On October 19, 2018, the U.S. Department of the Treasury released long-anticipated proposed regulations (the “Proposed Regulations”) relating to investments in Qualified Opportunity Zones (“QOZs”). On the same day, Treasury released (1) a related Revenue Ruling (Rev. Rul. 2018-29) addressing the “original use” and “substantial improvement” requirements as they apply to the acquisition by a qualified opportunity fund (“QOF”) of land in a QOZ that has an existing building on it; and (2) an early release draft form (Form 8996)1 pursuant to which an entity eligible to be a QOF may certify that it is qualified to invest in qualified opportunity zone property and that it meets the 90-percent investment standard (the “90-percent test”) of section 1400Z-2 of the Internal Revenue Code of 1986, as amended (the “Code”).2

The Proposed Regulations are not comprehensive, and Treasury and the Internal Revenue Service (“IRS”) intend to issue further proposed regulations to provide guidance on certain issues untouched by the Proposed Regulations. In addition, the Proposed Regulations have generated some uncertainties, and have “doubled down” on what many thought was a drafting error in the QOZ statute which results in a significant differentiation between the treatment of direct and indirect investments made by QOFs. Nevertheless, we believe the Proposed Regulations and related Revenue Ruling have provided meaningful clarity on several key issues, particularly around QOF qualification matters. In our view, so long as operating agreements for QOFs provide for flexibility in dealing with operational matters that are expected to be addressed in future guidance, the clarifications provided by the Proposed Regulations with respect to QOF qualification matters should permit investment program sponsors and investors to move forward with confidence in establishing, and investing in, properly designed QOZ investment programs.


The Tax Cuts and Jobs Act of 2017 (the “TCJA”) amended the Code to add section 1400Z-1 and 1400Z-2. Together, these new sections encourage investments in certain low income census tracts that have been designated as QOZs. Generally, a taxpayer may defer “gain” by timely investing that gain amount in a QOF in accordance with the requirements set forth in section 1400Z-2(a). Those requirements include making the investment within a 180-day period beginning with the date of the sale or exchange giving rise to that gain, and making an election on the taxpayer’s Federal income tax return for the taxable year in which the gain arises. A taxpayer who properly defers gain by investing in a QOF will defer recognition of that gain until the earlier of (1) the sale or exchange of the taxpayer’s interest in the QOF, or (2) December 31, 2026. Although the taxpayer will have a basis of $0 in its QOF investment, for purposes of determining the tax payable on the deferred gain, that basis may be increased by 10% of the amount of the deferred gain, if the investment is held for at least 5 years (provided the 5-year period ends by December 31, 2026) and by 15% of the amount of the deferred gain, if the investment is held for at least 7 years (provided the 7-year period ends by December 31, 2026). A special rule for QOF investments held for 10 years provides that, at the election of the taxpayer, the basis of the taxpayer’s interest in the QOF shall be equal to its fair market value on the date that it is sold or exchanged.

Although sections 1400Z-1 and 1400Z-2 of the Code did not garner significant attention immediately following the enactment of the TCJA, interest has since grown exponentially as investors and sponsors have awakened to the powerful tax deferral and basis step-up benefits offered by the QOZ program. The Proposed Regulations and Rev Rul. 2018-29 represent the first of Treasury’s efforts to provide guidance relating to sections 1400Z-1 and 1400Z-2 and are generally favorable in the manner in which they address many of the open issues that have held back investment to date.

The Proposed Regulations generally are expected to be effective on or after the date of their publication in the Federal Register of a Treasury decision adopting them as final regulations, however, the Proposed Regulations generally may be relied upon currently, so long as a taxpayer applies the rules in their entirety and in a consistent manner. Of course, the Proposed Regulations are subject to public comment and may be amended before they become final.

