First round of opportunity zone guidance offers flexibility for investors, but questions remain

By Dustin Stamper and Omair Taher, Washington

Editor: Greg A. Fairbanks, J.D., LL.M.

The IRS recently released the first round of guidance on opportunity zones established by the law known as the Tax Cuts and Jobs Act, P.L. 115-97. The package, which includes proposed regulations (REG-115420-18), a revenue ruling (Rev. Rul. 2018-29), and a draft form and instructions for participating entities, answers several fundamental and practical questions to help taxpayers begin using the powerful new incentive. It is generally permissive and generous toward a variety of investors, but it does include some limitations and leaves complex and potentially consequential issues to be resolved by future regulations. Taxpayers should carefully consider opportunity zone investments, keeping in mind that the program is still in its infancy, and the rules could evolve as the IRS issues additional guidance and responds to public feedback.

Congress created opportunity zones, enacted under new Subchapter Z, to boost investment in certain economically distressed communities. States have designated their opportunity zones, and 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 qualified opportunity funds (QOFs), generally defined as a corporation or partnership that self-certifies and holds at least 90% of its assets in qualified opportunity zone (QOZ) property.

Sec. 1400Z-2(b) allows taxpayers to defer and even partially exclude capital gains earned elsewhere if they are subsequently invested in a QOF within 180 days beginning on the date of the sale or exchange. For example, if a taxpayer sells stock for a gain and then invests an amount equal to the gain in a QOF, the gain would be tax-deferred until the fund is sold or on the mandatory recognition date of Dec. 31, 2026. The longer the taxpayer holds on to an interest in the QOF, the greater the potential benefit. If the investment is held for at least five or seven years, the taxpayer would only recognize 90% or 85%, respectively, of the original capital gain upon disposition. If the interest is held for 10 years, the taxpayer will recognize only 85% of the deferred gain on Dec. 31, 2026 (assuming the taxpayer made the investment seven years before this date), and the basis in the QOF interest will be increased to fair market value upon disposition, so no other gain is recognized.

The proposed regulations clarify that an investment in a QOF cannot be made in exchange for a debt interest, but they permit a taxpayer to borrow against an equity interest in the QOF. They also provide that passthrough entities such as partnerships, S corporations, estates, and trusts can invest in a QOF and make an entity-level election to defer gain recognized at the entity level. If an entity does not elect to defer gain, the owner can make a qualifying investment and an election after the gain is recognized at the owner level. These owners can choose to begin their 180-day period on either the last day of the entity's year (when the owner would be required to recognize the gain) or when the entity itself would begin the 180-day period (the date the entity actually makes the sale or exchange).

The IRS makes clear that any entity treated as a partnership or a corporation for federal tax purposes can be a QOF, meaning S corporations and limited liability companies organized as partnerships are eligible. A QOF self-certifies by filing new Form 8996, Qualified Opportunity Fund, with its annual income tax return. The form allows the QOF to identify both the tax year and the month in which the entity becomes a QOF and is subject to the requirements. The proposed rules also permit a preexisting entity to become a QOF, but only investments made after it is designated a QOF qualify for deferral. The preamble to the proposed regulations acknowledges that QOZ stock and partnership interests can also come from preexisting entities.

The proposed regulations offer no flexibility at the QOF level to hold cash, which is generally not a qualifying asset for the 90% asset test, but there is a safe harbor for cash held at the QOZ stock and partnership level, which is discussed later in this item. The statute also instructs the IRS to allow QOFs a reasonable period to reinvest the proceeds from selling qualified investments, but the IRS announced it will address this in the future.

Under 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.

The proposed regulations provide substantial flexibility by allowing working capital in cash, cash equivalents, and debt with a term of 18 months or less to be held at the QOZB level without violating the bar on holding more than 5% in nonqualified financial property. To qualify for this safe harbor, the QOZB must have a written plan that earmarks the financial property for the acquisition, construction, or substantial improvement of tangible property in the opportunity zone, and the QOZB must comply with a written schedule that is consistent with the ordinary business operations of the business.

Perhaps the greatest area of flexibility offered in the proposed regulations lies 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. Depending on how the IRS defines "substantially all" in future regulations, QOZ business property could possibly even be used outside the opportunity zone for some periods.

Substantial improvement of tangible property is 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. However, it will be difficult for taxpayers to know how permissive these rules will be until further proposed regulations are issued.

The proposed regulations are not effective until final, but taxpayers can rely on many of the rules if applied in their entirety and in a consistent manner. The IRS planned to release a second round of proposed regulations to address issues that remained outstanding, including:

  • The meaning of the phrase "substantially all" in other places in the statute where it is used;
  • The definition of the term "reasonable period" for a QOF to reinvest proceeds from the sale of qualifying assets;
  • Whether the requirement that qualifying property be put to "original use" in an opportunity zone can apply to property that was previously placed in service but is vacant, underutilized, or abandoned;
  • Administrative rules when a QOF fails to meet the 90% asset test; and
  • Transactions triggering a gain inclusion.

The relative latitude provided by the proposed regulations may make opportunity zone investments more alluring to some taxpayers. However, the rules are complex and evolving. Taxpayers should carefully review the proposed regulations for relevant limitations and be mindful of how future guidance may affect their investments.


Greg Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington..

For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or

Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.

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