ALERT: Treasury Releases Second Set of Qualified Opportunity Zone Regulations

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The Department of Treasury (“Treasury”) released its highly anticipated second set of proposed Opportunity Zone regulations on April 17, 2019 (the “New Regulations”). The New Regulations, which stretch over 80 pages (169 pages including the preamble), provide clarity on a number of (i) issues unaddressed in first set of Opportunity Zone proposed regulations (the “Initial Regulations”), and (ii) substantive and definitional issues that were necessary to foster certainty and stimulate investment in targeted communities. The New Regulations do not address all of the outstanding questions. For example, they do not address penalties associated with a failure to satisfy the 90% Test (as discussed in our previous alert), or whether a Qualified Opportunity Fund (“OZ Fund”) will be subject to annual reporting on its investments. Despite these few outstanding questions, the New Regulations do answer a myriad of other substantive questions that have been keeping investors sidelined. While this summary is not intended to be a comprehensive summary of all legal and tax issues addressed in the New Regulations, it does provide guidance on some of its key concepts.

The New Regulations Provide Guidance Regarding Operating Businesses

Fifty-Percent Gross Income Limitation

In order for a business to qualify as an Qualified Opportunity Zone Business (“OZ Business”), at least 50% of its income must be derived from the active conduct of a trade or business within a Qualified Opportunity Zone (the “Zone”). The Initial Regulations did not provide guidance on how to determine this. Questions included whether rental of residential real estate qualifies as a trade or business, and whether a triple net lease of real estate constitutes an active trade or business.

The New Regulations clarify that “active conduct of a trade or business” includes “the ownership and operation (including leasing) of real property used in a trade or business.” However, the New Regulations expressly provide that “merely” entering into a triple-net lease does not constitute an “active conduct of a trade or business.”

In addition, for purposes of determining whether 50% of the gross income of the business is derived from the active conduct of a trade or business within the Zone, the New Regulations offer three (3) alternative safe harbors. A business will be considered to meet the gross income test if:

  • At least 50% of the services performed by its employees and independent contractors, based on hours, are performed within the Zone;
  • At least 50% of the amount paid for services is for services performed within the Zone; or
  • The tangible property and management and operational functions located in a Zone are each necessary to generate at least 50% of the business’ gross income.

If a business cannot satisfy these safe harbors, the New Regulations also provide that a business can still meet this requirement based on facts-and-circumstances.

Original Use Requirement

Under the Opportunity Zone statute, Qualified Opportunity Zone Business Property (“OZ Property”) is tangible property used in the business of the OZ Fund or OZ Business. OZ Property must be (i) acquired by purchase after 2017, (ii) the original use of the property in the Zone must commence with the OZ Fund or the OZ Business, or the OZ Fund must substantially improve the property, and (iii) during substantially all (i.e., 90%), of the property’s holding period, substantially all (i.e., 70%) the use of the property must be in the Zone. The New Regulations provide that “original use” commences on the date when that person: (a) places the property in service in the Zone for purposes of depreciation, or (b) uses the property in the Zone in a manner that would allow amortization or depreciation if that person were the property’s owner. Therefore, an OZ Fund could purchase a partially finished building, complete construction, and place it in service, and still satisfy the “original use” requirement, even if completion of construction did not constitute substantial improvement, as long as the building had never been depreciated. Used property will also qualify as long as it has not been used in the Zone previously in a manner that would have allowed it to be depreciated. Finally, the New Regulations provide that use of buildings which have been vacant for a period exceeding 5 years will satisfy the “original use” requirement.

Working Capital Safe Harbor

In order to qualify as an OZ Business, less than 5% of the property of the business can consist of “nonqualified financial property” (e.g., stock, partnership interests, options, warrants, other similar property, or cash in excess of “reasonable amounts of working capital”). The Initial Regulations provided a safe harbor that an amount of working capital is reasonable with respect to the acquisition, construction, or rehabilitation of tangible property if (1) the intended uses are designated in writing, (2) there is a reasonable written schedule for expenditure within 31 months, and (3) the working capital is actually used in a manner substantially consistent with the designated uses and written schedule. The New Regulations clarify that the safe harbor includes costs and expenses of developing a trade or business. Additionally, the safe harbor will still be satisfied if a delay beyond the 31 months occurs if that delay is attributable to government inaction.

New Regulations Provide Guidance Regarding OZ Funds:

Substantially All Requirements

The Opportunity Zone statute uses the term “substantially all” five times. In each case, the term was left undefined. The Initial Regulations addressed only one such instance (i.e., that the “substantially all” requirement with respect to an OZ Business is satisfied if at least 70% of its tangible property is held in the Zone). The New Regulations clarify the definition in all remaining instances and specify that references to (i) “substantially all” of a holding period means 90% of the holding period, and (ii) the requirement that “substantially all” of the use of the property be in a Zone means 70% of its use.

