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Treasury Releases Final Regulations Implementing Qualified Opportunity Zones

AOL - US Tax Controversy And Lit

Treasury and the IRS recently issued final regulations (the “Final Regulations”) providing additional guidance on the implementation of the Qualified Opportunity Zone (“QOZ”) provisions of the Tax Cuts and Jobs Act, as well as Frequently Asked Questions on QOZs. In prior client alerts which can be found here and here, we highlighted tax implications for investors and sponsors of the QOZ proposed regulations (the “Proposed Regulations”). The Final Regulations clarify some important items where the Proposed Regulations were silent or ambiguous, and provide increased flexibility to investors. While not taxpayer-favorable across the board, on balance the Final Regulations should provide investors more certainty and confidence in structuring their QOZ investments.

This alert is not intended to be a comprehensive summary of the 500-plus-page Final Regulations package. For more information about Qualified Opportunity Zones, please contact one of the V&E attorneys listed at the end of this alert.


As discussed in our prior alerts, the QOZ provisions provide investors with the following tax benefits:

  • Temporary Deferral: eligible gains rolled into qualified opportunity funds (“QOFs”) are deferred until the earlier of December 31, 2026 or the date on which the investment in the QOF is transferred.
  • Elimination of up to 15% of deferred gain subject to tax: eligible gains invested in a QOF benefit from a basis increase of 10% of the deferred gain after 5 years and 5% of the deferred gain after 7 years, for a total potential 15% increase in basis.
  • Exclusion of gain on post-acquisition appreciation: if an investment in a QOF is held for at least 10 years, the taxpayer recognizes no gain on the post-acquisition appreciation in its QOF interest.
  1. Eligibility of 1231 Gains for QOF Investment.
    1. Section 1231 Gains Eligible For Investment on Gross Basis. The Final Regulations change the approach from the Proposed Regulations and now allow taxpayers to invest as eligible gains their gross section 1231 gains unreduced by section 1231 losses. This favorable change in the Final Regulations will allow taxpayers to reinvest gross section 1231 gains in a QOF immediately upon the sale of 1231 property. Under the prior approach, taxpayers had to wait until the conclusion of the taxable year to determine whether they had net section 1231 gains to invest. Accordingly, the Final Regulations start the 180-day investment clock on the date of the sale or exchange that triggers the section 1231 gain.
  2. Exclusion of Gain from Post-Acquisition Appreciation on QOZ Property1 Sold by QOF or QOZ Entity. The Proposed Regulations provided that, if an investment in a QOF is held for at least 10 years, the taxpayer recognizes no gain on the post-acquisition appreciation upon the sale by a QOF of QOZ Property. However, the Proposed Regulations were silent as to the treatment of gains received by a QOF from sales of QOZ Property from a lower-tier QOZ Entity, such as a QOZ partnership. The Final Regulations clarify that investors with a 10-year hold can elect gain exclusion for any gain allocated to them from the sale or property by either a QOF or a QOZ Entity. This helpful change will now allow assets to be sold separately in future exit transactions, rather than requiring that they be sold in bulk, providing QOFs, and in particular pooled QOFs, with greater flexibility.
  3. 180-Day Investment Clock.
    1. Partnerships. Under the Proposed Regulations, a partner in a partnership could choose to begin the 180-day investment period on either (a) the date the partnership in question sold property giving rise to the gain, or (b) on the last day of the investor’s taxable year. The Final Regulations provide taxpayers with a third option, to begin the 180-day period on the due date of the partnership’s tax return (not including extensions).
    2. REITs and RICs. The Final Regulations provide that the 180-day investment period for REIT and RIC capital gain dividends begins upon the closing of the investor’s taxable year in which the capital gain dividend would be recognized, or, if elected, on the date that the capital gain dividend is paid.
    3. Installment Sales. The Final Regulations allow taxpayers with gains from installment sales to begin the 180-day period either (a) on the date a payment under the installment note is received, or (b) the last day of the year in which gain under the installment method would be recognized.
  4. Gains from Sales to a QOF or QOZ Entity. In response to comments from certain commentators, the preamble to the Final Regulations contains language indicating that step-transaction and circular cash flow principles may apply to prevent a taxpayer from selling property to a QOF or QOZ Entity and reinvesting the cash from such sale into the QOF or QOZ Entity, even if such QOF or QOZ Entity is unrelated under the related-party rules. In such a scenario, the Final Regulations suggest that reinvested gain from such a transaction may not be a qualifying investment and that the property acquired by the QOF or QOZ Entity will not be QOZ Business Property. The inclusion of this language in the Final Regulations is an unwelcome development, as many sponsors and QOFs had previously assumed that the related-party rules were the relevant guardrails to protect against abuse. Consequently, any transaction in which a seller of property to a QOF or QOZ Entity also invests in the QOF will need to be carefully planned and scrutinized.