Summary and Analysis of Key Proposed Regulation Provisions

I. Provisions Addressing Qualification of Entities as QOFs

A. Working Capital On-Ramp 

Among the most important issues addressed by the Proposed Regulations is whether a QOF may hold cash reserves in order to acquire, construct, or rehabilitate tangible property without violating the section 1400Z-2 requirements that restrict the type of property that a QOF may hold. Section 1400Z-2(d)(1) sets forth the 90-percent test, providing that a QOF must hold at least 90 percent of its assets in “qualified opportunity zone property” (determined by the average of the percentage of qualified opportunity zone property held in the QOF as measured on the last day of the first 6-month period of its taxable year and on the last day of its taxable year). Qualified opportunity zone property includes (1) qualified opportunity zone stock, (2) qualified opportunity zone partnership interest, or (3) qualified opportunity zone business property. Qualified opportunity zone stock and qualified opportunity zone partnership interest must represent ownership of interests in a corporation or partnership that qualifies as a “qualified opportunity zone business”. A direct investment by a QOF in qualified opportunity zone business property, on the other hand, requires that such property (among other requirements) be tangible property used in a trade or business of the QOF.

Because section 1400Z-2(d)(2)(D) provides that qualified opportunity zone business property must be tangible property used in a trade or business, cash does not qualify as such and section 1400Z-2(e) imposes potentially onerous penalties on a QOF for failure to satisfy the 90-percent test.3 Accordingly, a QOF may not directly hold more than 10% of its assets in cash. In addition, with respect to QOFs that operate through subsidiaries, such subsidiaries are also subject to restrictions with respect to their cash holdings. A QOF subsidiary, which is required to operate as a “qualified opportunity zone business,” may hold no more than 5% of its assets as “nonqualified financial property” pursuant to section 1397C(b)(8). Nonqualified financial property includes cash other than cash that, pursuant to section 1397C(e), constitutes “reasonable amounts of working capital”. The foregoing limitations on a QOF’s direct and indirect holding of cash have led many to question how a QOF, absent significant debt financing or extraordinarily careful and coordinated staging of capital raising and deployment, may practically effectuate a project that satisfies a QOF’s obligation to acquire, construct, and otherwise substantially improve property within the statutory 30-month time frame.

The Proposed Regulations provide a working capital safe harbor for QOF investments in qualified opportunity zone businesses that acquire, construct, or rehabilitate tangible business property. To meet the safe harbor, (1) the relevant qualified opportunity zone business must designate in writing the amount of the working capital to be used for the acquisition, construction, and/or substantial improvement of tangible property in a QOZ, (2) the business must have a written schedule consistent with the ordinary start-up of a trade or business for the expenditure of working capital assets, and, the schedule must evidence that the working capital assets will be spent within 31 months of the receipt by the business of the assets, and (3) the working capital assets must actually be used in a manner that is “substantially consistent” with the foregoing two requirements.

It is important to note that the working capital safe harbor by its terms applies only to a QOF that invests in a QOZ through an operating subsidiary (i.e., a corporation or partnership in which the QOF owns qualified opportunity zone stock or a qualified opportunity zone partnership interest) and does not appear to apply to a QOF that makes direct investments in qualified opportunity zone business property. At this time it is not clear whether this distinction was intentional and what policy objective the difference is intended to address (if any at all).4 Additional guidance would be helpful to determine whether a QOF may rely on the safe harbor in order to directly acquire, construct, or rehabilitate qualified opportunity zone business property.

B. Qualified Opportunity Zone Business and Property

One of the oddities of section 1400Z-2 was set forth in section 1400Z-2(d)(2)(D)(i), which defines “qualified opportunity zone business property” to refer to tangible property used in a trade or business of a QOF. Notably absent from that definition was whether the trade or business of the QOF was required to be a “qualified opportunity zone business.” In other words, to the extent a QOF owns its business through a corporation or partnership, such entities are required to be engaged in a “qualified opportunity zone business,” but the statute did not impose that limit on businesses directly operated by a QOF. Many commentators, including the authors of this alert, considered this differentiation to be a drafting error that was the inevitable product of the fevered process that gave rise to the TCJA. Nevertheless, Treasury appears to have “doubled down” on this dubious differentiation, not just with respect to the working capital on-ramp described above, but also with respect to the definition of a “qualified opportunity zone business.”

The definition of “qualified opportunity zone business” set forth in section 1400Z-2(d)(3) provides that, among other requirements, “substantially all” of the tangible property owned or leased by the taxpayer must be qualified opportunity zone business property. However, the term “substantially all” is not defined in section 1400Z-2. The Proposed Regulations indicate that such term means, for purposes of section 1400Z-2(d)(3), 70%. However, a QOF that owns qualified opportunity zone business property directly (i.e., as opposed to owning such property through an operating subsidiary) does not get the benefit of this test, and instead still needs to meet the 90% good asset standard described above in order to satisfy the 90-percent test. The preamble to the Proposed Regulations makes it clear that Treasury was intentional in treating direct and indirect investments by QOFs differently on this issue, and as a result raises the question as to whether other distinctions, such as whether the “qualified opportunity zone business” requirements apply to direct investments by QOFs, should be read to mean what they literally say.5 Additional guidance on this issue would be welcome.

