INSIGHT: Highlights of the Final Opportunity Zone Regulations

INSIGHT: Highlights of the Final Opportunity Zone Regulations

Jan. 6, 2020, 5:00 AM

By now, you’ve seen that the IRS published final regulations on Opportunity Zones on Dec. 19, 2019. Between the preamble and the actual regulations, the publication amounts to 544 pages. This means that it will continue to take some time for tax advisors to make their way through all of the ins and outs, especially when it comes to issues left unaddressed or “under-addressed.” Here are some noteworthy items in the final regulations:


The final regulations provide quite a bit of flexibility that was not present in the proposed regulations. When it comes to a taxpayer’s original investment in a qualified opportunity fund (QOF), i.e., the investment that must be made within 180 days of a capital gain, there are several new options for picking the starting date, and in some cases, the amount that can be invested. When it comes to disposing of the investor’s investment in the QOF, i.e., the sale that will come 10 or more years after the investment, there are also many new options. Not only do these new options add flexibility, they are also more understandable to taxpayers considering their choices. Still, the flexibility comes with a price. Transition rules and grandfathering for deals structured to comply with the proposed regulations will force tax advisors to give qualified and lengthy responses to many questions.

The 180-day Period for Investing

Many of you will remember the serious, and often hard-to-explain complexities associated with investing “Section 1231 gains.” These are the gains that result from sales of property used in a trade or business, such as gains from the sale of rental real estate. Under the proposed regulations, the 180-day period for investing gain from such a sale began on Dec. 31 for most taxpayers, while the 180-day investment period for sales of most capital assets, like corporate stock, began on the date of the sale. And, Section 1231 gains were required to be netted against Section 1231 losses, possibly reducing the amount eligible for favorable OZ treatment as compared to investments arising from sales of capital assets like stock, where netting was not required.

For example, assume a taxpayer owned the stock of the family business as well as the company headquarters, which she leased to the business. Even if both were sold on the same day to the same buyer, under the proposed regulations, they had different start dates for the 180-day period. For the stock, the period started on the date of sale, but for the real estate, it started on Dec. 31. Moreover, the seller had to first add together all her 1231 gains and losses for the year in order to determine the net amount that could be invested in a QOF. Thus, if our seller sold two pieces of rental real estate, one for a $5 million gain, and the other for a $2 million loss, her maximum favorably-treated OZ investment would be just $3 million.

The final regulations make two significant changes to these rules: First, under the final regulations, the 180-day period for making an investment from a Section 1231 gain runs from the date of that sale, not the end of the year. Second, an investor can invest the gross amount of the particular 1231 gain without having to net this amount against later losses (if any) from other similar sales.

Alas, the rules here continue to be a bit complicated, largely due to the lingering effects of the rules of the proposed regulations. The IRS has offered some sensible transition rules, permitting a taxpayer to choose the old treatment provided by the proposed regulations. Of course, as a result, any explanation of the rules has to be that much longer to cover all the possibilities. Consider each of the following illustrations:

  • Investor had a 1231 capital gain on March 1, 2019. He followed the proposed regulations, and waited till Dec. 31, 2019, to invest. By the time the final regulations were published, it was too late to take advantage of the new rule, because Dec. 31, 2019 is well more than 180 days after March 1, 2019. Fortunately, the final regulations allow him to instead use Dec. 31 as the starting date if he wishes. But note that he has to take all of this section of the proposed regulations into account. In other words, he’d have to apply the rule that requires netting of 1231 gains and losses, too. As a result, if he also had a 1231 loss in 2019, then using the Dec. 31 start date from the proposed regulations would reduce her net 1231 gains, and therefore her possible OZ investment.
  • Investor has a 1231 gain on Sept. 1, 2019. She has the choice of (A) following the proposed regulations, which would allow an investment as late as the 180-day period commencing Dec. 31, 2019, but would also require him to apply the netting rule, or (B) following the final regulations, which would start the period on Sept. 1, but wouldn’t require him to reduce his 1231 gain by any 1231 loss he might have.
  • Investor had a 1231 gain on March 1, 2019, and invested the gain in a QOF on June 1, 2019, because he ignored (or was unaware of) the Dec. 31 start date of the proposed regulations. The final regulations rescue her actions and treat her June 1 investment as complying with the OZ requirements.

