In November 2018, we published a Client Alert summarizing the new Opportunity Zone program (OZ program) created by The Tax Cut and Jobs Act of 2017 and codified in Sections1400Z-1 and 1400Z-2 of the Internal Revenue Code (Code). The OZ program seeks to encourage investment in over 8,700 low-income and distressed communities across the country, designated as “qualified opportunity zones” (Zones), by allowing taxpayers to defer and reduce an unlimited amount of capital gains tax that would otherwise be recognized on sales of appreciated property where the gains are timely invested in a “qualified opportunity fund” (QOF) which in turn invests in one or more Zones. In October 2018, the Department of the Treasury and the Internal Revenue Service (IRS) issued proposed regulations and other guidance regarding the OZ program (the October Release). Click  here to see our prior Client Alert describing the OZ program, which includes links to the October Release and other information.

The October Release provided clarity on some key issues, particularly around real estate investments in Zones. However, uncertainties remained regarding other potential QOF investments, such as investments in operating businesses located in Zones. In April 2019 the Treasury Department issued a second set of proposed regulations (the April Release) which revise some guidance in the October Release and address issues that were not addressed in the October Release. Click here to see the April Release.


Under the OZ program, a taxpayer can elect to defer recognition of capital gains by investing the gain proceeds in a QOF within 180 days after the transaction giving rise to the gain, provided that the QOF timely invests those funds in “qualified opportunity zone property” (QOZ Property) and continues to hold 90% or more of its assets in QOZ Property. QOZ Property includes “qualified opportunity zone business property” (QOZ Business Property) and equity ownership in a “qualified opportunity zone business” (QOZ Business).

Many of the critical items addressed in the April Release are packed into the definitions of QOZ Business and QOZ Business Property since failure of a QOF to maintain its investment in entities or property that meet these definitions will reduce or eliminate the tax benefits afforded by the OZ program.

Qualifying as a QOZ Business

The definition of QOZ Business in Section 1400Z-2 has several components, all of which must be complied with throughout the life of a QOF investment, and many of which raise questions that are addressed in the April Release.

Substantially All. Substantially all (70% or more as defined in the October Release) of the tangible property owned or leased by a QOZ Business must be QOZ Business Property. What remained unclear after the October Release was how to determine, in many cases, whether property would qualify as QOZ Business Property.

QOZ Business Property. QOZ Business Property is defined in Section 1400Z-2 to mean tangible property: acquired after December 31, 2017; where the property’s original use commences with a QOF or QOZ Business or is substantially improved by a QOF or QOZ Business; and used in a Zone substantially all of the time (90% or more) that it is held by the QOF or QOZ Business. The April Release addresses many of the questions around the definition of QOZ Business Property, including the following:

  • Original Use. Original use of property commences when the property is first placed into service in a Zone for purposes of depreciation or amortization or, in the case of leased tangible property, first used in a Zone in a way that would have allowed depreciation or amortization if the property were owned rather than leased. This allows for used tangible property deployed in a Zone to meet the definition of QOZ Business Property as long as it was never previously in service and depreciated in the Zone. This, in turn, allows a QOF or QOZ Business to count a wider variety of tangible property as QOZ Business Property without having to expend capital to substantially improve it.
  • Vacant Structures and Abandoned Tangible Property. Buildings or other structures that have been vacant (or other tangible property that has been unused) for at least five years prior to purchase by a QOF or QOZ Business will satisfy the original use requirement notwithstanding that they existed in the Zone prior to their first use by the QOF or QOZ Business. This should encourage investors to acquire and use vacant or unused properties in Zones, furthering the purposes of the OZ program.
  • Land as QOZ Business Property. Land can qualify as QOZ Business Property, but only if it is used in a trade or business of a QOF or QOZ Business and not merely held for investment or “land-banked.”
  • Inventory and Raw Materials. Inventory and raw materials in transit from a QOZ Business or to a QOZ Business, respectively, will be deemed to be used in a zone for purposes of the QOZ Business Property definition. While this guidance gives a QOZ Business more operating flexibility, other questions remain; for example, the treatment of tangible property of a QOZ Business that is warehoused outside a Zone was not addressed.
  • Leased Tangible Property. Tangible property leased by a QOF or QOZ Business can qualify as QOZ Business Property subject to many of the same rules applicable to owned property as described above. (i.e., acquired under a lease entered into after December 31, 2017, with substantially all (70% or more) of the property used in a Zone during substantially all (90% or more) of the lease term). There is no original use or substantial improvement requirement for leased tangible property; however, the April Release sets forth additional requirements for leased tangible property to be treated as QOZ Business Property, including that the lease be a market rate lease (as defined elsewhere in the Code) and that the leased property be valued annually for purposes of including it in the 70% substantially all determination using one of two prescribed valuation methods.