C. Eligible Entities 

The Proposed Regulations indicate that a QOF must be an entity classified as a corporation or partnership for Federal income tax purposes. There had previously been some uncertainty regarding whether the literal language of section 1400Z-2(d)(1), providing that a QOF is, among other requirements, an “investment vehicle which is organized as a corporation or a partnership”, precluded the use of limited liability companies as QOFs, even if such entities were treated as partnerships or corporations for Federal income tax purposes. The Proposed Regulations support the position that a limited liability company is a permissible choice of entity. In addition, the Proposed Regulations clarify that a QOF must be created or organized in one of the 50 States, the District of Columbia, or a U.S. possession.6

D. Valuation Method for Applying the 90-Percent Asset Test

The Proposed Regulations provide that if a QOF has, for a taxable year, an “applicable financial statement” as defined in Treasury Regulation section 1.475(a)-4(h), then the value of the QOF’s assets for purposes of the 90-percent test in section 1400Z-2(d)(1) is the value of the assets that are reported in the applicable financial statement. If the QOF does not have an applicable financial statement, the value of each asset will be the QOF’s cost of the asset.

E. Designating When a QOF Begins

The Proposed Regulations provide that if a taxpayer classified as a corporation or partnership for Federal income tax purposes is eligible to be a QOF, it may self-certify as such. The self-certification must be effectuated in the manner prescribed by the IRS. The self-certification must identify the first taxable year in which the QOF intends to so qualify and the first month in that year in which it intends to qualify as such. If the self-certification does not specify the month, then the first month of the initial year of qualification will be the first month in which an eligible entity is a QOF. As noted above, it is anticipated that self-certification as a QOF may be made on Form 8996 (which has been released as an early draft that is not to be filed or relied upon at this time).

F. 10-Year Investment Period/Duration of QOZ Tract Designation

The Proposed Regulations clarify that the section 1400Z-2(c) special rule permitting a taxpayer to elect to increase its basis in a QOF investment to fair market value if such investment has been held for 10 years applies only to the portion of an investment in a QOF with respect to which a proper section 1400Z-2(a)(1) election to defer gain was previously made. In addition, the Proposed Regulations clarify that the ability to make an election to increase basis is not adversely impacted by section 1400Z-1(f), which provides that the designation of a QOZ as such ceases to be effective on December 31, 2028. However, an election to increase basis under section 1400Z-2(c) must be made by no later than December 31, 2047. In adopting this approach, Treasury sought to avoid compelling investors to rush to dispose of their interests in QOFs prior to the end of 2028 (or shortly thereafter).7

G. Becoming a QOF in a Month Other Than the First Month of the Taxable Year

The Proposed Regulations provide that if an eligible entity elects to be a QOF effective as of a month that is not the first month of the QOF’s taxable year, then, for purposes of the requirement in section 1400Z-2(d)(1) relating to testing whether a QOF meets the 90-percent test, the phrase “first 6-month period of the taxable year of the fund” means the first 6 months each of which is in the taxable year and in each of which the entity is a QOF. Accordingly, if an eligible entity used the calendar year as its taxable year became a QOF in March of a given year, it would be tested on each of August 31 and December 31 of that year. Note that if the QOF became a QOF in November, it would be tested on December 31 of that year. The working capital safe harbor will likely provide significant relief (assuming it is complied with) to concerns regarding testing the 90-percent test within a relatively short time after a QOF is formed or makes an election to be treated as such.

H. Pre-Existing Entities

The Proposed Regulations provide that there is no prohibition on a pre-existing eligible entity becoming a QOF, however, the entity must satisfy all of the requirements of section 1400Z-2 and the regulations thereunder, including, without limitation, the requirement that a QOF acquire all of its qualified opportunity zone property after December 31, 2017.

