A lower substantial-improvement threshold for rural opportunity zones

Editor: Alexander J. Brosseau, CPA

On Sept. 30, 2025, Treasury and the IRS issued guidance on qualified opportunity zone (QOZ) investments in rural areas to implement recent legislative changes to the substantial–improvement threshold for property located in those areas under H.R. 1, P.L. 119–21, the law commonly known as the One Big Beautiful Bill Act (OBBBA).

Notice 2025–50 identifies 3,309 of the 8,764 population census tracts designated as QOZs in 2018 as rural areas where taxpayers, invested through qualified opportunity funds (QOFs) directly or indirectly, through qualified opportunity zone businesses (QOZBs), in a trade or business in such areas may qualify for a lower 50% threshold for improving previously depreciated tangible property over a 30–month period in order to satisfy one of the requirements for such property to be qualified opportunity zone business property (QOZBP).

This item discusses thesubstantial–improvement threshold and what practitioners need to know about the lowering of the threshold for rural QOZs. Before turning to that topic, some background on QOZs may be helpful.

Background

Congress enacted the QOZ program as part of 2017’s Tax Cuts and Jobs Act (TCJA), P.L. 115–97, to stimulate investment through self–certified partnerships and corporations called QOFs in businesses located in lower–income census tracts nominated by the chief executive officers of every U.S. state and territory and the District of Columbia as QOZs. The IRS designated 8,764 such census tracts as QOZs in Notice 2018–48 and Notice 2019–42 (2018 QOZs), which will retain their designation through the end of 2028, pursuant to former Sec. 1400Z–1(f) (removed by the OBBBA for census tracts designated after July 4, 2025), as in effect immediately before the enactment of Section 70421(b) of the OBBBA.

The QOZ program, established under Secs. 1400Z–1 and 1400Z–2, created three incentives for taxpayers who realize eligible gain to timely roll over investments, within a 180–day period, into QOFs:

1. Deferral of recognition of the originally realized gain until the mandatory gain recognition date (currently, Dec. 31, 2026, for investments made in QOFs before 2027);
2. The potential to reduce that originally realized gain by 10% or 15% (Secs. 1400Z-2(b)(2)(B)(iii) and (iv), before the OBBBA), based on a holding period in the QOF investment of five to seven years, respectively, before the mandatory gain-recognition date; and
3. The potential to avoid federal income taxation of all post-acquisition appreciation in the value of the QOF investment upon its sale or exchange on or after the 10-year anniversary of that investment (Sec. 1400Z-2(c)).

In order to secure these benefits for investors and avoid penalties under Sec. 1400Z–2(f), QOFs must invest at least 90% of their assets in qualified opportunity zone property (QOZP), defined as (1) QOZBP; (2) QOZ stock; and (3) a QOZ partnership interest (QOZPI). While QOFs typically invest in QOZ stock or a QOZPI, such stock or partnership interest must be in a regarded entity (partnership or corporation) that is a QOZB for substantially all (at least 90%) of the QOF’s holding period in that entity, and a QOZB must hold substantially all (at least 70%) of its tangible property in QOZBP. In other words, if a QOF invests directly in a trade or business located in a QOZ, then 90% of its assets must be tangible property that satisfies the requirements for being QOZBP, and if a QOF invests 90% of its assets in QOZ stock or a QOZPI issued by a QOZB, 70% of that QOZB’s tangible property must satisfy the requirements for being QOZBP, making those QOZBP requirements a linchpin of the QOZ program.

This is where the substantial–improvement threshold comes into play. Sec. 1400Z–2(d)(2)(D) defines QOZBP to mean tangible property used in a trade or business of the QOF or QOZB (each, an eligible entity) if:

1. Such property was acquired by the eligible entity by purchase (as defined in Sec. 179(d)(2)) after 2017 from a no-more-than-20% related person (as defined in Sec. 1400Z-2(e)(2), using ownership rules derived from Secs. 267(b) and 707(b)(1));
2. The original use of such property in the QOZ commences with the eligible entity, or the eligible entity substantially improves the property (as defined below); and
3. During substantially all (at least 90%) of the eligible entity’s holding period for such property, substantially all (at least 70%) of the use of such property was in a QOZ.