In addition, leases of property from a lessor that is related (as defined elsewhere in the Code) to the QOF or QOZ Business are permitted as long as the lease meets some additional requirements, including limitations on prepayments and that within 30 months after the lease date (or the end of the lease term if shorter), the QOF or QOZ Business must purchase tangible property that has a value equal to or greater than that of the leased property. Recall that under Section 1400Z-2 contributions of property to a QOF by a related person are limited in that the contributor cannot acquire more than a 20% interest in the QOF in exchange for the contributed property. The related party lease provisions in the April Release should be attractive to QOF investors who have property that could be used by the QOF but do not want to be limited to a 20% ownership interest in the QOF.

Conduct of Business by a QOZ Business. The April Release clarifies some issues around determining if an operating business meets the definition of a QOZ Business, including the following:

  • 50% of Gross Income Test. The definition of QOZ Business states that at least 50% of the entity’s gross income must be derived from the active conduct of a trade or business (as defined in Section 162 of the Code) within a Zone. This requirement has caused significant uncertainty for operating businesses (as opposed to fixed real estate investments) in determining whether they qualify as a QOZ Business, particularly where their revenue and income are generated from sales made outside the Zone in which the business it situated. The April Release provides three safe harbors for a QOZ Business to determine if 50% or more of its gross income is derived from within a Zone:
    1. 50% or more of the services (based on number of hours worked) by employees and independent contractors are performed in the Zone;
    2. 50% or more of the services (based on the amounts paid for such services) by employees and independent contractors are performed in the Zone; or
    3. the tangible property located in the Zone and management activities performed in the Zone are each necessary to generate 50% or more of the gross income of the business.

If none of the foregoing safe harbors are met, a business may still seek to rely on a “facts and circumstances” test to determine if 50% or more of its gross income is derived from activity in the Zone. These safe harbors provide operating businesses significant flexibility to locate themselves in a Zone but grow their business to sell products and services to customers or clients outside the Zone.

  • Active Conduct of a Trade or Business. Solely for purposes of the 50% gross income test described above, the ownership and operation (including leasing, but excluding a triple-net-lease) of real property qualifies as the active conduct of a trade or business.
  • Intangible Property. The definition of QOZ Business in Section 1400Z-2 requires that a substantial portion of the entity’s intangible property be used in the active conduct of the QOZ Business. The April Release provides that substantial portion in this context means 40% or more.
  • Expansion of Working Capital Safe Harbor. The definition of QOZ Business in Section 1400Z-2 requires that less than 5% of the entity’s property is attributable to nonqualified financial property – debt, equity, derivatives and other financial instruments, but excepting a reasonable amount for working capital held in cash, cash equivalents, short term debt instruments, and trade receivables. The October Release provides that a “reasonable amount for working capital” includes cash reserves held by a QOZ Business provided there is: a written plan for the acquisition, construction and improvement of QOZ Property; a written schedule describing the use of the cash for that purpose within 31 months; and the cash is used in accordance with the written plan. In another attempt to make the OZ program more clearly applicable to operating businesses, the April Release expands the working capital safe harbor to include a written plan for the development of a trade or business in a Zone. The 31-month safe harbor period was also extended to the extent that any delays beyond that time frame are caused by waiting for governmental approvals that were applied for within the 31-month period.

QOF Qualification

The April Release clarifies several matters around the requirement in Section 1400Z-2 that a QOF certify annually that it qualifies as a QOF, including that 90% of its assets qualify as QOZ Property (based on the average of the percentages of QOZ Property held by the QOF on June 30 and December 31 of each year).

Cash Invested into a QOF. Cash held by a QOF would normally be counted against the QOF in calculating the 90% asset test since cash is an asset of the QOF but is not QOZ Property. The April Release permits a taxpayer to exclude any cash that is invested in the QOF within six months prior to the date of any 90% asset test provided that the contributed amounts are held in cash or short-term debt instruments. This allows a QOF to accept new investments and take up to six months to deploy the cash, or update its written plan to deploy the cash, without that new cash causing the entity to fail its 90% asset test as of the ensuing June 30 or December 31.

Dispositions of QOZ Property by a QOF. The April Release provides that proceeds from the sale of QOZ Property by a QOF are treated as being QOZ Property for purposes of the QOF’s 90% asset test so long as the proceeds are reinvested in other QOZ Property within 12 months (or longer to the extent delay is caused by waiting for governmental approvals that were applied for within the 12-month period). Note that this does not impact any recognition of gain on the sale of property by the QOF, but helps to preserve the entity’s QOF status.

