IRS, Treasury Issue Second Set of Proposed Rules on Qualified Opportunity Zone Funds

April 19, 2019

The Internal Revenue Service (IRS) and the US Department of the Treasury (Treasury) issued the much-anticipated second set of proposed regulations (the Proposed Regulations) on April 17 regarding Qualified Opportunity Zone Funds (QOFs).[1] The Proposed Regulations answer many questions that had previously kept prospective investors in qualified opportunity zones on the sidelines. Below are our key takeaways from the Proposed Regulations and a summary of certain key provisions along with some initial observations on these new rules.

Key Takeaways:

  • Investors do not need to sell their QOF Interest in order to receive the benefit of the 10-year basis step-up
  • Investors can buy QOF interests in a secondary transaction (i.e., not directly from the QOF) and have the interest be eligible for the tax benefits under the QOF regime
  • An interest in a QOF that is issued for services (i.e., a carried interest) is not eligible for the tax benefits under the QOF regime
  • The rules do not appear to have provided relief for tiered-partnership investments (i.e., requiring direct investments in QOFs to be eligible for tax benefits)
  • QOFs now have additional flexibility with respect to satisfying their asset tests when it comes to newly contributed capital as well as with respect to reinvestments
  • The new rules make it substantially easier for QOFs to hold investments in operating businesses that should greatly expand the QOF regime beyond pure real estate development:
    • There are relaxed rules for Qualified Opportunity Zone Businesses (QOZBs) that lease property to treat such property as eligible holdings
    • There are three new safe-harbors for QOZBs looking to satisfy the 50% gross income requirement
  • The new rules confirm that renting real estate is considered an active trade or business eligible for inclusion in the QOF regime

Below is a summary and analysis of the key issues addressed by the Proposed Regulations.


Guidance provided on the meaning of substantially all

For purposes of determining whether property is eligible to be treated as Qualified Opportunity Zone Business Property (QOZBP), the Proposed Regulations provide that a QOF must hold such property at least 90% of the time to satisfy the “substantially all” requirement, and a similar 90% rule applies for purposes of a QOF’s interest in a QOZB. The rules also provide that at least 70% of the “use” of tangible property must be located in a QOZ.

Morgan Lewis Insight: These new rules provide welcome clarity on this “substantially all” requirement and are not surprising in light of the direction of the first set of regulations.

‘Original use’ of tangible property in a QOZ begins when that property is first placed into service in the QOZ for purposes of depreciation and amortization

The “original use” of tangible property acquired by purchase by any person begins on the date when that person or a prior person first places the property in service in the QOZ for purposes of depreciation or amortization (or first uses the property in the QOZ in a manner that would allow depreciation or amortization if that person were the property’s owner).

Used tangible property will satisfy the “original use” requirement with respect to a QOZ so long as the property has not been previously used (i.e., has not previously been used within that QOZ in a manner that would have allowed it to be depreciated or amortized) in the QOZ by any taxpayer.

Where a building or other structure has been vacant for at least five years prior to being purchased by a QOF or qualified opportunity zone business, the purchased building or structure will satisfy the original use requirement.

Morgan Lewis Insight: This new guidance will facilitate investors’ ability to improve vacant and underused property.

Improvements made by lessees to leased property may satisfy the ‘original use’ requirement

Improvements made by a lessee to leased property satisfy the “original use” requirement and are considered purchased property with respect to the amount invested in such improvements.

Morgan Lewis Insight: This is particularly helpful guidance for operating businesses, which may lease a substantial portion of their tangible assets.

Tangible property leased by a QOZB may qualify as QOZBP and need not satisfy the ‘original use’ or ‘substantial improvement’ requirement

So long as the lease is entered into after December 31, 2017, and 70% of the leased property’s use is within the QOZ during 90% of the time for which the business leases the property, the property qualifies as QOZBP regardless of whether it is leased, rather than purchased, by the QOZB.

Leased property also need not satisfy the “original use” or “substantial improvement” requirement. In addition, leased tangible property need not be acquired from an unrelated party. However, the tangible property must be leased at market rates, satisfy a new, general anti-abuse rule, and additional restrictions apply when the lessor and lessee are related.

Morgan Lewis Insight: The Proposed Regulations provide much-needed relief for operating businesses that expect to lease a substantial portion of their tangible property, such as services businesses and helpfully clarify that leased property qualifies as QOZBP regardless of whether such property is “purchased.” This should make it much easier for many types of businesses to qualify as QOZBs.