Thus, if a QOF or QOZB purchases previously used tangible property, such as a building located in a QOZ, whose original use for depreciation or amortization purposes does not commence with that QOF or QOZB in the applicable QOZ, that property must be “substantially improved” in order to be considered QOZBP. For this purpose, tangible property (other than land) is generally substantially improved if, during any 30–month period beginning after the date the eligible entity acquires such property (30–month substantial–improvement period), additions to its basis exceed an amount equal to the adjusted basis of such property at the beginning of such 30–month period in the hands of the QOF or QOZB (i.e., the double–the–basis rule).

Relevant changes in OBBBA: Congress made the QOZ program permanent in Section 70421 of the OBBBA. The legislation established a decennial designation process for QOZs, beginning in the second half of 2026 for census tracts that will be QOZs from 2027 through 2036 (newly designated QOZs). Importantly here, the OBBBA also added incentives to encourage the investment of tax–advantaged capital into QOZs comprised entirely of a rural area. Beginning in 2027, investments through newly defined qualified rural opportunity funds (QROFs) that hold at least 90% of their assets in QOZP within a rural area will be eligible for a 30% reduction (rather than a 10% reduction) in deferred capital gains rolled over into a QOF investment when those gains are recognized after a five–year holding period in a QOF. Moreover, Section 70421(c)(4)(C) of the OBBBA immediately modified Sec. 1400Z–2(d)(2)(D)(ii)’s double–the–basis rule so that an eligible entity only needs to make improvements to tangible property located within a QOZ comprised entirely of a rural area that exceed 50% of such property’s basis at the beginning of the 30–month substantial–improvement period (i.e., a half–the–basis rule for rural areas). While many of the OBBBA’s provisions to enhance the QOZ program apply to QOF investments after 2026, the half–the–basis rule for substantial improvement of tangible property located within a QOZ in a rural area applies as of July 4, 2025.

Substantial-improvement threshold for rural opportunity zones

As discussed, the OBBBA reduced the substantial–improvement threshold for previously used tangible property within a QOZ from 100% to 50% over a 30–month period if the tangible property is located entirely within a rural area. This OBBBA amendment took effect on July 4, 2025.

Notice 2025–50 provides additional guidance on the definition of a “rural area” for purposes of the reduced 50% substantial–improvement threshold. This notice was necessary because of an issue involving effective dates. Specifically, Section 70421(c)(4)(C) of the OBBBA amended Sec. 1400Z–2(d)(2)(D)(ii)’s substantial–improvement rule to create a lower substantial–improvement threshold effective upon that amendment’s enactment (i.e., July 4, 2025) for “property in a qualified opportunity zone comprised entirely of a rural area (as defined in subsection [1400Z–2](b)(2)(C)(ii)” (emphasis added). Section 70421(c)(2) of the OBBBA provides a definition of “rural area” in Sec. 1400Z–2(b)(2)(C)(ii) for purposes of investments in QROFs and qualified rural opportunity zone businesses, which is incorporated by reference into the new substantial–improvement test for rural areas in Sec. 1400Z–2(d)(2)(D)(ii), as “any area other than — (I) a city or town that has a population of greater than 50,000 inhabitants, and (II) any urbanized area contiguous and adjacent to [such] a city or town.” However, unlike the 50% substantial–improvement test for rural areas, Sec. 1400Z–2(b)(2)(C)(ii)’s definition of “rural area” does not apply to amounts invested in QOFs before Jan. 1, 2027.