In addition to the new Section 1231 rules, the IRS also modified the rules where a pass-through entity (e.g., a partnership, LLC taxed as a partnership, or S corporation) has a capital gain, but does not, itself, defer that gain under the OZ rules. On those facts, the partner, member, or stockholder (as applicable) can instead make a QOF investment and defer their share of the gain, choosing among the following start dates for the 180-day investment period: (1) the day that would have otherwise applied to the pass-through entity (typically the date of sale), (2) the final day of the entity’s tax year, or (3) the due date for the entity’s tax return, without extensions.

Interactions with Other Deferral Techniques

When it comes to determining the 180-day period for capital gains arising from an installment sale (essentially a sale with multiple payments) the IRS made clear that installment sales can either (a) recognize and measure the 180-day period all in the year of sale (using a Dec. 31 start date), or (b) make investments over the years that the gain is recognized. Once again, the IRS gave a nod to providing flexibility to OZ investors. Also helpful: taxpayers who had installment sales before the OZ rules became law (December 2017) can still get OZ treatment for gains to be recognized on the installment method in later years.

Another well-known deferral technique, like-kind exchanges under Section 1031, also get a brief reference. It seems clear that an investor can do a part like-kind exchange-part QOF investment in appropriate circumstances, although an advanced class in tax-calculus may be needed to figure out just how much is eligible for OZ tax savings! In any case, remember a very important difference between like kind exchanges and OZ investing—with exchanges, it is important to invest the proceeds of the sale that generated the original gain; with OZ investing, it is important to invest the amount of the gain. With OZs, invest too much and some of your no-tax-after-10 years’ computation will be diluted by the excess investment; invest too little, and you will pay current tax on the portion you failed to defer. On the other hand, OZ investments have other strong points. In particular, there is no need for a “qualified intermediary” to monitor your OZ investment like there is with a deferred like kind exchange.

Investing in a QOF That Owns Property That It Purchased from the Investor

Here’s one spot where the IRS became more conservative. Some taxpayers had proposed selling assets that they already owned to a QOF or a qualified opportunity zone business (QOZB) in which the QOF invests, and then treating the resulting proceeds as capital gain (or, more likely, 1231 gain) that can serve as the “amount” that they then invest in the same QOF, assuring that the investors’ (or related parties’) interest in the QOF did not exceed 20%, in order to avoid any related party rules.

Unfortunately, the IRS does not approve of such a structure. Applying a step transaction analysis, it considers this to be more in the nature of a capital contribution of the actual property to the QOF (and then to the QOZB, if applicable) by the investor, so that there isn’t a sale or a capital gain to back the OZ investment.

In view of the disguised sale rules of Section 707, which the IRS has already incorporated in its analysis of the tax treatment of distributions made by QOFs, I hadn’t expected the IRS to take a relatively fixed (and unfavorable) position here. It seems like the IRS could have instead said that partner-partnership transactions (including those that are between QOF investors and the QOZBs in which the QOF invests) should simply be analyzed using disguised sale principles. Unfortunately, the IRS didn’t choose that path.

The 100% Substantial Improvement Rule

You will remember that used property is generally not eligible for favorable treatment unless it is “substantially improved.” To meet this requirement, a QOF or QOZB must spend as much or more than their basis in the used property (but not land) on “additions to basis” within a 30-month period. The proposed regulations had these computations done building-by-building, even though the tax code provision refers to additions to basis “with respect to” the used property, suggesting a broader treatment.

The final regulations have adopted a broader, “aggregate” rule. Indeed, they have two sets of substantial improvement rules, and both might apply at the same time. This will require developers and their advisors to closely study the rules with each rehabilitation.