Guidance provided on how to value tangible property leased by a QOZB for purposes of the QOZ rules

Leased tangible property may be valued using either an applicable financial statement (within the meaning of Treas. Reg. §1.475(a)-4(h)) or an alternative method as provided in the Proposed Regulations. Under the alternative valuation method, the leased tangible property’s value is determined based on a calculation of its “present value,” or the sum of the present values of the payments to be made under the lease for such tangible property.

Morgan Lewis Insight: The guidance provides relief for businesses that may not maintain applicable financial statements in accordance with GAAP and should make it substantially easier for operating businesses that lease a significant portion of their assets to qualify as QOZBs.

Safe harbors and additional guidance is provided with respect to 50% gross income requirement

The Proposed Regulations provide three safe harbors with respect to the requirement that 50% of a QOZB’s gross income be derived from the active conduct of a trade or business in the QOZ. The 50% gross income test is satisfied if a QOZB meets any of the following safe harbors:

  • At least 50% of the services performed for the business, measured by hours, is performed within the QOZ
  • At least 50% of the services performed for the business, measured by amounts paid for such services, is performed in the QOZ
  • Both (a) the tangible property of the business that is in a QOZ, and (b) the management or operational functions performed for the business in the QOZ are necessary to generate 50% of the gross income of the trade or business

In addition, QOZBs not meeting the safe harbor may meet the 50% test by showing that based on all the facts and circumstances, at least 50% of the gross income of a trade or business is derived from the active conduct of a trade or business in the QOZ.

Morgan Lewis Insight: The safe harbors provide much-needed guidance for businesses looking for clarity on the 50% gross income test. The safe harbors particularly provide relief for businesses whose customers may primarily be located outside the QOZ and whose businesses generate revenue outside of the QOZ.

Guidance regarding the intangible property requirement

For purposes of the requirement that a substantial portion of the intangible property of a QOZB be used in the active conduct of a trade or business in the QOZ, a “substantial portion” is 40%.

Guidance on the meaning of ‘active conduct of a trade or business’ for purposes of the QOZ rules

A trade or business for purposes of the QOZ rules is a trade or business within the meaning of Section 162 of the Internal Revenue Code of 1986, as amended (the Code). In addition, the Proposed Regulations provide that the ownership and operation (including leasing) of real property used in a trade or business is treated as the active conduct of a trade or business.

Morgan Lewis Insight: While the Proposed Regulations do not provide a bright-line test for the active conduct of a trade or business, taxpayers have much more guidance now that the definition is tied to Section 162, as there is a large body of case law and guidance that has been promulgated under that section. Furthermore, guidance indicating the renting of real property is a trade or business is welcome clarity.

Working capital assets designated for development are now eligible for the safe harbor

The Proposed Regulations provide that qualified uses of working capital include the development of a trade or business in the QOZ as well as the acquisition, construction, and/or substantial improvement of tangible property.

Morgan Lewis Insight: This provides helpful relief for new and expanding operating business that need working capital to cover startup operating expenditures and takes the working capital safe-harbor beyond real estate development. This rule should facilitate investments into operating businesses. The Proposed Regulations, however, appear to still only apply to QOZBs and not to QOFs, which means that QOFs will continue to be incentivized to contribute assets to subsidiary entities rather than making direct investments in QOZBP.

The safe-harbor period is extended for disruptions beyond a business’s control

A business does not violate the working capital safe harbor if it exceeds the 31-month period due to delays in government action, the application for which is completed during the 31-month period.

Morgan Lewis Insight: This is a sensible provision that provides flexibility for companies that expect to satisfy the safe harbor, but for potential delays beyond their control. Such delays may be common in real estate and other industries due to delays in permitting and other government approvals.

Unimproved land may qualify as QOZBP

Land can be treated as QOZBP only if it is used in a trade or business of a QOF or QOZB. The holding of land for investment does not give rise to a trade or business and such land could not be QOZBP.

A new, general anti-abuse rule would treat the acquisition of the unimproved land as an acquisition of non-qualifying property if a significant purpose for acquiring such unimproved land was to achieve inappropriate tax results that do not result in the QOF investing any new capital in, or increasing any economic activity or output of, the land.

Morgan Lewis Insight: This result is unsurprising considering the legislative mandate to facilitate the development of communities within opportunity zones.

Real property that straddles a QOZ and a non-QOZ may be deemed fully located in the QOZ

If the real property located within the QOZ is substantial as compared to the amount of real property outside the QOZ (in each case based on square footage), and the real property outside the QOZ is contiguous to all or part of the real property in the QOZ, then all of the property is deemed located in the QOZ.

