As part of the legislation known as the Tax Cuts and Jobs Act,1 Congress enacted two companion provisions designed to encourage investment and economic growth in certain low-income communities. First, Sec. 1400Z-1 paved the way for more than 8,700 such low-income communities and qualifying contiguous census tracts to be designated as "qualified opportunity zones" (QOZs). In turn, Sec. 1400Z-2 offers three federal income tax incentives to a taxpayer who invests in a business located within one of these zones: (1) the temporary deferral of capital gains, to the extent the gains are reinvested into a "qualified opportunity fund" (QOF); (2) the partial exclusion of previously deferred gains when certain holding period requirements in a QOF are met; and (3) the permanent exclusion of post-acquisition gains from the sale of an investment in a QOF held longer than 10 years.
While Sec. 1400Z-2 teases a tantalizing menu of tax breaks, the statutory language contains little practical guidance. As a result, taxpayers were initially uncertain of how to meet the various investment requirements to achieve the promised tax benefits. This was particularly problematic because Secs. 1400Z-1 and 1400Z-2 are temporary. QOZs will disappear at the end of 2028, and, as soon as 2020, a portion of the potential tax benefits will be gone forever.
On Oct. 19, 2018, however, the IRS published proposed regulations providing much of the direction taxpayers had been seeking.2 Guidance on investing in opportunity zones is far from a finished product, however. The IRS has promised additional rounds of proposed regulations, and as this article reveals, the previously published proposed regulations have generated no shortage of additional questions.3
This article discusses the October proposed regulations in detail and reviews issues that remain unresolved, which, until addressed, will curb the desired flow of private-sector investment into low-income communities.
Summary: The QOZ life cycle and resulting tax benefits
Sec. 1400Z-2 entails a specific process, complete with critical definitions, deadlines, and quantitative tests that must be satisfied before the promised tax benefits become a reality. The life cycle of an opportunity zone investment can be represented at a high level as follows:
A taxpayer realizes an eligible gain. The taxpayer reinvests the gain within 180 days into a QOF and defers the gain for the year of sale. The QOF conducts business, either directly by holding QOZ business property (QOZBP) or indirectly by holding QOZ stock or a QOZ partnership interest. The taxpayer recognizes the deferred gain on the earlier of Dec. 31, 2026, or the date the taxpayer sells or exchanges the QOF interest.
After holding the interest in the QOF for five years, the taxpayer excludes 10% of the original deferred gain. After an additional two years, another 5% of the original deferred gain is excluded. After an additional three years (a total of 10 years), the taxpayer may sell the investment in the QOF at any time before 2048 and exclude the gain resulting from the sale. A detailed look at this life cycle follows.
Qualified opportunity zones
Sec. 1400Z-1 allowed for the designation of certain low-income community population tracts4 as QOZs. In addition, a limited number of other, contiguous, census tracts could be designated as QOZs.5 These designations were made in 2018 and will remain in effect until Dec. 31, 2028. A listing of these zones can be found in Notice 2018-48.
The immediate benefit provided by Sec. 1400Z-2 is the deferral of "eligible gain" that is reinvested into a QOF within 180 days of the sale or exchange that gives rise to the gain. Eligible gain is gain that:6
- Is "treated as capital" for federal income tax purposes;7
- Would be recognized for federal income tax purposes before Jan. 1, 2027;8 and
- Does not arise from a sale or exchange with a related party.
For these purposes, persons are related to each other if they are described in Sec. 267(b) or Sec. 707(b), determined by substituting 20% for 50% wherever it appears in those sections.9
The use of the term "treated as capital gain" is important. It allows for gain arising from the sale of a Sec. 1231 asset — which by definition is not a capital asset but the net gain from which is taxed as capital gain — to qualify as eligible gain.10 Any depreciation recapture taxed as ordinary income under Secs. 1245 and 1250, however, is not eligible gain.
Eligible gain includes gain arising from an actual or deemed sale or exchange, or any other gain that is required to be included in a taxpayer's computation of capital gain.11
Any taxpayer that realizes eligible gain for federal tax purposes may elect to defer that gain if all of the requirements of Sec. 1400Z-2 are met. These taxpayers include individuals, C corporations (including regulated investment companies and real estate investment trusts), partnerships, S corporations, and trusts and estates.12
If a partnership realizes eligible gain, it has a choice: It may elect to defer that gain at the partnership level, or it may pass the gain through to its partners, who are then free to make their own decision on deferral.
If a partnership elects to defer the eligible gain, the deferred gain is not included in the distributive share of the partners and does not increase the partners' basis in the partnership.13 When some or all of the deferred gain is subsequently recognized by the partnership under the rules of Sec. 1400Z-2, the gain is included in the distributive share of the partners and increases the partners' basis at that time.14
Example 1: Individuals A, B, and C each own a one-third interest in PRS, a partnership. In 2019, PRS realizes eligible gain of $90,000. If PRS elects to defer the gain, no amount of the $90,000 gain is allocated to A, B, or C, and the basis of A, B, and C in PRS is not increased.
If the partnership does not elect to defer the eligible gain, the gain is included in the distributive share of the partners and immediately increases each partner's basis in the partnership.15 Each partner, in turn, may then elect to defer some or all of the eligible gain allocated from the partnership, but only if the sale by the partnership giving rise to the gain was to a taxpayer unrelated to the partner.16
Example 2: Assume the same facts as Example 1, only partnership PRS does not elect to defer the eligible gain realized in 2019. As a result, each of A, B, and C is allocated $30,000 of gain, and each partner increases his or her basis in PRS at that time. Any or all of A, B, or C may then elect to defer the gain at the individual level, provided all the requirements of Sec. 1400Z-2 are met.
The rules allowing a partnership to either defer gain at the entity level or choose instead to pass the gain on to its owners also apply to S corporations, trusts, and estates.17
The ability of a partnership to allocate eligible gain to partners, who in turn are free to make their own deferral elections, provides a partnership flexibility that is not available with a traditional Sec. 1031 like-kind exchange. To illustrate, assume a partnership with four partners holds an appreciated building. Two of the partners want to defer all of the appreciation in the building by exchanging it for another building in a Sec. 1031 transaction, but the other two partners would prefer that the partnership sell the building so they can cash out their portion of the investment. Absent proactive tax planning, it is very difficult to satisfy the goals of all four partners using a Sec. 1031 exchange, because the consequences are determined at the partnership level — the partnership must both transfer the relinquished property and hold the replacement property. Under Sec. 1400Z-2, however, the partnership can simply sell the building for cash, allocate the gain and distribute the proceeds among the partners, and allow each partner to make his or her own decision whether to report the gain and keep the cash or defer the gain by reinvesting the gain amount into a QOF.
Required timing of reinvestment of eligible gain
As stated earlier, a taxpayer that wishes to defer eligible gain must reinvest the gain into a QOF within 180 days from the date of the sale or exchange that gives rise to the gain. The 180-day period generally begins on the day on which the gain would be recognized for federal income tax purposes if the taxpayer did not elect under Sec. 1400Z-2 to defer recognition of the gain.18
Example 3: Stock is sold at a gain in a regular-way trade on an exchange on Feb. 2, 2019. The 180 -day period with respect to the gain on the stock begins on Feb. 2, 2019.
The effective date of Sec. 1400Z-2 is Dec. 22, 2017. On the IRS webpage titled "Opportunity Zones Frequently Asked Questions," however, the Service indicates that eligible gain may arise from a sale prior to Dec. 22, 2017.19 Thus, it would appear that eligible gain may occur prior to the effective date of Sec. 1400Z-2, provided the reinvestment of that gain takes place after Dec. 22, 2017. The webpage also states that a taxpayer who reinvested eligible gain between Dec. 22 and Dec. 31, 2017, may elect to defer that gain on an amended return.
