May 9, 2019

Proposed QOZ Regulations Offer Greater Clarity – But Significant Questions Remain

The Treasury Department and Internal Revenue Service recently issued a second round of proposed regulations (the Proposed Regulations) providing additional guidance for Qualified Opportunity Fund (QOF) investors and sponsors, and supplementing the initial proposed regulations issued in October of 2018 (the Prior Proposed Regulations) under Sections 1400Z-1 and 1400Z-2 of the Internal Revenue Code of 1986, as amended (the QOF Statute and together with the Proposed Regulations, the Prior Proposed Regulations and other IRS guidance released to date, the QOF Rules). Subject to certain exceptions, taxpayers generally may rely on the Proposed Regulations as long as they follow the relevant section in its entirety in a consistent manner.

The Proposed Regulations clarify several significant points but leave many open questions. We expect that the Proposed Regulations will boost the confidence of sponsors and investors regarding the ability of funds intending to qualify as QOFs to satisfy the various QOF Rules and make investments in qualified opportunity zones (QOZs), and we hope that additional clarifications will be forthcoming. Discussed below are some key takeaways that may be of interest to QOF sponsors, particularly with regards to QOF real estate funds.

Expansion of 10+ Year Tax Benefits

Most practitioners interpreted the QOF Statute as requiring investors to sell (or be treated as selling) their interests in the QOF in order to take advantage of the basis step-up to fair market value in connection with a disposition of a QOF investment held for more than 10 years. The Proposed Regulations clarify that, if an investor has held a qualifying investment in a QOF classified as a partnership (QOF Partnership) for at least 10 years, such investor may elect to exclude from gross income some or all of the capital gain arising from the QOF Partnership’s disposition of qualified opportunity zone property (QOZ Property). In addition, an investor that holds an interest in a QOF classified as a real estate investment trust (QOF REIT) for at least 10 years may elect to apply a 0% tax rate to any capital gain dividend that is attributable to the QOF REIT’s sales of QOZ Property, to the extent properly identified as such by the QOF REIT pursuant to applicable guidance.


At first blush, the foregoing provisions appear to facilitate multi-asset QOF structures by permitting QOFs to undertake an orderly liquidation of their assets after investors’ 10-year holding periods have been satisfied. However, the new elections impose certain limitations that do not apply to a sale of an investor’s qualifying interest in a QOF and may present practical challenges for a typical multi-asset fund structure, including the following:

  • Elections limited to capital gains for QOZ Property. The new elections are limited to capital gains from the sale of QOZ Property, whereas the 10-year basis step-up election that may be made in connection with the sale of an investor’s qualifying interest in a QOF appears to effectively eliminate all gain on sale, including ordinary income, depreciation recapture and gain attributable to non-QOZ Property held by a QOF or qualified opportunity zone business that is a subsidiary of the QOF (a QOZ Business), provided that the overall QOF asset tests have been satisfied.

  • Elections limited to sales by the QOF itself. The scope of the new elections appears to be limited to sales of QOF Property made by a QOF itself, as opposed to sales of assets by a QOZ Business. As a practical matter, multi-asset QOF structures generally will require investments to be made through one or more QOZ Businesses in order to utilize the working capital safe harbor for cash reserves that, if held directly by the QOF, could cause an asset test violation. While this rule should permit QOFs to sell interests in QOZ Businesses, it does not appear to permit QOZ Businesses themselves to sell assets.

While these elections are expected to facilitate multi-asset QOF structures, the apparent anomalies unfortunately create unnecessary risk and complexity for QOFs, particularly QOFs that intend to hold assets through a QOZ Business. Further guidance will be needed to determine whether these limitations were intended and what their overall impact will be on multi-asset QOF structures.

Leveraged Distributions From a QOF Partnership

The Proposed Regulations clarify that an investor in a QOF Partnership generally may receive distributions from the QOF Partnership up to the investor’s tax basis (including debt allocations) in the QOF Partnership interest without recognizing gain or losing any QOF benefits. This rule does not apply if the distributions are part of a transaction that would have been recharacterized as a “disguised sale” if the investor had contributed property rather than cash to the QOF Partnership.


This clarification should permit QOF Partnerships to make tax-free distributions of debt proceeds to investors relatively early in the life of a QOF Partnership and is welcome news for QOF sponsors and investors. However, the “disguised sale” overlay introduces a level of uncertainty and complexity that must be carefully considered in connection with any debt-financed distribution planning by a QOF Partnership.

As a practical matter, debt-financed distributions generally should not be contemplated during the two-year period following the last contribution of qualifying QOF capital.  After such two-year period, debt-financed distributions in many cases will present a viable option for QOF Partnerships to provide at least some liquidity to their investors. 

Carried Interest Considerations

As many practitioners anticipated, the Proposed Regulations confirm that the acquisition of an interest in a QOF Partnership in exchange for services (i.e., a “carried interest”) is not a qualifying interest in a QOF that gives rise to QOF benefits. A partner both making a qualifying investment in a QOF and acquiring a carried interest in such QOF will be treated as holding a “mixed-funds” investment, with the carried interest treated as a separate interest that is ineligible for tax benefits under the QOF Rules.