One set of rules allows improvements to buildings on contiguous parcels, or buildings located on a single parcel and transferred in a single deed, to be aggregated, as if they were a single property. To aggregate under this rule, all of the buildings must receive some rehabilitation. They must also be operated exclusively by one QOF or QOZB, they must share common business elements like human resources and accounting, and they must have a common or interdependent trade or business. Here’s an example of aggregating: assume two adjacent buildings have starting bases of $400 and $500 and pass the other tests required to aggregate. Further suppose that a QOZB undertakes a rehabilitation of $305 for the first building, and $600 for the second. Under the proposed regulations, the rehabilitation of the first building would have failed, because the $305 of rehabilitation is less than its $400 basis. However, under the final regulations, the total rehabilitation, $905, is more than the aggregate basis, $900, and the rehabilitation passes the OZ improvement requirement.

A second rule allows the cost of new assets, including another building, to apply towards the 100% rehabilitation requirement, provided the rehabilitated building and the new, purchased assets are used in the same trade or business in the opportunity zone or in an contiguous opportunity zone, and the new assets improve the functionality of the used assets. To illustrate: the cost of new furniture for use in a used building can be part of the substantial rehabilitation of the building. So, for example, a $1000 hotel could pass the test with a $900 rehabilitation and the purchase of $110 of mattresses and furniture for use in the hotel. On the other hand, the cost of a new apartment building cannot count towards the rehabilitation of a hotel, because these are different trades or businesses.

Note the difference between the contiguous tests in the first and second rules. While the first test combines rehabilitations of two buildings in the same or contiguous parcels, the second test includes the cost of new property purchased for use in the same trade or business in contiguous opportunity zones, which could quite a bit farther away.

An additional qualifier: environmental remediation and utility upgrades, even if properly chargeable to land, are also counted favorably in the substantial improvement computation.

Finally, the rules also change how long a building has to be vacant in order to avoid the need for substantial rehabilitation. The requirement had been five years in the proposed regulations. In the final regulations, the required period is just one year if the property was vacant at the time the census tract was designated an opportunity zone, and otherwise, the required period is just three years.

As I noted, this is an especially dense set of rules. If you plan to aggregate expenses across more than one project or building, be sure to run your plan past a knowledgeable tax advisor.

Improvements to Land

It’s been well established that the IRS fears taxpayers who “warehouse” land, presumably with the hope that someone will come along 10 years later and “make an offer that they can’t refuse,” after which they will sell the land and not have to pay any capital gains tax. Reluctant to adopt a minimum percentage test, perhaps for fear that taxpayers would do only the exact minimum required, the IRS nonetheless identified some modest improvements that it thought would be significant: adding an irrigation system to farm land or grading land would be enough. I, for one, hadn’t anticipated that grading would be sufficient. For example, in applying the “physical work” test that applies to determine whether a taxpayer has begun construction of a renewable energy project, “excavating to change the contour of the land (as distinguished from excavation for footings and foundations)” is considered an insufficient “preliminary activity.” Still, remember that mere grading won’t be sufficient under the more general OZ rules anyway. The owner must generally conduct a trade or business during the years that the QOF or a QOZB owns the land, indeed QOZB’s must be engaged in an active trade or business.

30-Month Expectations and 31-Month Written Plans

By statute, QOZBs aren’t allowed to have more than 5% of their assets held in “nonqualified financial property,” like cash. However, the proposed regulations allowed a QOZB to hold large amounts of “working capital,” provided they had an up-to-31-month written plan to spend the money and develop a property or qualified opportunity zone business. The final regulations maintain the 31-month written plan rule, and now permit a qualified opportunity zone business to apply subsequent 31-month working capital safe harbors up to a maximum 62-month period, provided that each 31-month period itself satisfies the requirements, and they are part of an integral plan.

The regulations also add favorable treatment where the taxpayer reasonably expects that a used property will become qualified opportunity zone business property within 30 months, even if there is no “working capital” associated with the rehabilitation. The final regulations treat property that is being rehabilitated as qualifying property during such a period, regardless of whether it is held at the QOF or QOZB level.