Notice 2025–50 identifies 3,309 of the 8,764 currently designated QOZs (about 37.8%) as rural areas. In particular, Section 4.01 of Notice 2025–50 defines a “rural area” as any area other than (1) an incorporated city or town with a resident population greater than 50,000 in the 2020 decennial census, or, in the case of Hawaii or the Commonwealth of Puerto Rico, a Census–designated place with a resident population greater than 50,000 in the 2020 decennial census, and (2) any Census Bureau—designated urbanized area sharing either a common boundary or at least one common point with such a greater–than–50,000–inhabitant incorporated city or town (or, in the case of Hawaii or Puerto Rico, a Census–designated place), as determined in the 2020 decennial census.

In an appendix, Notice 2025–50 lists all 3,309 population census tracts that are currently designated as QOZs through the end of 2028 and meet the applicable definition of a “rural area” for purposes of the lower 50% substantial–improvement threshold (2018 rural QOZs). All of the 2018 QOZs in six jurisdictions — West Virginia, Vermont, Guam, the U.S. Virgin Islands, American Samoa, and the Northern Mariana Islands — are identified by Notice 2025–50 as rural areas. In six other states, more than 75% of the 2018 QOZs are rural QOZs eligible for this 50% substantial–improvement standard: Maine (91%), Montana (84%), New Hampshire (81%), Idaho (79%), Mississippi (77%), and Wyoming (76%). And 25 states and territories in which at least half of their 2018 QOZs are composed entirely of a rural area include, along with those listed above, Kentucky (74%), Alaska (72%), South Dakota (72%), South Carolina (70%), Arkansas (69%), Iowa (65%), Kansas (62%), New Mexico (59%), Oklahoma (56%), North Dakota (56%), North Carolina (55%), Minnesota (52%), and Georgia (52%). But there are rural QOZs located in every state and territory of the United States.

Taxpayers with existing or prospective QOZ projects in those 2018 rural QOZs involving previously used tangible property may find that such property can be substantially improved without a significant amount of new investment, especially after applying various regulatory rules designed to make the substantial–improvement threshold easier to meet. For example, Regs. Sec. 1.1400Z2(d)-2(b)(4)(iv)(E) provides that if a QOF or QOZB purchases a building on land located entirely within a QOZ, there is no separate requirement to substantially improve the land, so that an improvement exceeding more than half the basis of the building located within a rural QOZ will suffice to meet the substantial–improvement test, unless the land is purchased with the expectation or intention not to improve it by more than an insubstantial amount.

Moreover, Notice 2025–50 applies to any determination of whether tangible property held by a QOF or QOZB in a rural area meets a QOF’s or QOZB’s substantial–improvement test on or after July 4, 2025, regardless of when the eligible entity acquired its property, as shown in the following example:

Example: On Jan. 1, 2025, a taxpayer invested $100x in a QOF that immediately used $90x to acquire a QOZPI in a partnership, organized for the purposes of being a QOZ, that purchased a warehouse on land in a rural QOZ from an unrelated business for $50x on Feb. 1, 2025. If $10x of the purchase price is allocated to the land and the remaining $40x is allocated to the building, the QOZB would only need to spend more than $20x (half the basis of the building, excluding the land) during a 30–month substantial–improvement period between Feb. 1, 2025, and July 31, 2027, in order for that building to be considered QOZBP substantially improved by the partnership within the rural QOZ under Sec. 1400Z–2(d)(2)(D)(ii), as amended by Section 70421(c)(4)(C) of the OBBBA.

Implications

Notice 2025–50 provides immediate guidance for taxpayers investing or considering investing through QOFs and QOZBs in businesses located in one of several thousand rural QOZs nationwide. In these places, it is now easier to substantially improve previously used business property over a 30–month period in a manner that will allow such property to qualify as QOZBP. While this notice applies only to 2018 QOZs, such QOZs will retain their designation through Dec. 31, 2028. Previously used tangible property located there may now be purchased from unrelated persons, and only half the investment on improvements is required that would otherwise have been needed over 30 months to turn that property into QOZBP.

Editor

Alexander J. Brosseau, CPA, is a senior manager in the Tax Policy Group of Deloitte Tax LLP’s Washington National Tax office.

For more information about these items, contact Brosseau at abrosseau@deloitte.com.

Contributors are members of or associated with Deloitte Tax LLP.

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