II. Provisions Addressing Investor and QOF Operational Matters

A. “Eligible Gain” Qualifying for Deferral Under Section 1400Z-2

Section 1400Z-2 generally provides that a taxpayer’s gross income for the taxable year will not include “gain” from the sale to, or exchange with, an unrelated person of any property held by the taxpayer, if such gain is invested in a QOF during the 180-day period beginning on the date of such sale or exchange. It was not clear whether only capital gain qualified as “gain” for purposes of section 1400Z-2 or if ordinary gain would so qualify. Prior to finalization, drafts of section 1400Z-2 referenced capital gain, however, the word “capital” was later removed - but for its continued inclusion in the title of the section (which appears to have been an error). Nevertheless, Treasury has taken the position in the Proposed Regulations that “eligible gain” (i.e., gain eligible for deferral under section 1400Z-2) includes only gain that would (if not for section 1400Z-2) be treated as capital gain for Federal income tax purposes. Under this rule, both short- and long-term gain qualify for deferral under section 1400Z-2. However, because section 1245 and section 1250 provide that their respective depreciation recapture gain amounts are in each case “treated as ordinary income” (per section 1245(a)) or “treated as gain which is ordinary income” (per section 1250(a)(1)), neither appears to qualify for deferral under section 1400Z-2. Section 1231 gain and section 1250 unrecaptured gain presumably qualify, although it is not specifically stated in the Proposed Regulations.

B. Mixed Funds and the Treatment of Deemed Capital Contributions Under section 752(a)

The “mixed fund” rule set forth in section 1400Z-2(e)(1) provides that if a taxpayer invests eligible gain in accordance with section 1400Z-2(a), and other amounts, the investment is bifurcated into amounts that qualify for deferral pursuant to section 1400Z-2 and amounts that do not. Some commentators expressed concern that pursuant to section 752(a), any debt allocated to an opportunity fund investor (i.e., in a QOF organized as a partnership for Federal income tax purposes) would be deemed a cash investment by the investor and treated as a separate investment in the QOF pursuant to the “mixed fund” rule which would not qualify for opportunity zone benefits. Significantly, the Proposed Regulations expressly state that any debt allocated to an opportunity fund investor is not treated as a separate investment by the investor in a QOF. Thus, on the important issue of the treatment of debt allocated to investors under section 752(a), Treasury has so far taken the position that there is no differentiation between capital provided by persons seeking the benefits of section 1400Z-2 and others. What this position suggests more broadly, and further guidance will hopefully confirm, is that with respect to non-opportunity zone-specific matters, all investors in a QOF that is a partnership for Federal income tax purposes are subject to the general rules of partnership tax law with respect to allocations of debt and other matters. If this suggestion is borne out, the use of debt allocations, whether under the rules for allocation of nonrecourse debt, or through the use of “vertical slice” or other investor guarantees, may provide a powerful tool that would allow QOF investors to extract untaxed cash from a QOF investment without prematurely triggering gain.

C. 180-Day Rule for Deferring Gain  

Section 1400Z-2(a) provides that in order to defer gain from a sale or exchange, a taxpayer must invest that gain in a QOF within 180 days of the relevant sale or exchange. However, there has been uncertainty as to how to determine the 180-day period in circumstances in which a taxpayer is treated as having deemed gain from the sale or exchange of a capital asset (where the statutory language that provides for such deemed gain does not provide a date for the deemed sale/exchange). In such instances, the Proposed Regulations provide that the first day of the 180-day period is the date on which the gain would be recognized for Federal income tax purposes, if not for the deferral under section 1400Z-2. We note that the Proposed Regulations do not address certain circumstances, including when a regulated investment company (“RIC”) or real estate investment trust (“REIT”) shareholder should be treated as having received a capital gain dividend. Example 2 in Proposed Regulation 1.1400Z-2(a)-1(b)(4) provides that the 180-day period should begin on the date on which a capital gain dividend is paid by a RIC or REIT to a shareholder, however, the Proposed Regulations do not take into account that a REIT may not designate the dividend as a capital gain dividend until a later date (and thus the taxpayer will not know upon receipt of the dividend whether the gain may be deferred pursuant to section 1400Z-2). In addition, a taxpayer might have section 1231 gain (treated as capital gain) from a sale or exchange, thereby triggering the start of the 180-day period. However, a subsequent section 1231 sale by the taxpayer in the same taxable year may result in a loss that will cause the gain from the prior sale to be offset. Further guidance from Treasury would be helpful in addressing these issues.