In the case of a partnership that realizes eligible gain but does not elect to defer that gain, choosing instead to allocate the gain to its partners, the 180-day period with respect to the partners' eligible gains generally does not begin on the date of sale. Instead, it begins on the last day of the partnership's tax year in which the partners' allocable share of the partnership's eligible gain is taken into account under Sec. 706.20
Example 4: A is a one-third partner in partnership PRS, a calendar-year partnership. On Jan. 8, 2018, PRS realizes $90,000 of eligible gain. PRS elects not to defer the gain and includes $30,000 in A's distributive share. A does not receive the Schedule K-1, Partner's Share of Income, Deductions, Credits, etc., reflecting the $30,000 of gain until March 12, 2019, a date well after the 180-day period beginning on the Jan. 8, 2018, sale date. For the purposes of determining A's 180-day period, however, the period begins on Dec. 31, 2018, the last day of PRS's tax year. This extends A's period for reinvestment until June 29, 2019.
Alternatively, a partner may elect to treat the 180-day period with respect to the partner's distributive share of that gain as being the same as the partnership's 180-day period.21 This would permit a partner to accelerate his or her reinvestment into a QOF.
Example 5: Assume the same facts as Example 4. A may elect to treat the 180-day period with respect to his $30,000 of gain from PRS as beginning on Jan. 8, 2018, the date of the partnership sale.
These timing rules also apply to S corporations, trusts, and estates and their shareholders or beneficiaries. 22
A taxpayer must affirmatively elect to defer eligible gain.23 The election is made on Form 8949, Sales and Other Dispositions of Capital Assets, by reporting the eligible gain as a positive number before then removing the gain on a separate line as a negative adjustment.24
A taxpayer is not required to reinvest the entire proceeds from the sale or exchange giving rise to the eligible gain; rather, to defer the full amount of eligible gain, the taxpayer must reinvest only the gain amount. Thus, unlike a Sec. 1031 exchange, a taxpayer reinvesting in a QOF can both take cash off the table and defer the full amount of gain resulting from the sale.
Example 6: A holds a building with an adjusted tax basis of $1 million and a fair market value (FMV) of $2 million. If A does a Sec. 1031 exchange with B, receiving replacement property with an FMV of $1.5 million and $500,000 of cash, A must pay tax on the $500,000 of gain under Sec. 1031(b) and thus may defer only $500,000 of gain. Alternatively, if A sells the building for $2 million of cash, A can retain $1 million of cash, reinvest the remaining $1 million into a QOF within 180 days, and defer the full $1 million of gain.
A taxpayer may elect to defer some or all of an eligible gain that is reinvested within the applicable 180-day period. The entire amount of the gain need not be reinvested at once; rather, a taxpayer may make multiple deferral elections related to the same gain but may make a deferral election with respect to the same portion of any eligible gain only once.25
Example 7: A realizes $40,000 of capital gain on April 12, 2018. A invests $15,000 of the gain into a QOF on May 3, 2018, and elects to defer that portion of the gain. On Aug. 20, 2018, A invests the remaining $25,000 of the gain into a QOF. A may elect to defer that portion of the gain as well because (1) no previous deferral election was made with respect to that $25,000 of gain, and (2) the gain was reinvested within the requisite 180-day period starting on the date of sale.
If a taxpayer invests more than the eligible gain amount into a QOF — or invests eligible gain but elects to defer only a portion of that eligible gain — the taxpayer is treated as having made two separate investments. The first represents only the investment of eligible gain for which a deferral election has been made. The second consists of all other amounts. The subsequent exclusion provisions (discussed later in this article) apply only to the investment of the eligible gain.26
Example 8: A realizes $100,000 of eligible gain on June 7, 2019. On June 23, 2019, A invests $120,000 into a QOF and elects to defer the $100,000 of gain. A is treated as having made two separate investments into the QOF; the first is the $100,000 of deferred gain that will be eligible for future tax benefits under Sec. 1400Z-2, and the second is a $20,000 investment that represents the amount invested in excess of the eligible gain. This second investment is not eligible for future tax benefits under Sec. 1400Z-2 but rather is subject to general tax principles.
Recognition of previously deferred gain; timing and character issues
Previously deferred eligible gain must be included in income at the earlier of:27
- The date on which the interest in the QOF is sold or exchanged, or
- Dec. 31, 2026.
The amount of gain included in gross income is determined by subtracting the taxpayer's basis in the investment in the QOF from the lesser of:
- The original amount of deferred gain, or
- The FMV of the interest in the QOF on the recognition date.28
Except as otherwise provided under Sec. 1400Z-2, a taxpayer's basis in a QOF related to an investment of deferred gain is zero.29
Example 9: On July 5, 2023, A realizes $100,000 of eligible gain. On July 7, 2023, A reinvests the $100,000 of gain into a QOF and elects to defer it. As a result, A does not recognize the $100,000 of gain on his 2023 tax return, and his basis in the investment is zero. A continues to hold the investment in the QOF on Dec. 31, 2026. At that time, A's basis in the investment remains zero, and the FMV of the investment is $140,000. On his 2026 tax return, A must recognize $100,000 of gain, the excess of the lesser of the original deferred gain ($100,000) or the FMV of the investment ($140,000) over A's basis in the investment ($0).
Alternatively, if A sells his investment in the QOF in 2026 for $80,000, A must recognize $80,000 of deferred gain at that time, the excess of the lesser of the original deferred gain ($100,000) or the FMV of the investment ($80,000), over A's basis in the investment ($0).
If a taxpayer sells an interest in a QOF that was previously subject to a gain deferral election, the taxpayer may in turn make a second election to further defer the recognition of the original deferred gain, if the taxpayer reinvests the gain amount within 180 days in the same or another QOF. This opportunity for a second deferral applies only when the taxpayer sells the entire interest in the QOF.30
Example 10: Taxpayer A invested in a QOF and properly elected to defer realized gain. During 2025, A disposes of its entire investment in the QOF in a transaction that triggers an inclusion of gain in A's gross income. A wants to elect to defer the amount that is required to be included in income. The 180-day period for making another investment in a QOF begins on the date of the inclusion-triggering disposition. Thus, to make a second deferral election, A must invest the amount of the inclusion in the original QOF or in another QOF during the 180-day period beginning on the date when A disposed of its entire investment in the QOF.
In Example 10, it is not clear whether A may continue to defer only the previously deferred gain or also any gain that was realized upon the sale of the QOF interest that was unrelated to the original deferred gain.
Example 11: Assume the same facts as Example 10. The original deferred gain invested in the QOF was $400,000. Assume that in 2025, when A sells its interest in the QOF, it realizes $500,000 of gain. The regulations are not clear whether A is limited to further deferring only the $400,000 of original gain by reinvesting in a second QOF within 180 days, or if A may also defer the additional $100,000 of gain if that amount is also reinvested in a QOF.
When previously deferred gain is included in income — either upon sale of the investment in the QOF or on Dec. 31, 2026 — the gain has the same attributes in the year of inclusion that it would have had if tax on the gain had not been deferred. These attributes include those taken into account by Secs. 1(h), 1222, 1256, and any other applicable provisions of the Code.31
Example 12: In 2018, B made an election to defer $100 of gain that, if not deferred, would have been short-term capital gain. In 2022, B sells his investment and is required to include the $100 of gain in gross income as short-term capital gain.
If a taxpayer acquires investments in a QOF with identical rights (fungible interests) on different days and sells less than all of those interests on a single day, the taxpayer must use the first-in, first-out (FIFO) method to identify which interests were disposed of. The FIFO method determines (1) whether the investment sold was subject to a previous deferral election, (2) the attributes of any gain subject to a previous deferral election, and (3) the extent of any basis increase resulting from reaching the five- or seven-year holding period (discussed later in this article).32
If, after application of the FIFO method, a taxpayer is treated as having disposed of less than all of the investment interests that the taxpayer acquired on the same day, then a proportional allocation must be made to determine which interests were disposed of (the "pro rata method").33
Example 13: In 2018, before Corporation R became a QOF, Taxpayer F invested $100 cash in R in exchange for 100 R common shares. Later in 2018, after R was a QOF, F invested $500 cash in R in exchange for 500 R common shares and properly elected to defer $500 of independently realized short-term capital gain. Even later in 2018, on different days, F realized $300 of short-term capital gain and $700 of long-term capital gain. On a single day during the 180 -day period for both of those gains, F invested $1,000 cash in R in exchange for 1,000 R common shares and properly elected to defer the two gains. Thus, at the end of 2018, R held 1,600 total shares in Corporation R.