The portion of the mixed-funds investment that is treated as nonqualifying is determined based on the highest share of residual profit attributable to the carried interest, potentially resulting in a larger portion of the interest being treated as nonqualifying than might be expected. QOF sponsors contemplating investing their own gains in the QOF should consider holding their carried interest through a separate regarded entity for tax purposes or taking their carried interest directly out of a QOZ Business that is structured as a partnership subsidiary to avoid distortions under this mixed funds rule.

6-Month Grace Period for Contributed Capital

The Proposed Regulations permit a QOF to exclude contributed capital from both the numerator and denominator of the 90% QOF asset test for a period of six months beginning with the date of the contribution, provided that the contribution is held continuously in cash, cash equivalents or debt instruments with a term of 18 months or less.


In practice, this rule should allow QOFs to hold contributed capital at the QOF level for an extended period of time (up to nearly one full year in certain cases), permitting QOFs significantly more flexibility to accept investor capital contributions during the start-up period without fear of triggering an imminent asset test violation. This rule is separate from (and applies independently of) the working capital safe harbor that may be employed by QOZ Businesses.

Qualified Opportunity Zone Property Requirements

The Proposed Regulations build on the Prior Proposed Regulations by adding a number of clarifying rules and standards regarding QOZ Property, which includes qualified opportunity zone business property (QOZB Property), as well as interests in partnerships and corporations that hold QOZB Property and meet certain requirements. These additions include:

  • Original Use. The Proposed Regulations clarify that the “original use” of tangible property acquired by purchase generally commences on the date when the property is first placed in service in the QOZ for purposes of depreciation or amortization. Thus, tangible property that is depreciated or amortized in the QOZ by someone other than the QOF or QOZ Business would not satisfy the “original use” requirement. However, where a building or other structure has been unused or vacant for at least five years, original use begins when any person first uses or places the property in service in the QOZ.

    Observation: Measuring a property’s “original use” from when it is first placed in service permits a QOF to purchase a completed building that has not yet received a certificate of occupancy. This may drive significant market activity involving third-party developers acquiring and developing QOZ assets for sale to QOFs.

  • Substantial Improvement. Under the Proposed Regulations, whether purchased tangible property satisfies the “substantial improvement” requirement is determined on an asset-by-asset basis. In addition, unimproved land that is within a QOZ is not itself required to be substantially improved, but such land must nonetheless be used in a trade or business of a QOF or QOZ Business.

    Observation: Applying the substantial improvement test on an asset-by-asset basis may present administrative complexities for QOFs and could hinder the ability of a QOF to invest in larger scale projects where individual buildings cannot meet the substantial improvement standard. Treasury and the IRS indicated in the Proposed Regulations that they will consider an alternative to allow grouping properties within the same or contiguous QOZs for purposes of satisfying the substantial improvement test. In the absence of such a rule, QOF sponsors should prepare to track and maintain asset-specific tax basis information as properties are improved.

  • “Substantially All” Requirements. The phrase “substantially all” is used throughout the QOF Rules. The Proposed Regulations provide that “substantially all” in the context of the “use” of QOZB Property in a QOZ is 70%, meaning that in order to be QOZB Property, at least 70% of the property’s use must be in a QOZ. By contrast, “substantially all” in the context of determining the holding period for a QOZ Business and QOZB Property is 90%. That is, a QOF’s subsidiary must qualify as a QOZ Business during at least 90% of the time the interest is held by the QOF, and that QOZB Property must be used 70% or more in the QOZ during at least 90% of the time held by the QOF or QOZ Business.

    Observation: These thresholds should provide QOF sponsors with more certainty regarding the contours of what qualifies as QOZ Property. 

Leases of Tangible Property

The QOF Statute requires that tangible property be “acquired by purchase,” raising concerns that property leased by a QOF (or QOZ Business) potentially could not satisfy this test. The Proposed Regulations clarify that leased tangible property is treated as QOZB Property, with respect to a lessee, if the leased property meets the following requirements:

  • The lease must be entered into after December 31, 2017;

  • Substantially all of the use of such leased tangible property must be in a QOZ during substantially all of the period for which such property is leased; and

  • The lease must have market rate terms.

The lessor may be related to the QOF or QOZ Business, but, in that case, the lessor (or a related person) may not make prepayments of such lease that exceed 12 months. Additional requirements apply with respect to a lease of tangible personal property.

The Proposed Regulations further clarify that leased tangible property need not be “substantially improved” or “original use” property in the hands of the lessee, and that any improvements made by a lessee to leased tangible property shall be considered original use property acquired by purchase.


These leasing rules provide considerable flexibility for a QOF to invest in QOZ projects that otherwise may not have been possible to structure in a compliant manner. Examples include projects in which an acquisition of the property would not have met the acquired by purchase, unrelated person, original use and/or substantial improvement requirements, all of which apply to acquisitions of QOZB Property generally but do not apply to leases of QOZB Property.