Morgan Lewis Insight: This guidance provides relief for prospective investors in properties that straddle multiple census tracts, some of which may not be located within a QOZ.


Tiered-partnership interests continue not to be an Eligible Investment (i.e., requiring a direct investment in a QOF)

In order for an investment to be treated as an “eligible investment,” the taxpayer must invest its capital gain into the QOF. This means that if the taxpayer invests in a partnership that then invests in a QOF, the taxpayer is not treated as making an eligible investment because they did not directly invest in a QOF. The Proposed Regulations do not appear to have provided relief as to this issue.

Morgan Lewis Insight: Investors had hoped that the Proposed Regulations would have provided relief such that an indirect investment in a partnership that then invests in a QOF would have treated the investment in the partnership as an eligible investment. Without relief on this point, additional structuring will be required to have all taxpayers seeking to receive the tax benefits of the QOZ program make direct investments in QOFs. Structuring of QOFs to fit within these parameters will not accommodate traditional market practices (e.g., feeder funds) and will introduce new legal complexities in the overall structuring of QOFs.

The 180-day window for investing capital gain income from Section 1231 property in a QOF begins on the last day of the taxable year

Morgan Lewis Insight: Since Section 1231 gains are required to be netted with Section 1231 losses to determine the amount, if any, of capital gains a taxpayer has, this guidance alleviates the uncertainty for investors with potential Section 1231 gains, as such income is only determinable as of the last day of the taxable year.

A QOF has 12 months to reinvest proceeds from the sale of QOZ stock, QOZ partnership interests, and QOZBP

So long as the QOF reinvests the proceeds received by the QOF from a sale of QOZ stock, QOZ partnership interests, and QOZBP within 12 months, such proceeds will qualify as QOZ property for purposes of the 90% investment requirement.

Morgan Lewis Insight: Since QOFs will need time to analyze, evaluate, and underwrite potential investments, the 12-month period provides much-needed relief for QOFs that have a return of capital, but are otherwise not prepared to invest in new projects. The IRS acknowledged, however, the recognition of such gains by a QOF and the reinvestment of the proceeds will not, under the current statutory framework, prevent investors in a QOF taxed as a partnership from recognizing their deferred gain that could be allocated to such investors.

Benefits for transferred QOF interests

If a taxpayer acquires a direct investment in a QOF from a direct owner of the QOF, for purposes of making an election under Section 1400Z-2(a), the taxpayer is treated as making an investment in an amount equal to the amount paid for the eligible interest.

Morgan Lewis Insight: This rule effectively facilitates a secondary market for interests in QOFs because secondary purchasers are now eligible to treat their purchase as an eligible investment as if they had contributed the purchase proceeds directly to the QOF rather than the seller of the QOF interest. This new rule is sensible and should provide liquidity to the extent an original holder needs to prematurely sell their interest in a QOF.

Deferred gain recognized upon any disposition (not just sales or exchanges). In addition, deferred gain may be subject to an inclusion event whenever a transaction constitutes a ‘cashing out’ of the QOF investor’s qualifying investment

Subject to a number of exceptions, the Proposed Regulations clarify that the deferred gain is subject to inclusion to the extent that a transfer of a qualifying investment in a transaction reduces the taxpayer’s equity interest in the qualifying investment.

Morgan Lewis Insight: A taxpayer’s inclusion of deferred gain may thus be triggered by gifts, bequests, devises, charitable contributions, etc., of their QOF interest. It also means that whenever a taxpayer receives property (generally, money, securities, or any other property) from a QOF in a distribution for tax purposes the taxpayer triggers the deferred gain. This means that there are now many additional situations in which taxpayers need to carefully consider whether they are prematurely triggering the recognition of their deferred gain.

No tacking of holding periods for interests in QOFs

If an investor disposes of its entire qualifying investment in QOF 1 and reinvests in QOF 2 within 180 days, the investor’s holding period for its qualifying investment in QOF 2 begins on the date of its qualifying investment in QOF 2, not on the date of its qualifying investment in QOF 1.

Morgan Lewis Insight:In light of the way in which the statute is drafted, it is not necessarily a surprising result that investors cannot tack their holding periods from one QOF investment to another; however, there had been hopes that the IRS and Treasury would have provided a more taxpayer favorable answer to this tacking issue.