In 2020, F sold 100 R shares. F must apply the FIFO method to identify which investments in R were disposed of. As determined by that identification, F sold the initially acquired 100 common shares, which were not part of a deferral election. Thus, F must recognize gain or loss on the sale of its R shares under the generally applicable federal income tax rules, but the sale does not trigger an inclusion of any deferred gain.
Then, during 2021, F sold an additional 500 common shares. As determined by the FIFO rules, F sold the 500 common shares that had been acquired in 2018 and were associated with the deferral of $500 of short-term capital gain. Thus, the deferred gain that must be included upon sale of the 500 common shares is short-term capital gain.
Finally, during 2022, F sold an additional 500 of the remaining 1,000 common shares. This will trigger $500 of the remaining $1,000 of deferred gain. Using the FIFO method provides no clarity, because the 1,000 remaining shares F holds in R were acquired on the same day in 2018. The 1,000 shares relate to two separate gain deferrals with different characteristics: $300 of short-term capital gain and $700 of long-term capital gain. Therefore, R must use the pro rata method to determine the characteristics of the previously deferred $500 of gain that is now recognized. Under the pro rata method, because half of the total shares were sold, half of each deferred gain will be recognized, resulting in $150 of short-term capital gain ($300 × 500 ÷ 1,000) and $350 of long-term capital gain ($700 × 500 ÷ 1,000).
Qualified opportunity funds
A taxpayer may defer eligible gain only if, within 180 days of the sale or exchange, some or all of the gain is reinvested into a QOF. A QOF is a special-purpose entity that effectively acts as a conduit, achieving the policy goal of ensuring that invested capital is ultimately employed in a business located within a QOZ.
A QOF may be organized as a corporation or partnership34 and may be newly formed or a preexisting entity.35 A QOF does not need to be located within a QOZ, but it must be created or organized in one of the 50 states, the District of Columbia, or a U.S. possession.36
A QOF must self-certify that it is a QOF by filing Form 8996, Qualified Opportunity Fund, with its tax return for each year the entity intends to operate as a QOF. In the first tax year the entity intends to operate as a QOF, the entity has the option of specifying the first month it wants to be a QOF.37 If no month is specified, then the first month of the entity's initial tax year as a QOF is treated as the first month that the entity is a QOF.38 Designation of the initial year and month as a QOF is critical, because any eligible gain invested by a taxpayer into an entity before the entity's first month as a QOF is not eligible for deferral.39
Eligible investment and basis rules
A taxpayer that wishes to defer eligible gain must acquire an equity interest in a QOF. For these purposes, an equity interest includes preferred stock in a corporation or a partnership interest with special allocations but does not include any debt instrument.40 In general, a taxpayer is free to use an interest in a QOF as collateral for a loan.41
As stated earlier, a taxpayer that elects to defer gain by reinvesting that gain into a QOF takes a basis in the QOF interest of zero.42 If a taxpayer invests money in a QOF and does not make an election to defer eligible gain with respect to that investment — or if the taxpayer invests more than the eligible gain amount into a QOF — this investment is treated as a separate investment in the QOF, and the taxpayer's basis in that investment in the QOF is determined under general tax principles.43 Only investments attributable to deferred gains are eligible for the five-, seven-, and 10-year holding period exclusion provisions discussed later in this article.
In the case of a QOF that is a partnership, any basis increase to a partner resulting from the partner's increase in its share of the liabilities of the partnership44 is not treated as a separate investment eligible for the 10- year exclusion; instead, the basis increase is allocated pro rata between the two investments.45
Example 14: Taxpayer A owns a 50% capital interest in Partnership P. Ninety percent of A's investment includes only amounts for which an election of deferred gain was made, and 10% is treated as a separate investment consisting of other amounts. Partnership P borrows $8 million. Under Sec. 752, taking into account the terms of the partnership agreement, the partnership allocates $4 million of the $8 million liability to A. Under Sec. 752(a), A is treated as contributing $4 million to Partnership P. A's deemed $4 million contribution to Partnership P is ignored for purposes of determining the percentage of A's investment in Partnership P that is subject to the deferral election or the portion not subject to the deferral election. As a result, after A's Sec. 752(a) deemed contribution, 90% of A's investment in Partnership P is eligible for a complete exclusion after 10 years, and 10% is not.
The 90% test
A QOF must hold at least 90% of its assets in QOZ property (the "90% test"), determined by the average of the percentage of QOZ property held in the fund, as measured on:46
- The last day of the first six-month period of the tax year of the QOF, and
- The last day of the tax year of the fund.
If an entity's self-certification as a QOF is effective for a month other than the first month of the entity's tax year, then in the QOF's first year, the first six-month period begins on the first day the entity is designated as a QOF, but only if its tax year is longer than six months.47
Example 15: PRS, a calendar-year partnership, self-certifies that it intends to operate as a QOF beginning April 1, 2019. For purposes of satisfying the 90% test, the first six-month period of the QOF runs from April 1 to Sept. 30, 2019. The second testing date is Dec. 31, 2019.
If an entity's first month as a QOF is the seventh month of its tax year or later, there is only one testing date for the year: the last day of the QOF's tax year.48
Example 16: PRS, a calendar-year partnership, self-certifies that it intends to operate as a QOF beginning Aug. 1, 2019. Because there are not six months in PRS's initial tax year as a QOF, there is only one measurement date for purposes of the 90% test: Dec. 31, 2019.
The 90% test does not take into account any months before the first month in which an entity self-certifies that it is a QOF.49
If a QOF has an applicable financial statement,50 then the value of each asset for purposes of the 90% test is the value of that asset as reported on the QOF's applicable financial statement for the relevant reporting period.51 If a QOF does not have an applicable financial statement, the value of each asset of the QOF for purposes of the 90% test is the QOF's cost of the asset.52
If a QOF fails to meet the 90% test for any year, the QOF must pay a penalty for each month it fails to meet the requirement. Thus, computing the penalty requires a three-step process. First, the exposure to the penalty is determined by dividing the QOF's QOZ property on each of the two testing dates by the QOF's total assets on those dates and then taking the average of those two percentages. If the result is less than 90%, the penalty is then computed on a monthly basis by multiplying the underpayment rate53 for that month by the excess of (1) 90% of the QOF's total assets on the last day of each month, over (2) the QOZ property owned by the QOF on the last day of the month. The result is then divided by 12 to determine the penalty for that month.54
In the case of a QOF that is organized as a partnership, the penalty is taken into account proportionally by each partner of the partnership as part of the partner's distributive share.55
No penalty is imposed, however, if it is shown that the failure to satisfy the 90% test was due to reasonable cause.56 The proposed regulations do not provide examples of reasons for failing to satisfy the 90% test that would satisfy the reasonable-cause exception.
By requiring that a QOF hold 90% of its assets in the form of QOZ property, Sec. 1400Z-2 ensures that the QOF is investing in a business located within a QOZ. There are three types of QOZ property:57
- QOZ business property,
- QOZ stock, or
- QOZ partnership interests.
The first option permits a QOF to operate a business directly. The latter two options permit a QOF to operate a business indirectly through a subsidiary.
QOZ business property
A QOF that operates a business directly — and not through a subsidiary — must hold 90% of its assets as QOZBP.58 To meet the definition of QOZBP, the property must satisfy a number of statutory and regulatory requirements.
First, only tangible property used in a trade or business counts toward the 90% test.59 Thus, a QOF with substantial intangible value will have difficulty passing the test.