  5. Additional Inclusion Events. The Final Regulations provide several new inclusion events for deferred gain with respect to QOF interests, including:
    • Loss of QOF’s status as a QOF (either voluntary or involuntary);
    • Transfers incident to divorce; and
    • Change in entity classification of a QOF by virtue of the “check-the-box” rules. Importantly, Treasury’s conclusion that the loss of QOF status is an inclusion event confirms that taxpayers will suffer the consequences of a QOF’s disqualification.
  6. Reinvestment of Gain from Inclusion Events. The Final Regulations provide that, if a taxpayer has an inclusion event causing it to recognize deferred gain prior to the end of 2026, that taxpayer may reinvest the gain as eligible gain in a QOF. However, in such instances the holding period in the QOF into which such gain is reinvested will start anew.
  7. Tax Rate Upon Inclusion. The Final Regulations clarify that gain recognized upon an inclusion event is subject to tax at the federal tax rates in effect for the year of the inclusion event, not the year of the original deferral. Consequently, taxpayers will need to plan for (potentially higher) future federal income tax rates when considering future inclusion events with respect to deferred gain.
  8. Impact of Inclusion Events on 10-Year Basis Step Up. The Final Regulations provide a taxpayer is generally not eligible to make the 10-year basis step-up election for a QOF interest with respect to which there has been an inclusion event. Specifically, inclusion events result in the reduction or termination of an investor’s ability to elect the 10-year basis step-up to the extent of the reduction or termination caused by the inclusion event. The Final Regulations do provide, however, that inclusion events from partnership or corporate distributions in excess of tax basis do not prevent a taxpayer from making the 10-year basis step up election provided that the taxpayer continues to hold the QOF interest.
  9. No Basis Step-Up Upon Death. The Final Regulations provide that if an interest in a QOF is transferred by reason of death, the rules of Code section 1014 (which generally provides a fair market value tax basis as of the decedent’s death) do not apply. However, the QOF interest remains a qualifying investment in the hands of the beneficiary.
  10. Gain Recognized by Foreigners and Tax-Exempts.
    1. Gain Recognized by Foreigners. The Final Regulations provide that FIRPTA gains and other capital gains effectively connected to a U.S. trade or business are eligible gains under the QOZ rules, but only if the foreigner in question waives treaty benefits limiting the tax on such gains.
    2. Gain Recognized by Tax-Exempts. The Final Regulations provide that capital gains recognized by tax-exempt entities constitute eligible gains to the extent such gains would otherwise be treated as UBTI.
  11. Built-in Gain Recognized by REITs. The Final Regulations confirm that Code section 1374 built-in gains recognized by a REIT are eligible gains that may be deferred under the QOZ rules.
  12. REIT E&P Issues. Unfortunately, Treasury did not accept NAREIT’s request to modify the rules for REIT earnings & profits (“E&P”) purposes such that a REIT’s distribution of gain from the sale of an investment in a QOF would not result in ordinary income to a REIT’s shareholders. Specifically, tax-free gain at the end of a 10-year hold, as well as the 5- and 7-year basis step-ups on deferred gain, increase the REIT’s E&P, which, holding other factors equal, increases the amount of a REIT’s dividends that are taxable at ordinary rates (subject to the Code Section 199A deduction) in the hands of shareholders.
  13. FIRPTA Withholding. In response to requests from commenters for guidance on FIRPTA withholding as it relates to the QOZ rules, Treasury reserved the topic for further study and consideration.
  14. Clarifications Regarding Basis-Step Ups for QOF Partnerships.
    1. 5-Year and 7-Year Basis Step-Up for QOF Partnerships. The Final Regulations provide that the basis step-ups for QOF partnership are treated as basis step-ups for all federal income tax purposes, including with respect to the use of suspended losses.
    2. 10-Year FMV Basis Step-Up for QOF Partnerships. The Final Regulations provide that with respect to a QOF partnership, the 10-year FMV basis step up will be an amount equal to the fair market value of the interest, plus the partner’s share of the partnership’s debt under section 752 principles.
  15. Specific Identification of Disposed Interests in a QOF. The Proposed Regulations provided for the use of first-in, first-out or pro rata methods with respect to identification of disposed interests in a QOF. The Final Regulations adopt a taxpayer-favorable rule allowing for specific identification of a disposed interest in a QOF for corporate QOFs only (which includes REITs and RICs).