Failure to Meet 90% Asset Test. A QOF’s failure to meet the 90% asset test does not, by itself, result in the entity losing its QOF status. Rather, Section 1400Z-2 imposes a monthly penalty for such a failure (excluding any failure that is due to reasonable cause) which is generally equal to the excess of the amount equal to 90 percent of the QOF’s assets over the amount of its assets that are QOZ Property, times an underpayment rate established elsewhere in the Code.

Other Matters

Inclusion Events. Deferred capital gains that are invested in a QOF will be recognized for federal tax purposes on the earlier of December 31, 2026 or the sale or other disposition of the QOF investment. The April Release includes a list of events that will be treated as a “disposition” of a taxpayer’s QOF investment under the OZ program and result in their deferred gains being included in income at that time (inclusion events). The list is long and complex and references a variety of transactions covered by other Code sections, but the consistent theme is that each inclusion event results in a reduction of the QOF owner’s direct interest in the QOF. In addition to a variety of sale or transfer transactions, inclusion events include certain distributions of cash or property to the QOF owner and redemptions of QOF stock, again where the result is a reduction in the taxpayer’s interest in the QOF.

Gifts, Donations, and Transfers Upon Death. With certain exceptions, gifts and charitable donations of a QOF investment are inclusion events (since they reduce the taxpayer’s interest in the QOF) and will cause the taxpayer to recognize previously deferred capital gains. However, transfers as a result of the taxpayer’s death are not inclusion events, nor are transfers to a grantor trust of which the taxpayer is (and continues to be) deemed the owner.

Disposition of QOF Investment After 10 Years. A key incentive of the OZ program is that after a taxpayer holds its QOF investment for more than 10 years, the taxpayer can elect to increase its basis in the QOF investment to fair market value on the date it is sold or exchanged, thus paying no tax on the appreciation in that investment over the past 10 or more years. Under Section 1400Z-2 and the October Release, this election is limited to basis in the QOF investment (not the assets owned by the QOF) which means that the only way for a taxpayer to get the benefits of the 10-year hold would be to dispose of the QOF investment, not the assets or business of the QOF or a QOZ Business. This severely limits ways to structure an exit from a QOF investment, particularly where the QOF holds multiple assets and the taxpayer would like to dispose of less than all of them. The April Release offers some relief here by providing that where a taxpayer holds an interest in a QOF that is a pass-through entity, such as a partnership or S Corporation, for more than 10 years, it may exclude from income its share of capital gains from the QOF’s sale its assets. This allows greater flexibility for a pass-through entity QOF to exit its investment (in whole or in part), but still leaves significant limitations. For example, the rules do not: exclude partnership income allocated to the taxpayer that is categorized as ordinary income rather than capital gains; provide relief to a QOF that is organized as a C corporation; or allow exclusion of gains generated by the disposition of property by a QOZ Business that is owned by a QOF. It remains to be seen whether these concerns will be addressed in future rulemaking or guidance.

Holding Periods. A taxpayer’s holding period for its QOF investment, which begins on the date that the investment in the QOF is made, drives many of the tax benefits available under the QOZ program, including the basis step-ups available after 5, 7 and 10 years. If a taxpayer disposes of a QOF investment and reinvests the proceeds in a new QOF within 180 days, the second investment will qualify as a QOF investment, but the taxpayer’s holding period for that investment will begin anew. The holding period rules can be complicated as they apply differently to different types of transactions.

General Anti-Abuse Rule. The April Release empowers the IRS to recast a transaction for federal tax purposes where they find that a significant purpose of the transaction is to achieve a tax result that is inconsistent with the OZ program. Any such determination would be based on all of the relevant facts and circumstances as determined by the IRS.


Both the October Release and the April Release indicate that Treasury and the IRS are working to make the OZ program flexible and easy to use for taxpayers who are interested in investing in Zones, and to support the program’s mission of encouraging investment and development in those areas of the U.S. and its territories that can most benefit. Martin LLP will continue to monitor this new law and apprise our clients and friends of important developments as they arise.

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This Client Alert is for the benefit of our clients and friends and provides only a high-level summary of the subject matter. It is not intended to be comprehensive or address any particular transaction or set of facts and should not be relied upon as legal advice or a legal opinion. In addition, the proposed regulations in the October Release and the April Release are not final and different or additional regulations or interpretations may be adopted.