In addition, as a general rule, the original use of the property within the QOZ must begin with the QOF (the "original use" requirement).62 This would prove problematic to a QOF that planned, for example, to purchase and renovate a building within a QOZ, because the building will have already existed within the QOZ. The statute and proposed regulations provide an exception to this original-use requirement, however, if a QOF "substantially improves" personal or real property acquired within the QOZ.63 Property is substantially improved by the QOF if during any64 30-month period beginning after the date of acquisition of the property, the QOF spends as much to improve the property (measured by additions to basis) as the QOF's original basis in the property at the beginning of the 30-month period.65
The proposed regulations clarify that if a QOF purchases a building located on land wholly within a QOZ, the "substantial improvement" requirement is measured only by reference to the QOF's original basis in the building; as a result, the QOF is not required to separately substantially improve the land upon which the building is located.66 In addition, Rev. Rul. 2018-29, published at the same time as the proposed regulations, clarifies that when land is purchased with a building that is substantially improved, the original-use requirement for the land is ignored. This will result in the value of both the land and the improved building being treated as QOZBP for purposes of the 90% test.67
Example 17: A QOF acquires land and a building in a QOZ on Jan. 1, 2019, for $10 million; $4 million of the basis is allocated to the land, with the remaining $6 million of basis allocated to the building. Because the land and building were previously located within the QOZ, they do not satisfy the original-use requirement. On Jan. 1, 2019, the QOF begins to improve the building, and those improvements add $6 million to the basis of the building during the 30-month period beginning Jan. 1, 2019. The building has been substantially improved, and both the land and the building will be treated as QOZBP.
The combination of the original-use requirement and the mandate that QOZBP be purchased after Dec. 31, 2017, by a QOF from an unrelated party poses problems to a taxpayer that owned property in a QOZ prior to Dec. 31, 2017. To illustrate, assume a taxpayer had begun construction on a hotel in a QOZ prior to 2018. That taxpayer would not satisfy the requirement that QOZBP be acquired after 2017. If the taxpayer sells the property to a QOF, however, for the taxpayer to defer any gain on the sale — and for the QOF to be able to count the property as QOZBP — the taxpayer and the QOF cannot be related, and as a result, the taxpayer cannot own more than 20% of the QOF after the sale. Giving up this much equity may be unpalatable to a taxpayer, and any alternative to a sale — for example, a lease of the property from the taxpayer to the QOF, with the QOF then "substantially improving" the lease — would create additional challenges for both the QOF and the taxpayer that the proposed regulations do not adequately address.68
Finally, to meet the definition of QOZBP, during "substantially all" of the QOF's holding period for the tangible property, substantially all of the use of the tangible property must be in a QOZ.69 The definition of "substantially all" for these purposes was reserved in the proposed regulations.70 Until guidance is issued, it is unclear how these requirements will be met or enforced.
QOZ stock and partnership interests
Alternatively, a QOF may satisfy the 90% test by conducting a business in a QOZ through a subsidiary by holding QOZ stock or a QOZ partnership interest.71
Stock in a corporation is treated as QOZ stock if:72
- It was acquired by a QOF after Dec. 31, 2017, directly from the corporation or through an underwriter, solely for cash;73
- At the time the stock was issued, the corporation was a qualified opportunity zone business (QOZB) or, in the case of a new corporation, was organized for purposes of being a QOZB; and
- During substantially all of the QOF's holding period for the stock, the corporation is a QOZB. The definition of "substantially all" for this purpose was reserved in the proposed regulations.
Similarly, an interest in a partnership is treated as a QOZ partnership interest if:74
- It was acquired by a QOF after Dec. 31, 2017, directly from the partnership solely for cash;
- At the time the partnership interest was issued, the partnership was a QOZB, or in the case of a new partnership, was organized for purposes of being a QOZB; and
- During substantially all of the QOF's holding period for the partnership interest, the partnership is a QOZB (the definition of "substantially all" for this purpose was reserved in the proposed regulations).
If corporate stock or a partnership interest held by a QOF satisfies these requirements, then all of the assets of the subsidiary partnership or corporation are considered QOZ property for purposes of applying the 90% test to the QOF. There is no prohibition on a QOF investing in a preexisting corporation or partnership, but from a practical perspective, if the subsidiary owns significant assets that were acquired prior to 2018, it will be difficult for the subsidiary to satisfy the 70% test (discussed below).
When a QOF operates a business through a subsidiary, for all of the assets of the subsidiary to count toward the 90% test, at the time the subsidiary's stock was issued or its partnership interest was acquired by the QOF, and during substantially all of the QOF's holding period for the stock or partnership interest in the subsidiary, among other requirements, the subsidiary must meet the definition of a QOZB. To be a QOZB, the subsidiary must satisfy a "70% test," an "income-and-assets test," and a "qualifying-business" test.
The 70% test
At least 70%75 of all of the tangible property owned or leased76 by the trade or business of the subsidiary must meet the definition of QOZBP.77 As previously discussed, QOZBP is property that meets the following requirements:
- The property must have been acquired by the subsidiary by purchase78 after Dec. 31, 2017;
- The original use of the property in the QOZ must have commenced with the subsidiary, or in the alternative, the subsidiary must substantially improve the property;79 and
- During substantially all of the subsidiary's holding period of the tangible property, substantially all of the use of the tangible property was in a QOZ80 (the definition of "substantially all" for these purposes was reserved in the proposed regulations).81
For taxpayers with an applicable financial statement within the meaning of Regs. Sec. 1.475(a)-4(h), the value of each asset, as reported on the financial statement, is used to measure compliance with the 70% test.82
Specific to QOZBs, the proposed regulations provide that any tangible property that ceases to meet the definition of QOZBP will nonetheless continue to be treated as QOZBP for the lesser of (1) five years after the date on which the tangible property ceases to so qualify, or (2) the date on which the tangible property is no longer held by the QOZB.83
The income-and-assets test
For each tax year, a QOZB must satisfy the following requirements set forth by Sec. 1397C(b).84
- At least 50% of the gross income must be derived from the active conduct of a trade or business in the QOZ (the "50%-of-income test");85
- A substantial portion of the intangible property must be used in the active conduct of a trade or business in the QOZ (the "intangible test");86 and
- Less than 5% of the aggregate unadjusted bases of the property of the trade or business is attributable to nonqualified financial property (the "5%-of-assets test").87
Nonqualified financial property includes debt, stock, partnership interests, options, futures contracts, forward contracts, warrants, notional principal contracts, annuities, and other similar property.88 Excluded from the definition of nonqualified financial property are reasonable amounts of working capital held in cash, cash equivalents, or debt instruments with a term of 18 months or less.89
The 5%-of-assets test would prove problematic for QOZBs that receive a large influx of investment capital but need time before they can convert that capital into tangible property. To illustrate, a QOF may invest significant cash into a subsidiary partnership that intends to build affordable housing. Absent an exception, while the subsidiary partnership is seeking approvals and beginning construction, the cash would be treated as nonqualified financial property. Fortunately, the proposed regulations contain such an exception in the form of a safe harbor.
Working capital assets are considered reasonable — and thus are not treated as nonqualified financial property — if the amounts are designated in writing for the acquisition, construction, and/or substantial improvement of tangible property in a QOZ. In addition, there must be a written schedule consistent with the ordinary startup of a trade or business for the expenditure of the working capital assets within 31 months of the business's receipt of the assets; and the working capital must actually be used in a manner that is substantially consistent with the written plan.90
If these requirements are met, any gross income earned on the working capital throughout the 31-month period counts toward the satisfaction of the 50%-of-income test.91 Likewise, throughout the entire 31-month period, the business is treated as having satisfied the intangible test.92
Example 18: In 2019, Taxpayer H realized $10 million of capital gains and within the 180- day period invested $10 million in QOF. QOF immediately acquired from Partnership P a partnership interest in P, solely in exchange for $10 million of cash. P immediately placed the $10 million in working capital assets, which remained in working capital assets until used. P had written plans to acquire land in a QOZ on which it planned to construct a commercial building. Of the $10 million, $4 million was dedicated to the land purchase, $5 million to the construction of the building, and $1 million to ancillary but necessary expenditures for the project. The written plans provided for purchase of the land within a month of receipt of the cash from QOF and for the remaining $5 million and $1 million to be spent within the next 30 months on construction of the building and on the ancillary expenditures. All expenditures were made on schedule, consuming the $10 million. During the tax years that overlap with the first 31-month period, P had no gross income other than that derived from the amounts held in those working capital assets. Prior to completion of the building, P's only assets were the land it purchased, the unspent amounts in the working capital assets, and P's work in process as the building was constructed.