The QOZ rules provide that a QOF must hold at least 90% of its assets in QOZ Property, which includes both QOZ Business Property and QOZ Entities. Generally, for property to be QOZ Business Property, the property must satisfy either the “substantial improvement” or the “original use” test, and must be acquired by purchase from an unrelated person, or by lease. QOZ Business Property must also be used in a trade or business within a QOZ. Finally the QOZ Business Property must comprise 70% of the tangible assets of a QOZ Entity in order for the QOZ Entity to constitute QOZ Property. The Final Regulations make several updates to these rules.

  1. Substantial Improvement. As discussed in our prior alerts, QOZ Business Property is property with respect to which either (a) the original use in the QOZ commences with the QOF or (b) “substantial improvements” are made by the QOF. The Final Regulations provide further clarity on the “substantial improvement” requirement.
    1. Aggregation. The Proposed Regulations required that the “substantial improvement” test be viewed on an asset-by-asset basis. In response to comments, the Final Regulations provide greater flexibility.
      • The Final Regulations allow for a group of buildings to be treated as a single property for purposes of substantial improvement if:
        • each building in a building group is located entirely within the geographic borders of a parcel of land described in a single deed; or
        • the buildings in a building group are located entirely within the geographic borders of contiguous parcels of land described in separate deeds if each building is operated as part of one or more trades or businesses that:
          • are operated exclusively by the eligible entity (i.e., the QOF or QOZ partnership);
          • share facilities or significant centralized business elements, such as personnel, accounting, legal, manufacturing, purchasing, HR, or IT resources; and
          • are operated in coordination with, or reliance on, one or more of the trades or businesses.
      • The Final Regulations also allow for purchased tangible property (which would otherwise be original use property) to be treated as part of an asset’s improvements for purposes of the substantial improvement test, provided that the original use property:
        • Is used in the same trade or business in the QOZ (or a contiguous QOZ) in which the non-original use asset is used; and
        • Improves the functionality of the non-original use asset in the same QOZ (or a contiguous QOZ).

        The Final Regulations contain an example illustrating this approach: if a QOF purchases and intends to substantially improve a hotel, the QOF may include “original use” purchased assets in the basis of the purchased hotel to meet the substantial improvement requirement if those assets are integrally linked to the functionality of the hotel business. For example, such assets could include mattresses, linens, furniture, etc. But an unrelated asset to the hotel business, such as an apartment building, that is operated in a separate trade or business of the QOF cannot be aggregated under this rule.

