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Final Regulations Expand Prospects for Businesses and Investors in Qualified Opportunity Zones

March 12, 2020

The Treasury Department released final regulations in December 2019 (the “Final Regulations”) under Section 1400Z-2 of the Internal Revenue Code of 1986, as amended (the “Code”), which govern the qualified opportunity zone (QO Zone) program introduced by the Tax Cuts and Jobs Act of 2017.  The Final Regulations resolve a number of questions left open in proposed regulations issued in October 20181 and April 20192 (the “Proposed Regulations”) and generally pursue a lax approach to interpreting the statute, providing investors and businesses more flexibility when seeking the benefits of the QO Zone program.  This alert describes the key changes made by the Final Regulations for investors and businesses seeking to obtain the benefits of this program.

Legal Framework

As described in more detail in earlier client alerts, the QO Zone program is intended to promote investment in certain qualifying low-income communities designated as QO Zones.  Taxpayers are provided several incentives to invest in QO Zone funds (QO Funds), including:

  • temporary tax deferral of capital gains from the sale or exchange of assets reinvested in QO Funds until the earlier of (a) the date on which the investor disposes of its investment in a QO Fund and (b) December 31, 2026;
  • a permanent 10% exclusion of such deferred gains after five years;3
  • an additional permanent 5% exclusion of such deferred gains after seven years;4 and
  • a complete exemption from federal tax for any future appreciation from investments in a QO Fund held for at least ten years.

To qualify as a QO Fund, a corporation or partnership must hold at least 90% of its assets (the “90% Tangible Property Requirement”) in “qualified opportunity zone business property” (QO Business Property) or equity investments in QO Zone businesses (QO Business) (i.e., “qualified opportunity zone stock” or “qualified opportunity zone partnership interests”).  QO Business Property is property used in a trade or business of the QO Fund or a QO Business (a) acquired by purchase after December 31, 2017, (b) for original use or which is “substantially improved”, and (c) substantially all of the use of which is within a QO Zone during substantially all of the time held by the QO Fund or QO Business.

A QO Business must satisfy each of the following tests:

  • at least 70% of its tangible property must be QO Business Property (the “70% Tangible Property Requirement”);
  • at least 50% of its total gross income must be from the active conduct of a trade or business in a QO Zone (the “50% Income Requirement”);
  • at least 40% of its intangible property must be used in the active conduct of a trade or business in a QO Zone (the “40% Intangible Property Requirement”);
  • less than 5% of its assets can be non-qualified financial property (generally, debt, stock, partnership interests, options, futures contracts, and other similar property) other than “reasonable amounts of working capital” held in cash, cash equivalents, or debt instruments with a term of 18 months or less (the “5% Financial Property Limitation”); and
  • it may not be engaged in certain specified businesses (i.e., private or commercial golf courses, country clubs, massage parlors, hot tub facilities, suntan facilities, racetracks, or other gambling facilities or stores primarily selling alcohol for consumption off-premises) (Sin Businesses).

As noted above, under the Final Regulations, the Treasury Department has sought to expand the reach of these rules so as to encourage further development in QO Zones.  The remainder of this discussion explains the most significant changes from the Final Regulations.

Qualification of Opportunity Funds and Businesses

Expansion of Working Capital Safe Harbor.  The Proposed Regulations provided a safe harbor that allows both real estate and operating companies to satisfy the 5% Financial Property Limitation despite holding a substantial amount of working capital if the business is able to establish that it has a plan to use that working capital within 31 months (and actually follows that plan) (the “WC Safe Harbor”).  The Final Regulations introduce an additional safe harbor for businesses undergoing multiple rounds of financing.  Under this new safe harbor, tangible property purchased, leased, or improved using cash satisfying the WC Safe Harbor will also help satisfy the 90%/70% Tangible Property Requirements for the 31-month period while the cash is subject to the WC Safe Harbor and an additional 31-month period (for a total of 62 months).  In addition, gross income derived from that property will help satisfy the 50% Income Requirement, and intangible property created from working capital subject to the WC Safe Harbor will be considered used in the trade or business for purposes of the 40% Intangible Property Requirement during that same 62-month period.

Use of Intangible Property.  The Proposed Regulations did not define what it means to “use” intangible property for purposes of the 40% Intangible Property Requirement.  The Final Regulations offer some additional clarification, indicating that “use” means (a) normal, usual, or customary use in the conduct of a trade or business, and (b) use contributing to the generation of gross income satisfying the 50% Income Requirement.

Sin Businesses.  Although the rules prohibit QO Businesses from engaging in specified Sin Businesses, the Final Regulations permit them to lease up to 5% of their property (i.e., 5% of the net rentable space for real property and 5% of the value for all other tangible property) to tenants that engage in Sin Businesses.  This safe harbor will be particularly useful for a stadium development that meets the QO Business requirements, but features a minimal amount of gambling, or for a hotel that leases part of its space to a spa.