P met the three requirements of the safe harbor. P had a written plan to spend the $10 million received from QOF for the acquisition, construction, and/or substantial improvement of tangible property in a QOZ. P had a written schedule consistent with the ordinary startup of a business for the expenditure of the working capital assets. And, finally, P's working capital assets were actually used in a manner that was substantially consistent with its written plan and the ordinary startup of a business. Therefore, the $4 million, the $5 million, and the $1 million are treated as reasonable in amount. Because P had no other gross income during the 31 months at issue, 100% of P's gross income during that time is treated as derived from an active trade or business in the QOZ for purposes of satisfying the 50%-of-income test. For purposes of satisfying the intangible test, during the period of land acquisition and building construction, a substantial portion of P's intangible property is treated as being used in the active conduct of a trade or business in the QOZ.93
The disqualified-business test
- Any private or commercial golf course;
- Country club;
- Massage parlor;
- Hot tub facility;
- Suntan facility;
- Racetrack or other facility used for gambling; or
- Any store, the principal business of which is the sale of alcoholic beverages for consumption off the premises.
Tax benefits resulting from an investment of eligible gain into a QOF
A taxpayer who invests eligible gain within 180 days into a QOF is eligible for four distinct tax benefits, provided the taxpayer holds the investment in the QOF for at least 10 years. The first three benefits relate to the reinvested eligible gain, while the final benefit relates to gain realized on the disposition of the investment in the QOF.
To illustrate the application of these benefits, assume that on Feb. 5, 2019, A sells publicly traded stock in which A has a basis of $1 million for $2 million, realizing $1 million of eligible gain. Within 180 days, A reinvests $1 million into a QOF.
Tax benefit No. 1: Deferral of eligible gain
A may elect to defer the recognition of the $1 million of gain. If she makes this election, A will not report the gain on her 2019 tax return. A's basis in the QOF is zero.96
Tax benefit No. 2: Exclusion of 10% of the deferred gain
If A holds the investment in the QOF for five years, the basis of the investment is increased by 10% of the deferred gain. Stated another way, 10% of the deferred gain is now permanently excluded and will never be recognized.97
On Feb. 5, 2024, the basis of A's interest in the QOF increases from $0 to $100,000, or 10% of the deferred eligible gain.
Tax benefit No. 3: Exclusion of additional 5% of the deferred gain
If A holds the investment in the QOF for an additional two years, the basis of the investment is increased by an additional 5% of the deferred gain. As a result, 15% of the deferred gain is now permanently excluded.98
On Feb. 5, 2026, the basis of A's interest in the QOF increases from $100,000 to $150,000.
The seven-year basis increase creates a sense of urgency for investing in opportunity zones. For investments made in 2020, it will be impossible to achieve the seven-year holding period prior to the deferred gain's being automatically triggered on Dec. 31, 2026. Thus, to maximize the tax benefits available under Sec. 1400Z-2, taxpayers should reinvest deferred gain into a QOF before Dec. 31, 2019.
Recognition of deferred gain
Any remaining deferred gain must be recognized by Dec. 31, 2026. The amount of gain to be recognized is determined by subtracting the taxpayer's basis in the investment — increased in years 5 and 7 — from the lesser of (1) the amount of eligible gain originally deferred, or (2) the FMV of the investment in the QOF on Dec. 31, 2026.99
If A continues to hold the investment in the QOF at Dec. 31, 2026, at a time when the investment has an FMV of $1.4 million, A must recognize the remaining $850,000 of deferred gain. This is the lesser of the FMV of the investment ($1.4 million) or the original deferred gain ($1 million), less A's basis in the investment ($150,000, as increased at the five- and seven-year anniversaries).
It is important to note that if a taxpayer holds an interest in a QOF until the end of 2026, the deferred gain becomes due without a liquidating event. Thus, it is critical that taxpayers reinvesting deferred gain into a QOF plan accordingly and set aside cash to pay the 2026 tax liability.
Also on Dec. 31, 2026, A increases her basis in the investment in the QOF by the amount of gain recognized, or $850,000. Thus, the investment now has a basis of $1 million.100
Tax benefit No. 4: Exclusion from gain on the sale of a QOF interest held longer than 10 years
If a taxpayer holds an interest in a QOF for 10 years that is attributable to a previous election to defer eligible gain, upon the sale of that investment, the basis of the investment is treated as being equal to its FMV. In simpler terms, this means that no gain is recognized upon the sale of the investment in the QOF. This represents the ultimate benefit offered by Sec. 1400Z-2: the ability to exclude all gain upon the subsequent disposition of an interest in a QOF that has been held for 10 years. To receive the benefit of the tax-free gain, however, the taxpayer must sell the investment in the QOF before Jan. 1, 2048.101
In 2035, A sells her investment, with a basis of $1 million, for $6.4 million. Because the investment has been held longer than 10 years, the basis of the investment is treated as being equal to the sales price of $6.4 million, and no gain is recognized on the appreciation of the investment after Dec. 31, 2026.
It is important to remember that only gain from the sale of an investment in a QOF that was originally attributable to the investment of eligible gain for which a deferral election was made is eligible for the gain exclusion upon sale of the investment.
Example 19: Assume the same facts as in the previous case study, except in addition to the investment of $1 million of eligible gain for which a deferral election was made into the QOF, A also invested an additional $500,000 into the QOF that was not related to eligible gain. Upon the subsequent sale of the investment in the QOF in 2035, only the gain attributable to the $1 million investment is eligible for the basis increase and related gain exclusion.
Even after the IRS's publication of the proposed regulations, taxpayers contemplating an investment into a QOF face a number of practical questions.102 The remainder of this article examines issues that will need to be addressed or resolved in final regulations or other future guidance.
Difference between a QOF's operating a business directly or through a subsidiary
The statutory and regulatory language uses the term "qualified opportunity zone business" only in connection with a business being conducted through a subsidiary of a QOF. Whether intentional or not, this application of the QOZB requirement only to a subsidiary of a QOF results in vastly different consequences when a QOF operates a business directly, as compared with through a subsidiary. For example:
- A QOF that operates a business directly is required to hold 90% of its assets as QOZBP. If, however, the same QOF were instead to operate a business through a subsidiary, for the subsidiary to meet the definition of a QOZB, the subsidiary would be required to hold only 70% of its assets as QOZBP. This means that a QOF operating through a subsidiary could hold 10% of its assets outside a QOZ and 90% in the form of an interest in the subsidiary. That subsidiary, in turn, could hold as much as 30% of its assets outside a QOZ. Thus, in total, a QOF that operates through a subsidiary could hold 37% (10% + (30% × 90%)) of its assets located outside the QOZ, while a QOF that operates a business directly would be limited to 10%.
- Only a QOZB is subject to the rules of Sec. 1397C. This creates several important distinctions. For example, only a business conducted by a subsidiary would be required to generate 50% of its income from an active conduct of a trade or business in a QOZ. In addition, the 31-month working-capital safe harbor applies only to a QOZB. As a result, from a practical perspective, it would be virtually impossible for a QOF to directly undertake a large construction project without running afoul of the 90% test, because the QOF's cash would not qualify for the working-capital exception throughout the 31-month period.