Adjustments of basis resulting from the 10-year rule are taken into account immediately before the disposition of the qualifying investment

For dispositions of qualifying QOF partnership interests, the bases of the QOF partnership’s assets are also adjusted with respect to the transferred qualifying QOF partnership interest. Such adjustments are calculated similarly to those made pursuant to a Section 754 election.

Morgan Lewis Insight: This will permit basis adjustments to the QOF partnership’s assets, and avoid the creation of capital losses and ordinary income upon sale because QOF partnerships will be able to adjust the basis of their assets, including its inventory and unrealized receivables.

Partnership mixed-funds investments treated as unitary interest for Subchapter K

A partner holding a mixed-funds investment is treated as holding a single partnership interest with a single basis and capital account for all purposes of Subchapter K. However, the mixed-funds investment is still treated as separate interests for purposes of Section 1400Z-2.

Morgan Lewis Insight: This bifurcated approach with respect to partnership interests can create some unique situations. For example, whereby an investor may not recognize gain from a debt financed distribution, but for purposes of QOF rules, may be required to treat the distribution as triggering the investor’s deferred gain. The Proposed Regulations provide a simple example demonstrating how this bifurcation approach will work.

Investors in QOF partnerships and S corporations that have held their interests for at least 10 years won’t recognize gain on the QOF’s disposition of QOZ property and QOF REITs can pay tax-free capital gain dividends to investors of 10 years or more

Provided that the investor has held its QOF interest for 10 years, an investor in a QOF partnership or QOF S corporation that has disposed of “qualified opportunity zone property” may elect to exclude from its gross income some or all of the capital gain generated by such disposition. In addition, a QOF REIT may designate capital gain dividends (not to exceed its long-term gains on sales of QOZ property), which are tax-free to shareholders who could have made an election to increase basis in case of a sale of the QOF REIT shares (i.e., an investor who has held its interest for 10 years or longer.)

Morgan Lewis Insight: This is perhaps the most important clarification in the Proposed Regulations because without this much-needed clarification, investors would have been required to sell their interests in QOFs in order to be eligible for the 10-year basis step-up tax benefit. Now QOFs can sell assets after 10 years and investors do not need to sell their interest in order to receive the basis step-up. It appears investors will still need to sell their interest in a QOF in order to receive the step-up in basis attributable to appreciation of any non-“qualified opportunity zone property” held in the QOF. 

QOF stock is not ‘stock’ for purposes of determining affiliation

A QOF C corporation can be the common parent of a consolidated group, but it cannot be a subsidiary member of a consolidated group. Thus, a QOF C corporation that is owned by members of a consolidated group is not a member of that consolidated group.

Morgan Lewis Insight: Consequently, all issues related to consolidated return stock basis adjustments and excess loss accounts are rendered moot.

The IRS may recast an abusive transaction

The Proposed Regulations adopted a broad anti-abuse rule, which provides that the IRS commissioner can recast a transaction (or series of transactions) for federal tax purposes, if a significant purpose of a transaction is to achieve a tax result that is inconsistent with the purposes the QOF rules.

Morgan Lewis Insight: The anti-abuse rule is quite broad and can seemingly encompass any transaction that is not clearly sanctioned by the rules. While the Proposed Regulations provided investors with certainty in many areas, this broad rule must be considered when structuring investments that do not fit squarely within the spirit of the rules.

QOFs may be established in Indian tribal territories

The Proposed Regulations provide that an entity eligible to be a QOF includes an entity organized under the law of a federally recognized Indian tribe, provided that the entity’s domicile is located in one of the 50 states.

Forthcoming Guidance

The Treasury and IRS announced that they expect to address the administrative rules under Section 1400Z-2(f) of the Code applicable for a QOF that fails to maintain the required 90% investment standard, as well as information-reporting requirements for an eligible taxpayer in separate regulations. Treasury and IRS also anticipate revising Form 8996.

Additional Morgan Lewis Resources

Please contact our team with all comments and questions regarding the regulations, and stay tuned for a forthcoming webinar in which we will further discuss the observations and takeaways from the newest set of proposed regulations. Webinar details will be posted on our Opportunity Zone Funds resource page soon, and please visit the page to access Qualified Opportunity Zone-related publications, news items, programs, and more.

Dan Nelson

New York
Richard Zarin 

San Francisco
Sarah-Jane Morin

Washington, DC
Richard C. LaFalce
Bill McKee

[1] See our prior coverage on QOFs and the first set of regulations as well as our dedicated webpage with resources for QOFs.