D. Taxpayers Eligible to Elect Gain Deferral 

The Proposed Regulations clarify that an “eligible taxpayer” (i.e., who may elect to defer recognition of eligible gains under section 1400Z-2) is a person that may recognize gains for purposes of Federal income tax accounting. Such eligible taxpayers include individuals, C corporations (including RICs and REITs), partnerships, S corporations, and trusts and estates.

E. Gains of Partnerships and Other Pass-Through Entities, and How to Elect Deferral

The Proposed Regulations provide special rules applicable to partnerships and other pass-through entities. Pursuant to these rules, a partnership is an eligible taxpayer that may elect to defer recognition of some or all of its eligible gains pursuant to section 1400Z-2(a)(2). If the partnership properly elects to defer such gain, the gain is not recognized and is not included in the distributive shares of the partners. If the partnership does not make such an election with respect to some or all of an eligible gain, the gain is included in the partners’ distributive shares pursuant to section 702 and is subject to section 705(a)(1). A partner may then choose whether to elect to defer some or all of the gain pursuant to section 1400Z-2(a)(1)(A), provided that such gain did not arise from a sale or exchange with a person related to the partner. In such an instance, the partner will have 180 days to make an election, commencing on the last day of the partnership taxable year in which the partner’s allocable share of the partnership’s eligible gain is taken into account under section 706(a). However, a partner may elect to instead use the partnership’s 180-day period to invest (for example, if the partner has identified an investment opportunity). Rules analogous to the foregoing rules apply to S corporations, trusts, and estates.

The Proposed Regulations provide that the IRS may prescribe in guidance the time, form, and manner in which an eligible taxpayer may elect to defer eligible gains and in which a partner may elect to apply the elective 180-day period (discussed above) to use a partnership’s 180-day period for electing to defer gain. It is currently anticipated that a taxpayer will make deferral elections on Form 8949 (Sales and Other Dispositions of Capital Assets), which will be attached to the taxpayer’s Federal income tax return for the taxable year in which it otherwise would have recognized the relevant gain.

F. Attributes of Included Income When Gain Deferral Ends

Section 1400Z-2(a)(1)(B) and (b) require a taxpayer to include previously deferred gain under section 1400Z-2(a)(1) in income in the taxable year which includes the earlier of the date on which a QOF investment is sold or exchanged, or December 31, 2026. The Proposed Regulations provide that such gain will have the same attributes in the taxable year of inclusion that it would have had if the gain had not been deferred. For example, if a taxpayer defers short term capital gain by investing such gain in a QOF in accordance with section 1400Z-2(a)(1), and holds such investment through December 31, 2026, the taxpayer will (subject to any increases in basis under 5 year and 7 year rules set forth in section 1400Z-2(b)(2)(B)(iii) and (iv)) include in income for 2026 the deferred gain as short term capital gain.

Revenue Ruling 2018-29

Rev. Rul. 2018-29 addresses certain issues relating to the application of the original use and substantial improvement requirements in situations where a QOF acquires land in a QOZ with a pre-existing building on it. The ruling holds that (1) if a QOF purchases an existing building located on land that is wholly within a QOZ, the original use of the building in the QOZ is not considered to have commenced with the QOF and the requirement that the original use of tangible property in the QOZ commence with a QOF is not applicable to the land on which the building is located; (2) if a QOF purchases a building wholly within a QOZ, a substantial improvement to the building is measured by the QOF’s additions to the adjusted basis of the building; and (3) measuring a substantial improvement to a building by additions to the QOF’s adjusted basis of the building does not require the QOF to separately substantially improve the land upon which the building is located. The ruling does not address vacant land without any improvements on it. It is not clear from the ruling or the Proposed Regulations whether a taxpayer must more-than-double its basis in the entirety of a vacant parcel of land, whether improvements constructed on a vacant parcel would be subject to the “original use” standard, or whether another standard applies. Further guidance would be helpful to determine whether a QOF must take into account its basis in the entire parcel of land or some other standard.8 Further guidance would also be useful in clarifying whether the land on which a building is located will in all instances be ignored for purposes of determining whether the QOF satisfies the 90-percent test,9 and thus, for example, in the case of acquisitions of vacant land, whether the “original use” test rather than the “substantial improvement” test would be the appropriate test for constructed improvements.