- A QOF must purchase QOZBP,103 but a QOZB can purchase or lease such property.104
- A QOZB may not be a "sin business" as defined under Sec. 144. There is no prohibition on a QOF's directly conducting a sin business, however.
It is possible that these differences are simply the result of poorly constructed statutory and regulatory language, but at least in the case of the 70% test (QOZB) versus the 90% (QOF) test, the preamble to the proposed regulations appears to have anticipated that result. There are no policy reasons why such important distinctions should exist between operating a business directly in a QOF versus through a subsidiary, and final regulations must address and correct this disparate treatment.
Challenges in investing in an operating business
The proposed regulations provide taxpayers enough guidance to move forward with constructing or improving real estate in a QOZ. The 30- month substantial-improvement rule, the 31-month working-capital safe harbor, and the 70% and 90% asset tests combine to provide a framework by which a QOF or subsidiary business can enter into a construction or rehabilitation project with a degree of certainty as to how those projects will comply with the requirements of Sec. 1400Z-2.
What remains far less clear, however, is how a QOF or subsidiary may invest in an operating business — for example, a grocery store. While nothing in the conference committee reports to Sec. 1400Z-2 suggest that the opportunity zone incentive is to be solely the domain of the real estate developer, significant barriers exist to investing in any other type of activity.
To illustrate, as previously discussed, if a QOF were to invest in a grocery store through a subsidiary, to meet the definition of a QOZB, at least 50% of the income of the grocery store would be required to be earned in a QOZ in each year. But how is this requirement measured when customers reside both within and outside the QOZ? Do the regulations contemplate that more than 50% of the store's customers must reside within the QOZ? Or is the test satisfied if the store is located within the QOZ, regardless of where the customers reside?
As discussed above, as the regulations are currently constructed, a QOF can avoid the imposition of the 50% test by operating the grocery store directly. But in this situation, how would the QOF comply with the 90% test? For many operating businesses, the need for property is limited to inventory, office equipment, and leasehold improvements. How, then, would a QOF conducting a grocery store pass the 90% test when the majority of its assets are composed of working capital and self-created intangible goodwill?
The goal of the opportunity zone incentive was not simply to improve the aesthetics of a low-income community via construction projects but also to generate jobs and improve the quality of life of residents of the community. As a result, final regulations will need to address and loosen requirements for conducting an entrepreneurial business within a QOZ.
QOZBP must be "used in a trade or business." Sec. 1400Z-2 and the proposed regulations, however, do not define a trade or business for these purposes. If the intention is that the activity of a QOF or QOZB must rise to the level of a trade or business under the meaning of Sec. 162, the relevant authority — to say nothing of the recently finalized regulations under Sec. 199A — presents a problem when property is rented on a triple-net basis. The IRS has historically viewed these types of rentals as an investment rather than a Sec. 162 trade or business;105 as a result, if a QOF or subsidiary constructs a building that is rented, for example, to Walmart on a triple-net basis,106 the IRS may take the position that the building is not used in a trade or business and should not count toward the 90% or 70% test.
Final regulations should clarify that all rental activities will be treated as a trade or business for purposes of Sec. 1400Z-2.
Treatment of acquisition of raw land
When a QOF or QOZB acquires land, the land cannot satisfy the requirement that the original use of QOZBP begin in the QOZ with the taxpayer.107 This casts doubt on whether the value of land is counted toward the 90% or 70% test.
Rev. Rul. 2018-29 provides some clarity by stating that when a QOF or QOZB acquires land and a building together, provided the building is substantially improved within a 30-month period, the original-use requirement does not apply to the land on which the building is located. Thus, the value of both the land and the building will meet the definition of QOZBP. But what if a QOF or QOZB acquires only raw land and then constructs a new building? Can the conclusion reached in Rev. Rul. 2018-29 be expanded to exclude the land from the original-use requirement even when it is not purchased in conjunction with a building that is subsequently substantially improved? Neither Rev. Rul. 2018-29 nor the regulations address such a scenario.
If land purchased separately is not QOZBP because of the failure to satisfy the original-use test, how can raw land be substantially improved? What types of improvements increase the basis of raw land such that the 30-month test could be met?
The most logical solution, in keeping with the stated goal of Sec. 1400Z-2 to encourage construction and renovation in a QOZ, would be to simply exempt all land purchased after Dec. 31, 2017, from the original-use requirement. That, however, could lead to abuse. For example, a QOF could purchase raw land for $10 million and construct a small structure for $50,000 that is rented to a tenant. If the land is exempt from the 90% test, then the QOZ could engage in what amounts to little more than long-term land speculation — without engaging in any meaningful business within a QOZ — and qualify for the various tax benefits of Sec. 1400Z-2 when the land appreciates in value. As a result, safeguards would be necessary; perhaps final regulations could provide that land will be treated as QOZBP only when it does not exceed a de minimis percentage of the total property.
Treatment of Sec. 1231 gains
The proposed regulations make clear that gain from the sale of a Sec. 1231 asset is eligible gain because it is "treated as capital gain." Sec. 1231 requires a netting process, however; only net Sec. 1231 gains, after reduction for Sec. 1231 losses, are treated as capital gain. This netting process poses a problem in several ways. First, if a partnership recognizes a Sec. 1231 gain, the character of that gain is determined only at the partner level, after the partner has netted the gain with any Sec. 1231 losses. How, then, can a partnership reinvest Sec. 1231 gain if it has not yet been determined that the gain will be treated as capital gain?
In addition, assume an individual sells a Sec. 1231 asset for a gain of $1 million on Jan. 2, 2019. The 180-day window begins on that date. Assume further that on Dec. 5, 2019, the same individual sells a second Sec. 1231 asset, this time recognizing a loss of $1.2 million. The taxpayer has no net Sec. 1231 gain for the year, but that has not been revealed to be the case until after the 180-day window related to the Jan. 2 sale has expired.
Final regulations should clarify that any Sec. 1231 gain, whether recognized by a partnership or partner, may immediately be reinvested in a QOF before application of the netting process. Then, when the deferred Sec. 1231 gain is subsequently triggered and recognized, it will enter into the taxpayer's netting of gains and losses.
How do general tax principles apply to a QOF established as a partnership or S corporation?
Sec. 1400Z-2(b)(2)(B)(i) provides the general rule that a taxpayer's basis in an investment in a QOF related to deferred gain is zero. Notice, the statute does not say the taxpayer's "initial" basis in the investment is zero.
Then, Sec. 1400Z-2(b)(2) provides that when deferred gain is triggered, the amount included in the income of the taxpayer is the lesser of (1) the FMV of the investment in the QOF on the triggering date or (2) the deferred gain, less the taxpayer's basis in the investment.
But what is the taxpayer's basis in the investment in the QOF on that date (ignoring any increase at the fifth and seventh anniversaries)? Is the basis in an investment in a QOF adjusted during the partner's or shareholder's holding period under the general tax principles of Sec. 705 for a partnership and Sec. 1367 for an S corporation? And if it is, how does any positive basis resulting from those adjustments factor into the recognition of deferred gain?
To illustrate, assume A invests $50,000 of deferred gain in a partnership QOF on Jan. 1, 2023. From 2023 through the end of 2026, A is allocated $10,000 of income that, under normal tax principles, would increase A's basis in the partnership by $10,000. On Dec. 31, 2026, A's deferred gain is triggered. If the investment in the QOF is worth more than $50,000 at that time, mechanically, A's gain recognition is equal to $50,000 (the deferred gain) less his basis in the investment. But is his basis zero? Or is it $10,000? It seems strange that such a rudimentary question regarding the operation of a partnership or S corporation QOF would remain at this point, but the regulations do not address the issue, other than to say a taxpayer's investment in a QOF related to deferred gain is zero. Final regulations will need to address the issue.
Sale of a QOF held longer than 10 years
A taxpayer may exclude the gain from the sale of an investment in a QOF that (1) is attributable to an investment of deferred gain and (2) has been held longer than 10 years. The use of the word "investment" implies that to benefit from the exclusion, a taxpayer must sell the equity interest in the QOF. Presumably, if the QOF were instead to sell its assets, any gain realized inside the QOF would be recognized.