Compliance with the 90% Test

As noted in our prior alert, an OZ Fund must hold at least 90% of its assets in Qualified Opportunity Zone Property, which can be either: (A) OZ Property, or (B) stock in a corporation or an interest in a partnership which qualifies as an QZ Business. The 90% Test is assessed at the end of the first 6 month period and last day of each taxable year of the OZ Fund. We had hoped that Treasury would provide a grace period for deployment of new investments in the Initial Regulations. It did not. However, the New Regulations provide that an OZ Fund may choose to determine compliance with the 90% Test by excluding investments received within the 6 months before the testing date. The effect of this is that the OZ Fund will never have less than 6 months to deploy an investor’s capital. This should allay the concern that a significant capital contribution close to the testing date may cause the OZ Fund to fail the 90% Test because deployment was not feasible. 

Leased Property

The New Regulations provide that leased property can qualify as OZ Property if the lease is: (1) a “market rate lease,” (2) entered into after 2017, and (3) substantially all (i.e., 70%) the use of the leased property is in a Zone for substantially all (i.e., 90%) of its holding period. In addition, the lease can be between “related” parties, however, a couple of additional conditions will apply in such circumstance. The New Regulations also provide that neither the “substantial improvement” nor “original use” requirements apply to leased property. Finally, improvements made to leased property by a lessee will satisfy the “original use” requirement for the amount of the cost of the improvements.

Substantial Improvement of Raw Land

While the Initial Regulations and Rev. Rul. 2018-29 provided guidance regarding what constitutes “substantial improvement” of real property, they did not directly address raw land. The New Regulations provide comfort that, even though the raw land cannot satisfy the “original use” requirement, it is not required to be substantially improved. While this approach could lead to abuses (e.g., land banking), it appears unlikely based on (i) the fact that it must be used in an active business in the Zone (even if not “substantially improved”), and (ii) the anti-abuse rules contained in the New Regulations. 

Other Aspects:

Debt-Financed Distributions

The New Regulations provide that, subject to certain limitations, debt-financed distributions are permissible to the extent of the investor’s basis (increased through his or her share of debt) in the OZ Fund.

Taxation of Deferred Gain

Investors in an OZ Fund will be taxed on their deferred gain upon the occurrence of an “inclusion event.” In general, an “inclusion event” will occur any time a transaction reduces the investor’s equity in the OZ Fund (i.e., the investor is “cashing out” all or part of his or her investment). The New Regulations provide an expansive list of events that do and do not constitute “inclusion events.” For example, sales, taxable liquidations, gifts, and charitable contributions are “inclusion events” that trigger taxation, whereas transfers to grantor trusts, transfers at death, tax-free mergers, and spin-offs are not.

Sale of Assets

Under the Opportunity Zone statute, investors, in order to escape tax on gain on their OZ Fund investment (after 10-years), must sell their equity interest in the OZ Fund itself. The New Regulations provide that an investor who has held for 10-years can elect to exclude from gross income the capital gain passed through arising from a sale of assets by an OZ Fund. This provision solves a dilemma that had arisen regarding whether the OZ Fund could sell its assets or whether (as more clearly dictated in the Opportunity Zone statute), the investor needed to sell his or her interest. It is worth highlighting that if the pass-through entity sells its assets, as opposed to the investor selling his or her interest in the OZ Fund, only the capital gain is excludible, while ordinary income items (e.g., inventory, cash basis receivables, and assets subject to ordinary income depreciation recapture) arising from a sale of assets are fully taxable.


If an OZ Fund sells or disposes of assets, the OZ Fund has 12-months to reinvest those proceeds without violating the 90% Test. However, the gain recognized by the OZ Fund on the sale of those assets will be taxable at the time of sale.

Contribution of Property

In a surprise, the New Regulations permit the contribution of property, but not services, by an investor to an OZ Fund. Accordingly, carried interests in an OZ Fund will not be eligible for the tax benefits associated with an investment in an OZ Fund. The New Regulations provide extensive detail regarding contributions of property. Importantly, however, property acquired by the OZ Fund through such contribution would not constitute OZ Property because in order to be OZ Property, the property must be “purchased” by the OZ Fund and contributed property is not acquired by purchase. Accordingly, the benefit of contributing property seems questionable.

Holding Period upon Reinvestment of Proceeds.

Investors holding interests in an OZ Fund will receive greater tax benefits the longer they hold it (i.e., 5, 7, and 10-years). The Initial Regulations provided that investors could sell their OZ Fund interest and defer tax on the gain by reinvesting in another OZ Fund. The New Regulations make clear that if a taxpayer disposes of its investment in an OZ Fund and subsequently reinvests within 180 days, then their holding period does not tack, but rather restarts with their new investment. On a similar note, the New Regulations make it clear that the holding period for property contributed to the OZ Fund does not tack, but starts on the date of contribution.

To learn more about the New Regulations or this new tax saving opportunity, please contact James E. Duffy at (612) 977-8626 or, or Dimitrios C. Lalos at (612) 977-8830 or, or another member of our tax department. It is important to note that the foregoing summary is provided for general advice; but should not be considered legal advice that can be relied upon by any specific taxpayer without further consultation with their tax attorney or tax accountant.