Qualified Opportunity Zones

By Herman Spence III

On October 19 the IRS issued proposed regulations and a revenue ruling about opportunity zones, which are an important tax incentive program in the major tax legislation enacted late last year.  Although the guidance addresses many important issues, the IRS intends to issue further guidance on additional issues.

The opportunity zone program encourages investments in economically distressed qualified opportunity zones by allowing taxpayers to defer, and in some cases reduce or eliminate, tax on capital gains when they reinvest their gains within 180 days in qualified opportunity funds (“QOFs”).  Opportunity zones are receiving a great deal of attention because of significant tax advantages.


An opportunity zone is a population census track that meets the definition of low-income community and has been designated as a qualified opportunity zone.  There are over 8,700 certified opportunity zones.  Notice 2018-49 (July 9, 2018) lists all of the population census tracks designated as qualified opportunity zones.


For a taxpayer to obtain any of the following tax benefits, it must (i) realize capital gain from a sale of property to an unrelated person and (ii) invest all or a portion of that gain in a QOF within 180 days of the realization event.  The potential tax benefits for such an investor are:

1. Taxation of the capital gain is deferred until the earlier of the disposition of the QOF interest or the end of 2026. The deferred gain that is later taxed will keep its character (e.g., long-term or short-term capital gain).

2. If the investor holds the QOF interest for at least five years before the recognition date described above, there is a basis step-up equal to 10% of the deferred gain. Thus, 10% of the gain is permanently excluded.

3. If the investor holds the QOF interest for at least seven years prior to the recognition date described above, there is an additional basis step-up equal to 5% (i.e., 15% total) of the deferred gain. That 5% is also permanently excluded from taxable income.

4. If the QOF interest is held for at least ten years, all of the appreciation after the initial investment in the QOF is permanently excluded. That exclusion applies only to appreciation after the investment in the QOF and does not apply to the initially deferred gain.  The proposed regulations would limit such permanent exclusion by requiring the QOF interest to be disposed of before 2048.

The benefits described above are available only as to gain recognized before 2027.  Earlier investments receive more deferral because the deferral lasts only until December 31, 2026.  Also, the 10% basis increase is available only for investments made before 2022.  The full 15% basis increase is available only for investments made before 2020.

Only invested gain is eligible for the above benefits.  Although a taxpayer may invest more than the gain realized, the tax benefits are available only as to an investment made with deferred gain.  If a taxpayer invests more than the gain realized, the taxpayer is treated as having two separate investments, one to which the benefits apply and one to which they do not apply.

North Carolina has decoupled from the opportunity zone provisions.  A taxpayer must add back for North Carolina purposes gain that is excluded under the above rules for federal purposes.  See G.S. § 105-130.5(a)(26) and (27).


A taxpayer cannot defer gain by making a direct investment in property located in an opportunity zone.  Instead, a taxpayer must acquire an equity interest in a QOF.  A QOF can be a corporation, partnership, or an LLC classified as a corporation or partnership for income tax purposes.  A single-member LLC that is disregarded for income tax purposes cannot be a QOF.

A QOF does not have to have a specific number of investors.  A QOF may be a partnership with as few as two partners or a wholly-owned S corporation or C corporation.

A qualifying interest in a QOF must be an equity interest and cannot be any type of debt.  The equity may have a preference and can be a partnership interest with special allocations.

Taxpayers make deferral elections by attaching Form 8949 to the tax return for the year in which the gain is realized.  A taxpayer may make multiple elections as to gain from the sale of a single asset.  Thus, a taxpayer may diversify by investing gain in numerous QOFs.

There is no direct tracing of the proceeds from the sale generating the gain to be deferred.  A taxpayer may borrow funds to invest in a QOF.  Because the statute and regulations do not address the issue, it may be permissible for a contribution of property other than cash to be made to a QOF.

When a partnership sells an asset, either the partnership or a partner in the partnership may make a deferral election.  For the partnership, the 180-day rollover period starts on the day it recognizes the gain.  For a partner, if the partnership does not make the election, the 180-day period starts on the last day of the partnership’s tax year.  A partner need not receive a distribution of sale proceeds to make a rollover election as to the partnership’s gain.  Similar rules will apply to S corporations.