Property Straddling Opportunity Zones.  The Proposed Regulations permitted real property located outside of a QO Zone to count towards satisfying the 90%/70% Tangible Property Requirements where the real property is contiguous to the QO Zone and if the square footage of the real property located inside the QO Zone is greater than the square footage of the contiguous property located outside the QO Zone.  The Final Regulations introduce an additional test, which allows contiguous real property to satisfy the 90%/70% Tangible Property Requirements if the cost of the property inside the QO Zone exceeds the cost of the property outside the QO Zone.  This additional test may be useful, for example, where an existing building in a QO Zone is acquired as part of a development that includes adjacent vacant land or a parking lot outside the QO Zone that may have a lower acquisition cost than the portion of the land with the building on it.

Aggregation Rule for Substantial Improvement.  Under the Proposed Regulations, tangible property was considered to meet the substantial improvement test to be classified as QO Business Property if the improvements result in a tax basis double the property’s cost.  The Final Regulations make this test more flexible by treating two pieces of tangible property as the same property, at the option of the taxpayer, thus allowing a piece of tangible property to be treated as QO Business Property even if its tax basis has not been doubled so long as improvements to other tangible property are sufficient to meet the shortfall.

Decertification of a QO Fund.  Our prior client alerts describe the relatively simple process for QO Funds to self-certify their compliance with the rules described above.  A QO Fund self-certifies by filing Form 8996 with its tax return during the first taxable year the entity intends to operate as a QO Fund.  The Final Regulations introduce a simple process to de-certify a QO Fund as well; the Treasury Department will be releasing the forms necessary to de-certify a QO Fund in the near future.  The Treasury Department has also indicated that it is considering rules for involuntary decertification, though it has not yet determined how those rules will apply.

Additional Benefits and Easier Qualification for Investors in QO Funds

Eligible Section 1231 Gains.  A taxpayer that sells property used in a trade or business for more than one year generates what is referred to as Section 1231 gain.  Under the Proposed Regulations, the amount of Section 1231 gain eligible for investment in a QO Fund was limited to a taxpayer’s net Section 1231 gain, determined as of the end of the taxable year after netting Section 1231 gains and losses for the entire year.  The Final Regulations remove this limitation and instead allow the taxpayer’s gross Section 1231 gains to be invested in QO Funds regardless of any Section 1231 losses.

Partner Election for Partnership Gain.  If a partnership recognizes an eligible gain, the Proposed Regulations allowed the partnership to invest that gain in a QO Fund.  If the partnership chose not to invest that gain in a QO Fund, then each partner could elect to do so.  Although eligible gain generally must be reinvested in a QO Fund within 180 days, the Proposed Regulations provided that the partner has the option of reinvesting an eligible gain within 180 days of the date the gain was recognized or the end of the taxable year in which it was recognized.  Acknowledging that a partner may not know that an eligible gain has been recognized by a partnership until the partner receives its schedule K-1 from the partnership (generally at least a few months after the end of the taxable year), the Final Regulations go a step further and extend a partner’s reinvestment period to as late as 180 days following the due date (without taking extensions into account) for the partnership’s Form 1065 tax return for the taxable year during which an eligible gain was recognized.  This additional time will provide significant relief for partners in partnerships that recognize gain in 2021, the last year for which it will be possible to satisfy the five-year holding period and obtain the 10% gain exclusion described above, and for partners in partnerships that recognized gain in 2019, the last year for which it will be possible to satisfy the seven-year holding period and obtain the additional 5% gain exclusion described above.

Anti-Abuse Rules

While many of the rules introduced by the Final Regulations are quite taxpayer-favorable, the Final Regulations also include anti-abuse rules intended to promote the policy goals of the program.  One such rule permits the IRS to recharacterize a transaction, including by disqualifying an investment for the benefits provided for QO Fund investments, if the facts and circumstances of the transaction indicate that the tax result is inconsistent with the purpose of the statute.  This rule is broad in its scope and will require both QO Funds and their investors to carefully consider whether a particular transaction is abusive, even where the letter of the statute and regulations have been satisfied.


The Final Regulations demonstrate that the Treasury Department is taking a flexible approach to the rules governing QO Funds in order to promote the program’s objectives, while retaining the authority to prevent outright abuses.  Given the inherent complexity of administering the QO Zone program, taxpayers should expect that guidance will continue to be issued to address some outstanding questions.  But, taxpayers should be encouraged by the Treasury Department’s interest in pursuing Congress’s goal of promoting investment in QO Zones.

1 We previously described the October 2018 proposed regulations in a client alert found here

2 We previously described the April 2019 proposed regulations in a client alert found here.  Another client alert, found here, describes the particular benefits available for early stage operating companies, and the client alert posted here addresses special issues relevant for stadium development.

3 Subject to the discussion below of gains recognized by a partnership, this partial exclusion will not be available for gains recognized after December 31, 2021.

4 Subject to the discussion below of gains recognized by a partnership, this partial exclusion is not available for deferred gains realized after calendar year 2019.

This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Alexander Anderson, an O’Melveny partner licensed to practice law in New York, Luc Moritz, an O’Melveny partner licensed to practice law in California, Billy Abbott, O’Melveny counsel licensed to practice law in California and New York, Alexander Roberts, an O’Melveny counsel licensed to practice law in New York, and Dawn Lim, an O’Melveny associate licensed to practice law in New York, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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