If an equity sale is indeed contemplated by Sec. 1400Z-2, it would not be alone among gain exclusion incentives in the tax law. Sec. 1202, which allows a taxpayer to exclude gain from the sale of "qualified small business stock," also applies only to gain realized on the sale or exchange of an equity interest in a qualifying corporation.
The problem, of course, is that buyers will generally prefer to acquire the assets of a business rather than the equity, to obtain a step- up in basis of the underlying assets to FMV, resulting in greater depreciation deductions. This would pose a significant hurdle to taxpayers who have held their interest in a QOF for 10 years and are now seeking the ultimate prize of tax-free gain.
In the absence of further clarity on the issue, taxpayers should consider forming QOFs as partnerships. After 10 years, a buyer could purchase all of the interests in the QOF in one purchase; each seller would be treated as having sold the interest in the partnership — allowing them to exclude the gain. However, under the principles of Rev. Rul. 99-6, the buyer would be treated as having purchased the underlying assets of the partnership QOF, allowing the buyer to achieve the desired step-up.
Consequences of failure to qualify as a QOF or QOZB
Sec. 1400Z-2 requires a QOF to hold at least 90% of its assets in QOZ property or else be subject to a monthly penalty. In addition, a subsidiary of a QOF must meet the definition of a QOZB for substantially all of the QOF's holding period of the stock or partnership interest in the subsidiary. But what are the consequences if a QOF continuously fails the 90% test, or a subsidiary does not satisfy the "substantially all" requirement? Are the deferred gains of all investors triggered? Are investments in the QOF no longer eligible for exclusion after the 10-year holding period is met? The statute and proposed regulations are silent on such an important consideration, leaving investors unclear as to the potential negative consequences of a failed QOZ investment.
Meeting the potential
Sec. 1400Z-2 has the potential to generate a tremendous inflow of capital into low-income communities, with some government leaders anticipating investments topping $100 billion throughout the life of the program.108 While the first tranche of proposed regulations has provided enough of a framework for many investors in real estate projects to move forward, the provision will not reach its full potential until additional issues are addressed and resolved.
1. P.L. 115-97.
2. REG-115420-18. Taxpayers are permitted to rely on the proposed regulations but only if they apply the rules in their entirety and in a consistent manner.
3. This article numbers the proposed regulations as they appear in the IRS's notice of proposed rulemaking (REG-115420-18). However, the official version of the proposed regulations published in the Federal Register (83 Fed. Reg. 54279 (Oct. 29, 2018)) omits the hyphen of the statute designation of the proposed regulation numbers. For example, Prop. Regs. Sec. 1.1400Z-2(a)-1 (IRS) appears as 1.1400Z2(a)-1 (Federal Register).
4. As defined in Sec. 45D(e).
5. Sec. 1400Z-1(e). Qualifying contiguous census tracts must have a median family income not exceeding 125% of that of the contiguous low-income community.
6. Prop. Regs. Sec. 1.1400Z-2(a)-1(b)(2).
7. See also Prop. Regs. Sec. 1.1400Z-2(a)-1(b)(2)(iii). The only gain arising from Sec. 1256 contracts that is eligible for deferral is capital gain net income for a tax year. This net amount is determined by taking into account the capital gains and losses for a tax year on all of a taxpayer's Sec. 1256 contracts. If, at any time during the tax year, any of the taxpayer's Sec. 1256 contracts was part of an offsetting-positions transaction, and any other position in that transaction was not a Sec. 1256 contract, then no gain from any Sec. 1256 contract is an eligible gain with respect to that taxpayer in that tax year. Also, see Prop. Regs. Sec. 1.1400Z-2 (a)-1(b)(2)(iv). Capital gain resulting from a position that is or has been part of an offsetting-positions transaction is not eligible for deferral. An offsetting-positions transaction is a transaction in which a taxpayer has substantially diminished the taxpayer's risk of loss from holding one position with respect to personal property by holding one or more other positions with respect to personal property (whether or not the same kind). It does not matter whether either of the positions is with respect to actively traded personal property. An offsetting-positions transaction includes a straddle as defined in Sec. 1092.
8. This is because, as discussed later in this article, the last day for deferral of eligible gain is Dec. 31, 2026.
9. Sec. 1400Z-2(e)(2). As discussed later in this article, this related-party rule poses a problem to taxpayers who owned property located in a QOZ prior to Dec. 31, 2017, but want to take advantage of the tax benefits of Sec. 1400Z-2.
10. But see the discussion later about unanswered questions surrounding the Sec. 1231 netting process and Sec. 1400Z-2.
11. From a practical perspective, however, gain recognized by a shareholder or partner on a distribution from a corporation or partnership that results in capital gain will violate the related-party rules if the shareholder or partner owns 20% or more of the corporation or partnership immediately before or after the distribution.
12. Prop. Regs. Sec. 1.1400Z-2(a)-1(b)(1). The preamble to the proposed regulations states that eligible taxpayers also include common trust funds described in Sec. 584 as well as qualified settlement funds, disputed-ownership funds, and other entities taxable under the Sec. 468B regulations.
13. Prop. Regs. Sec. 1.1400Z-2(a)-1(c)(1)(i).
14. Prop. Regs. Sec. 1.1400Z-2(a)-1(c)(1)(ii).
15. Prop. Regs. Sec. 1.1400Z-2(a)-1(c)(2)(ii).
17. Prop. Regs. Sec. 1.1400Z-2(a)-1(c)(3).
18. Prop. Regs. Sec. 1.1400Z-2(a)-1(b)(4).
20. Prop. Regs. Sec. 1.1400Z-2(a)-1(c)(2)(iii)(A).
21. Prop. Regs. Sec. 1.1400Z-2(a)-1(c)(2)(iii)(B).
22. Prop. Regs. Sec. 1.1400Z-2(a)-1(c)(3).
23. Sec. 1400Z-2(a).
24. See instructions to Form 8949, Sales and Other Dispositions of Capital Assets.
25. Prop. Regs. Sec. 1.1400Z-2(a)-1(b)(2)(ii); Sec. 1400Z-2(a)(2)(A).
26. Sec. 1400Z-2(e)(1).
27. Sec. 1400Z-2(b)(1).
28. Sec. 1400Z-2(b)(2)(A).
29. Sec. 1400Z-2(b)(2)(B)(i). This is prior to any 10% or 5% increase occurring on the fifth and seventh anniversary of the investment in the QOF, as discussed later in this article. It is also unclear how this specific basis is adjusted under the general basis maintenance rules of Sec. 705. For example, if a partner invests deferred gain into a QOF and starts with a zero basis, what happens if the partner is subsequently allocated $100 of income that increases the partner's basis in the interest? It would not seem logical that this basis would decrease the amount of deferred gain. The regulations are not clear on this matter, however.
30. Preamble to the proposed regulations, REG-115420-18, Explanation of Provisions, §I.D.
31. Prop. Regs. Sec. 1.1400Z-2(a)-1(b)(5). Presumably, the gain will be taxed at the rates in place for the year of recognition, similar to the treatment of gain recognized on the installment method under Sec. 453.
32. Prop. Regs. Sec. 1.1400Z-2(a)-1(b)(6).
33. Prop. Regs. Sec. 1.1400Z-2(a)-1(b)(7).
34. Sec. 1400Z-2(d)(1).
35. Prop. Regs. Sec. 1.1400Z-2(d)-1(a)(3). A preexisting entity, however, must satisfy all of the requirements of Sec. 1400Z-2 and the proposed regulations, including the requirements regarding QOZ property. And because QOZBP must have been acquired after Dec. 31, 2017, a preexisting entity with significant assets will struggle to qualify as a QOZ.
36. If a QOF is organized in a U.S. possession but not in one of the 50 states or the District of Columbia, then it may be a QOF only if it is organized for the purpose of investing in QOZ property that relates to a trade or business operated in the possession in which the QOF is organized (Prop. Regs. Sec. 1.1400Z-2(d)-1(e)(1)).