If a taxpayer sells an interest in a QOF, the capital gain recognized may be invested in another QOF if the first QOF investment is disposed of in its entirety.  The 10-year holding period for the new QOF investment starts on the date of the new investment.

The proposed regulations do not address whether a taxpayer who acquires a QOF interest may transfer that interest to a corporation or partnership without triggering deferred gain or eliminating other tax benefits.  Similarly, the proposed regulations do not state whether, when an upper-tier partnership holds an interest in a lower-tier partnership that holds an interest in a QOF, the upper-tier partnership may transfer its interest in the lower-tier partnership without jeopardizing the tax benefits.


At least 90% of a QOF’s assets must be invested in qualified opportunity zone property.  The QOF may hold the business property directly or hold interests in qualified opportunity zone business (“QOZB”) entities.  A QOF must acquire interests in QOZBs for cash contributions to the entity in exchange for a newly-issued interest.

An entity self-certifies as a QOF by filing Form 8996 with its federal income tax return.  There is no additional approval process.  A QOF will also attach the form to its tax returns for all relevant years to report annual compliance with the 90% test.

The proposed regulations provide entities flexibility in identifying the first month the entity wants to be a QOF.  That permits a fund to be created and begin certain actions and choose a later month for its self-certification.

1. 90% test. In applying the 90% test, a QOF that has audited GAAP financial statements must use the asset values reported on those statements. If the QOF does not have such financial statements, it must use the cost basis of its assets.

The 90% test is applied by determining the average of the percentage of qualified opportunity zone property held by the fund as measured at the end of the first six months of the taxable year of the fund and on the last day of the taxable year of the fund.  The QOF uses the average of the two to determine whether a penalty is imposed.  If a QOF fails to meet the 90% test and does not establish reasonable cause, the QOF must pay a monthly penalty on the excess of 90% of its aggregate assets over the amount of qualified opportunity zone property held by the fund, multiplied by the underpayment rate.

2. Substantially all test. A QOF’s interest in a QOZB corporation or partnership is a qualifying investment only if substantially all of the entity’s assets are directly held qualified opportunity zone business property (“QOZBP”).  The proposed regulations provide “substantially all” means at least 70% of the tangible property owned by the entity.

In applying the substantially all test to a QOZB entity, the entity must use its financial statement values if it has audited GAAP statements.  If it does not, the entity may value its assets using the same approach as the QOF if no other holder of an interest in the QOZB entity is a QOF with at least a 5% interest.  If the entity does not have audited GAAP financial statements, and two or more QOFs are investors with at least 5% interests, the methodology used by the QOF investor that produces the highest percentage of QOZB property may be used.

3. 5% limit on nonqualified financial property. No more than 5% of the total assets of a QOZB corporation or partnership can be nonqualified financial property.  Working capital that meets certain requirements is not treated as nonqualifying.  Such requirements include the entity’s having a written plan and schedule for using the working capital in the acquisition of qualifying assets within 31 months and substantial compliance with the plan and schedule.  Because the 5% limitation does not apply to QOFs, a QOF can have up to 10% of its assets in financial property.  QOZB entities generally cannot have interests in subsidiary entities (other than disregarded entities such as wholly-owned LLCs) because interests in such entities are treated as nonqualified financial property subject to the 5% limit.

4. Qualified opportunity zone business property. QOZBP is tangible property used in a trade or business if (i) the property is acquired by purchase after 2017 from an unrelated party (generally using a 20% common ownership standard), (ii) either the original use of the property commences with the QOF or QOZB, or the QOF or QOZB substantially improves the property, and (iii) during substantially all of the holding period for the property, substantially all of the use of the property is in the zone.

The property must have its original use with the QOF or be substantially improved with a 100% increase in basis within 30 months.  The revenue procedure released with the proposed regulations provides land is not counted for the original use test.  Also, in determining whether there have been substantial improvements to property, the purchase price is allocated between the land and building, and only the building needs to be substantially improved.