The addition of a 30-month reasonable expectation rule has created some confusion as to whether a QOF can do a rehabilitation and avoid failing the 90% test if it sits on working capital during that period. As written in the tax code, the working capital rules only apply to QOZBs (and not QOFs), so it seems unlikely that the IRS meant to change the 31-month written capital rule in the final regulations by extending it to QOFs. When the preamble and final regulations discuss the ability of an entity to hold working capital, they still only refer to tax code sections and tests that apply to QOZBs. Still, it should be possible for a QOF to undertake a rehabilitation at the QOF level, remembering that a QOF is only tested for compliance every six months. As a result, it may be possible for an appropriate rehabilitation project to obtain capital at the QOF level, and use it up in 6 month cycles, thereby passing the 90% good assets requirement that applies to QOFs. Or, alternatively, the QOF might never have much cash on hand, and instead use a line of credit and a requisition procedure to pay its bills. In the end, I’d expect most projects to continue to be done by QOZBs, and not QOFs.

Tax Consequences of Sales After 10 years

And finally we come to the biggest change of all: the final regulations have adopted many of the post-10-year disposition changes requested by the investment community. As a result, each of the following is eligible for favorable tax treatment after ten years:

  • sale of a QOF interest held by an investor;
  • sale of a directly owned property by a QOF;
  • sale of an interest in a partnership, limited liability company, or stock held by a QOF; and
  • sale of property held by a QOZB partnership, LLC, or corporation in which the QOF invests.

Obviously, this is very useful on a practical level and it addresses a lot of concerns that had been voiced ever since the new tax code provision became law. You will remember concepts like “one fund per project” to assure flexibility in future sales, as well as the fear that perhaps deprecation recapture wouldn’t be saved by the no-tax rule. All of these concerns are now gone. So, now a single fund can undertake multiple investments, through one or more subsidiary partnerships, LLCs or corporations, as well as direct ownership, and still be able to sell just a single property or interest after ten years without tax.

Note that the new rule applies to the sale of all assets held by the QOF or QOZB, even property that was on the wrong side of the 90% test for QOFs or the 70% test for QOZBs. To illustrate: suppose that QOF owns an interest in an LLC that, in turn, holds two properties, one in an opportunity zone that constitutes 75% of its assets and another, not in a zone, that constitutes 25%. A sale of either property, once the investor has held its interest in the QOF for at least 10 years, will not be subject to tax.

Investors didn’t get everything that they were asking for. Under the final regulations, a sale by the investor, QOF or QOZB during the 10-year period will still be taxable. For example, assume that investor forms a QOF on Jan. 31, 2020, and its capital contribution is used to purchase a new qualifying building on March 31, 2020. Assume further that the building is sold on Dec. 1, 2025. This sale, when the investor’s investment is a bit under five years old, will be taxable, recognizing that the investor may be able to roll this gain into another QOF investment, which could potentially delay gain recognition until Dec. 31, 2026.

And remember that timing is an investor-by-investor issue. If A invested in a QOF in December 2019, and B invested in March 2020, and ultimately, the QOF sells property it owns in February 2030, A will get the benefit of the 10-year rule, but B will not. It remains to be seen whether fund managers will try to assure that all investors have adequate holding periods to meet the 10-year requirement.


Starting with 544 pages, it would be easy to write a few thousand pages with examples and illustrations of all the features of these final regulations. I’ve limited this discussion to just a few, but it is important to remember that there is a lot more here. For example, the IRS provided a bit more guidance on the triple net lease rule, it confirmed that the fair market value of property should include the debt that encumbers it, and while it declined to provide much in the way of favorable treatment for tax credit transactions (it wrote that they are “still being considered”), it did provide that one member of a corporate group can have the gain while another does the investing, a common structure for tax credit investors.

In the end, I think that the IRS deserves a great deal of credit for working its way through so many comments and suggestions and applying an excellent measure of flexibility at many turns. At the same time, I think we can expect to uncover many more investment opportunities and obligations as we spend more time with the regulations and working through investments with taxpayers, developers, fund organizers and managers.

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

Author Information

Forrest David Milder is a partner in the law firm, Nixon Peabody, LLP, where he specializes in the tax aspects of tax-equity investing. He is a frequent speaker and author on tax-equity topics, including the Bloomberg Tax Management Portfolio, “Rehabilitation Tax Credit and Low-Income Housing Tax Credit.” He is a past chair of the American Bar Association’s Forum on Affordable Housing and Community Development and the MIT Enterprise Forum of Cambridge. He can be reached at 617-345-1055 and

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