacant for five years or more prior to being acquired by a QOF or QOZ business, the structure or building acquired will satisfy the original use requirement immediately upon acquisition.

VI.  Structuring

QOF Real Estate Investment Trusts (“REITs”), pursuant to clarification provided under the second round of proposed regulations, may issue special capital gain dividends, never to exceed the QOF REIT’s long-term gains, upon the sale of QOZ property. Moreover, any gain that is attributable to a service portion of an interest in a QOF partnership is not eligible for the benefits that are afforded to qualifying QOF investments.


The six points highlighted above, in conjunction with other features of the new proposed regulations, remove some of the most blatant uncertainties that, to date, have kept investment capital relative to QOFs and QOZs on the sidelines. Taken as a whole, this round of proposed regulations is a significant step forward, adding clarity to the previously murky Opportunity Zone waters. There is little doubt that this increasing clarity afforded by the announced specifics, along with the direction that Treasury is clearly heading will spur many investors and prospective fund organizers into action. The amount of capital that will ultimately find its way into QOFs and QOZs is anyone’s guess, but the more certainty there is, the more capital will be deployed – and the sky truly is the limit.