37. Prop. Regs. Sec. 1.1400Z-2(d)-1(a)(1)(iii).
38. Prop. Regs. Sec. 1.1400Z-2(d)-1(a)(1)(iii)(A).
39. Prop. Regs. Sec. 1.1400Z-2(d)-1(a)(1)(iii)(B).
40. Prop. Regs. Sec. 1.1400Z-2(a)-1(b)(3)(i).
41. Prop. Regs. Sec. 1.1400Z-2(a)-1(b)(3)(ii). A debt instrument is defined under Sec. 1275(a)(1) and Regs. Sec. 1.1275-1(d).
42. Sec. 1400Z-2(b)(2)(B)(i).
43. Prop. Regs. Sec. 1.1400Z-2(e)-1(a)(1).
44. See Sec. 752.
45. Prop. Regs. Sec. 1.1400Z-2(e)-1(a)(2).
46. Sec. 1400Z-2(d)(1).
47. Prop. Regs. Sec. 1.1400Z-2(d)-1(a)(2)(i).
49. Prop. Regs. Sec. 1.1400Z-2(d)-1(a)(2)(ii).
50. Within the meaning of Regs. Sec. 1.475(a)-4(h).
51. Prop. Regs. Sec. 1.1400Z-2(d)-1(b)(1).
52. Prop. Regs. Sec. 1.1400Z-2(d)-1(b)(2).
53. As determined under Sec. 6621.
54. Sec. 1400Z-2(f)(1).
55. Sec. 1400Z-2(f)(2).
56. Sec. 1400Z-2(f)(3).
57. Sec. 1400Z-2(d)(2)(A).
58. As discussed later in this article, however, the definition of QOZBP is also relevant when operating a business through a subsidiary.
59. Sec. 1400Z-2(d)(2)(D)(i).
60. Under the meaning of Sec. 179(d)(2). See Sec. 1400Z-2(d)(2)(D)(i)(I).
61. See Sec. 1400Z-2(d)(2)(D)(iii). For these purposes, the related-person rule of Sec. 179(d)(2) applies.
62. Sec. 1400Z-2(d)(2)(D)(i)(II).
64. The word "any" seems to indicate that the QOF is not required to begin improving QOZBP immediately upon acquiring it.
65. Sec. 1400Z-2(d)(2)(D)(ii).
66. Prop. Regs. Sec. 1.1400Z-2(d)-1(c)(8)(ii)(A).
67. See the discussion at the conclusion of the article regarding the treatment of raw land that is purchased with no building.
68. While a QOZ business is permitted to "lease" property, it is not yet clear how a lease satisfies the purchase or original-use requirement if the leased property was already located within a QOZ. In addition, it is unclear how a QOF would "substantially improve" a lease.
69. Prop. Regs. Sec. 1.1400Z-2(d)-1(c)(4)(iii).
70. Prop. Regs. Secs. 1.1400Z-2(d)-1(c)(5) and (6).
71. See Prop. Regs. Sec. 1.1400Z-2(d)-1(e)(2). The subsidiary must be organized in one of the 50 states, the District of Columbia, or the U.S. possessions. If the subsidiary is organized in a U.S. possession, an equity interest in the entity may be qualified business stock or a partnership interest only if the entity conducts a QOZ business in the U.S. possession in which the business is organized.
72. Prop. Regs. Sec. 1.1400Z-2(d)-1(c)(2).
73. Rules governing redemptions of corporate stock similar to Sec. 1202(c)(3) apply.
74. Prop. Regs. Sec. 1.1400Z-2(d)-1(c)(3).
75. Prop. Regs. Sec. 1.1400Z-2(d)-1(d)(3).
76. Interestingly, when one applies the 90% test to a QOF, QOZ property must be "acquired by purchase" by the QOF. However, when one applies the 70% test to a QOZB, QOZ property can be "owned or leased."
77. Prop. Regs. Sec. 1.1400Z-2(d)-1(d)(1)(i).
78. As defined in Sec. 179(d)(2). Query how this purchase requirement interacts with a QOZ business's ability to "purchase or lease" QOZBP.
79. Prop. Regs. Sec. 1.1400Z-2(d)-1(d)(2)(B). See the definition of "substantial improvement" in the previous discussion of QOZBP.
80. Prop. Regs. Sec. 1.1400Z-2(d)-1(d)(2)(C).
81. Prop. Regs. Secs. 1.1400Z-2(d)-1(d)(ii) and (iii).
82. Prop. Regs. Sec. 1.1400Z-2(d)-1(d)(3)(ii)(A). For rules governing a taxpayer without an applicable financial statement, see Prop. Regs. Sec. 1.1400Z-2(d)-1(d)(3)(ii)(B).
83. Sec. 1400Z-2(d)(3)(B).
84. Prop. Regs. Sec. 1.1400Z-2(d)-1(d)(1)(ii).
85. Prop. Regs. Sec. 1.1400Z-2(d)-1(d)(5)(i). See Sec. 1397C(b)(2).
86. Prop. Regs. Sec. 1.1400Z-2(d)-1(d)(5)(ii). See Sec. 1397C(b)(4).
87. Prop. Regs. Sec. 1.1400Z-2(d)-1(d)(5)(iii). See Sec. 1397C(b)(8).
88. Sec. 1397C(e), flush language.
89. Sec. 1397C(e)(1).
90. Prop. Regs. Sec. 1.1400Z-2(d)-1(d)(5)(iv).
91. Prop. Regs. Sec. 1.1400Z-2(d)-1(d)(5)(v).
92. Prop. Regs. Sec. 1.1400Z-2(d)-1(d)(5)(vi).
93. Query: Based on this example from the regulations, should taxpayers assume that the land was treated as QOZBP even though it did not satisfy the original-use requirement?
94. Sec. 1400Z-2(d)(3)(A)(iii).
95. Prop. Regs. Sec. 1.1400Z-2(d)-1(d)(6).
96. Sec. 1400Z-2(b)(2)(B).
97. Sec. 1400Z-2(b)(2)(B)(iii).
98. Sec. 1400Z-2(b)(2)(B)(iv).
99. Sec. 1400Z-2(b)(2)(A).
100. Sec. 1400Z-2(b)(2)(B)(ii).
101. Prop. Regs. Sec. 1.1400Z-2(c)-1(b). Note, the preamble to the proposed regulations contemplated other options, including giving taxpayers an unlimited time to sell the investment in the QOF, or a "triggering" of any appreciation on a given date even if the investment were not sold. Ultimately, the IRS chose the Dec. 31, 2047, deadline, but not without some controversy: Many fear that setting a date by which all investments in a QOF must be sold could lead to a "race to the exit" that will cause property values to plummet prior to 2048.
102. The preamble to the proposed regulations reserved paragraphs for addressing certain items, such as the definition of "substantially all" for those purposes where it currently remains undefined, the types of transactions that will trigger recognition of any deferred gain, and the "reasonable amount of time" a QOF has to reinvest cash after a sale of its assets.
103. Sec. 1400Z-2(d)(2)(D)(i)(I).
104. Prop. Regs. Sec. 1.1400Z-2(d)-1(d)(1)(i).
105. See Rev. Rul. 73-522.
106. A triple-net lease is one where the tenant is responsible for paying the insurance, real estate taxes, and maintenance and repairs attributable to the property.
107. See Rev. Rul. 2018-29.
108. See, e.g., U.S. Department of the Treasury press release, "Treasury Releases Proposed Regulations on Opportunity Zones Designed to Incentivize Investment in American Communities" (Oct. 19, 2018).
Tony Nitti, CPA, MST, is a partner at RubinBrown in Aspen, Colo. For more information on this article, contact firstname.lastname@example.org.
Tony Nitti, CPA, MST, is a partner at RubinBrown in Aspen, Colo. For more information on this article, contact email@example.com.