5. Qualified opportunity zone business. A QOZB is a trade or business that meets the following requirements: (i) substantially all of the tangible property owned or leased by the entity is QOZBP, (ii) at least 50% of the entity’s total gross income is derived from the active conduct of the business, (iii) a substantial portion of the intangible property is used in the active conduct of the business, (iv) less than 5% of the aggregate adjusted basis of property is attributable to nonqualified financial property, and (v) the business does not include the operation of a private or commercial golf course, country club, massage parlor, hot tub facility, sun tan facility, race track, gambling establishment, or a store the principal business of which is the sale of alcohol for consumption off premises.

QOZBP owned directly by a QOF must be used in a trade or business.  A QOZB entity generally must engage in the active conduct of a business.  The case law and rulings under Section 162 will probably be applied in determining whether there is a trade or business.  Triple net lease arrangements may not constitute a trade or business.  The active conduct of a business requirement for QOZB may impose a higher standard than the general trade or business requirement.

QOFs and QOZB entities may incur debt.  There is no requirement that QOFs be funded solely with rollover gains.

An investor will initially have a zero basis in its QOF interest.  The QOF and any QOZB entity, however, will have basis in purchased assets reflecting their cost.

Where a QOF is a partnership, it may be possible for the QOF to borrow and distribute proceeds to investors without their being immediately taxed on the proceeds.  A QOF’s debt may provide its investors with sufficient basis to receive distributions tax-free.

Income generated by an opportunity zone business will be taxable to the QOF if it is a corporation and will be taxable to its partners if it is a partnership.  If the QOF sells an asset, the gain will be taxable to the QOF if it is a corporation or to its partners if it is a partnership.  Although the owner of an interest in a QOF can use its basis step-up to reduce or avoid gain on a sale of its QOF interest, it is unclear how that benefit is realized if the QOF or a QOZB entity sells its assets.


1. Leverage. The use of debt by a QOF or QOZB entity may greatly expand the potential tax benefits.

2. Complete avoidance of tax on appreciation for up to 30 years. Because a QOF interest can be held until 2048, appreciation over as much as 30 years may be completely nontaxable.

3. Exit by sale of interest in QOF rather than sale of assets or subsidiary entities. The proposed regulations do not provide a mechanism by which gain is not taxable if a QOF sells property or interests in subsidiary entities or if QOZB entities sell assets.  It may be prudent to plan for exits to involve the sale of the investors’ interests in QOFs rather than sales of the underlying assets or subsidiaries.

4. Operating income is taxable. The operating income of a QOF or QOZB entity is taxable at either the entity or investor level.  The tax benefits of QOFs involve only gain from sale.  QOF tax benefits may be more significant where the business venture is likely to have more gain on exit and less operating income.

5. Land. Land may be more likely to appreciate and produce less operating income than other assets.  The proposed regulations would apparently treat land as not violating the original use or substantial improvement requirements so long as the land is used in the QOZB.  The tax benefits of QOFs may be enhanced when the venture has large amounts of valuable land.

6. Use of QOZB entities rather than direct operation by the QOF. It may be beneficial, or necessary from a practical standpoint, for QOFs to operate through QOZB entities rather than to own and operate businesses directly.  For example, a business operated by a QOZB entity could apparently develop goodwill and other intangible assets that are used in the QOZB, which could greatly enhance the value of the 100% exclusion where the QOF interest is held for at least 10 years.  In contrast, where assets are held directly by a QOF, intangible assets apparently must not exceed 10% due to the 90% requirement.  Also, given the 90% test is applied at the QOF level and the 70% test is applied at the QOZB entity level, the asset test may actually be 63% where the QOF operates through subsidiaries.  In addition, the proposed regulations do not currently extend the working capital safe harbor to QOFs.

7. Intangible assets used by a QOZB entity. As described in the preceding paragraph, a QOZB entity may apparently develop unlimited intangible assets used in a QOZB.  Where such a business is, for example, a tech start-up owned by a QOZB partnership, it may be possible for (i) up to thirty years’ of appreciation to be nontaxable and (ii) the ultimate buyer to receive a basis step-up in the technology and other assets.

Herman Spence III is an attorney with Robinson Bradshaw in Charlotte.