The improvements that a QOZ Business makes to the leased property may now qualify as QOZB Property, enabling the QOZ Business to more easily qualify as such. In addition, the leasing rules are likely to be particularly useful to QOFs that make investments in operating businesses, especially those that rely heavily on the use of depreciable property. 

Clarification of 180-Day Period for Section 1231(b) Gains

In the case of gain recognized from the sale of Section 1231 property (including real property used in a trade or business held for more than one year), only net Section 1231 gains are eligible for the deferral election in connection with a QOF investment. Net section 1231 gains are generally determinable only as of the end of each tax year, as the excess of gains over losses from sales of Section 1231(b) property. Accordingly, the Proposed Regulations provide that taxpayer’s 180-day period to reinvest capital gain net income from Section 1231 property begins on the last day of the taxable year in which the gains were recognized.


While we agree with the technical basis for the 180-day period for Section 1231 gains, we note that the timing rule could be detrimental to taxpayers under certain circumstances:

  • Challenges for 2019 gains. Taxpayers that recognize gain from sales of Section 1231 property in 2019 may not be able to invest in a QOF until 2020, at which time the 5% basis increase for QOF investors that have held their investment for at least seven years at the end of 2026 will not be available prior to the QOF investors’ initially deferred gain being recognized on December 31, 2026. While it might be possible to achieve the full basis benefit with respect to Section 1231 gains recognized in 2019 that are actually invested in a QOF on December 31, 2019, there are a number of practical considerations that may make threading that particular needle exceedingly difficult.

  • Partnership considerations. There is considerable uncertainty as to how, if at all, a partnership that recognizes Section 1231 gains may make a deferral election with respect to a QOF investment, because Section 1231 gains generally must be netted only at the partner level, and hence a partnership generally does not have net Section 1231 gains.

  • Prior 1231 Gain Investments. Taxpayers that invested Section 1231 gains prior to the release of the Proposed Regulations may now face concerns that their investments may not qualify for a valid deferral election, despite having made their investment decision based on a reasonable interpretation of the QOF Statute and Prior Proposed Regulations at the time. We hope that additional guidance will provide further clarification and relief for such investors.    

Other Notable Aspects of the Proposed Regulations

Tiering of QOF Subsidiaries. The Proposed Regulations neglect to address an important tiering problem that is faced by many multi-asset QOFs. Due to the structure of the reasonable working capital safe harbor under the Prior Proposed Regulations, a QOF generally must establish one or more subsidiary QOZ Businesses in order to hold cash and working capital assets without violating the 90% asset test. A QOZ Business, however, cannot itself own substantial interests in other partnerships or regarded entities for federal income tax purposes, which effectively prohibits a QOF from investing in many traditional joint venture and other nonabusive tiered structures. Because the Proposed Regulations did not address these concerns, QOF sponsors will need to continue to avoid standard joint venture structures in many situations and require overly complex arrangements in others.

Reinvestment of Proceeds. The Proposed Regulations provide that proceeds received by a QOF from the sale or disposition of QOZ Property generally are treated as QOZ Property for purposes of the QOZ Rules as long as the QOF reinvests the proceeds received within 12 months. However, both the QOF and, if applicable, the investors in a QOF, must report and pay tax on any gain recognized in the sale. As a result, although the new rules provide added flexibility for a QOF to sell investments and reinvest the proceeds without jeopardizing its QOF status, QOFs may be hesitant to engage in taxable sales given the potential for phantom income to the QOF and/or its investors.  

Real Estate Operations Qualify as a Trade or Business. The Proposed Regulations confirm that the ownership and operation (including leasing) of real property qualifies as the active conduct of a trade or business, allowing real estate leasing businesses to qualify as a QOZ Business. However, a triple-net-lease with respect to real property is not considered the active conduct of a trade or business. The Proposed Regulations do not offer further guidance as to how much incremental activity relative to a triple-net-lease is needed in order to satisfy the active trade or business test.

Working Capital Safe Harbor. The Proposed Regulations include two key changes to the working capital safe harbor. First, the safe harbor now applies to working capital used for the development of a trade or business in a QOZ, in addition to the acquisition, construction and/or substantial improvement of tangible property. Second, if the expenditure of working capital assets within the required 31-month period is delayed as a result of government action the application for which is complete, that delay will not cause a failure to comply with the working capital safe harbor.

Secondary Purchases Permitted. The Proposed Regulations clarify that an investor may make a qualifying investment in a QOF by purchasing an interest in the QOF from an existing equity owner – the investor need not invest directly in the QOF. While this rule may facilitate syndication of QOF interests and warehousing of investments, its utility is likely limited to situations where the seller/warehouse investor is not attempting to obtain QOF benefits in respect of its QOF investment (because the seller’s deferred gain would be recognized as a result of selling to the new QOF investor).

For additional discussion and observations relating to the Prior Proposed Regulations and QOF Statute, please refer to our prior client alert.