    2. Land. The Final Regulations retain the rules from the Proposed Regulations specifying that land is not required to be substantially improved, but must be improved by a “more than insubstantial amount,” which Treasury declined to define in the Final Regulations.
    3. Treatment of Assets During Substantial Improvement Period. The Final Regulations provide a helpful safe harbor stating that, so long as property is expected to meet the substantial improvement test at the end of the relevant 30-month period, the property in question may be treated as QOZ Business Property even if the basis in the property has yet to be doubled.
  2. Original Use. The Final Regulations provide further clarity on the “original use” requirement in several areas.
    1. Vacant Property. The Proposed Regulations provided that vacant property could qualify as original use property if it had been vacant for 5 years. The Final Regulations make several helpful changes in this respect. First, the 5-year period from the Proposed Regulations has been reduced to 3 years. Second, if a particular property was already vacant at the time when the QOZ was designated, it need only be vacant for one year to qualify as original use property. Third, the Final Regulations clarify that a property will be considered “vacant” if more than 80% of the square footage is unused. Finally, the Final Regulations state that real property purchased from a local government that such government holds as a result of an involuntary transfer can satisfy the original use requirement in its entirety.
    2. New Construction. The Final Regulations clarify that, if a newly constructed building is purchased prior to being placed in service, it will meet the original use requirement. For this purpose, “placed in service” is tied to the date when depreciation starts for tax purposes.
    3. Brownfield Sites. The Final Regulations contain a new provision providing that Brownfield sites can qualify as original use property. Brownfield sites comprise real property, the expansion, redevelopment, or reuse of which may be complicated by the presence or potential presence of a hazardous substance, pollutant, or contaminant, within the meaning of CERCLA. Specifically, Brownfield sites can qualify as original use property provided the QOF makes investments in the Brownfield site that ensures that all property composing the site meets basic safety standards for human health and environment.
  3. Self-Constructed Property. The Final Regulations confirm that self-constructed property may qualify as QOZ Business Property despite not being “purchased” from an unrelated party. Specifically, construction on the self-constructed property must begin after December 31, 2017 and the materials and supplies used in the construction must themselves meet the purchase requirement. The Final Regulations treat self-constructed property as acquired on the date that “significant physical work” begins. The Final Regulations also include a safe harbor for this purpose under which a QOF can elect to make the acquisition date the date on which more than 10% of the cost of the property is paid or incurred, exclusive of the cost of land and preliminary activities.
  4. Leased Property.
    1. Leased Property as QOZ Business Property. The Proposed Regulations provided that leased property may qualify as QOZ Business Property, if, among other requirements, the terms of the lease were market-rate at the time the lease was entered into. The Final Regulations provide that (1) leases between unrelated parties are presumed to be market-rate leases, and (2) properties leased from state and local governments or Indian tribal governments are exempt from the requirement that the lease be a market-rate lease. The relaxing of the rules with respect to state and local governments will make it easier for those governments to incentivize business in their QOZs.
    2. Triple Net Leases. The Final Regulations retained the concept from the Proposed Regulations that leasing a building pursuant to a triple net lease does not constitute a trade or business for purposes of the definition of a QOZ Business. However, the Final Regulations do provide a helpful example in which a taxpayer is considered to be engaged in a trade or business in a scenario under which it leases the three separate floors of a single building to three different tenants, one pursuant to a triple-net lease and the other two pursuant to non-triple net leases in which the employees of the lessor meaningfully participated in the management and operation of the two floors.
  5. Working Capital Safe Harbor. As discussed in our prior alerts, a QOZ Entity may benefit from a safe harbor during which working capital will be a qualifying asset so long as certain recordkeeping requirements are met.
    1. 62-Month Total for Multiple Working Capital Safe Harbors. The Proposed Regulations provided that the 31-month working capital safe harbor applies serially. In other words, new cash can benefit separately from the 31-month safe harbor. The Final Regulations retain these rules but provide that the total time that the working capital safe harbor can be applied is limited to 62 months from the initial capital infusion.
    2. 50% Trade or Business Gross Income Test. A QOZ Entity must derive a minimum of 50% of its total gross income from the active conduct of a trade or business in the QOZ. The Final Regulations helpfully provide that income from working capital covered by the working capital safe harbor is qualifying income for purposes of the 50% gross income test.
    3. Tangible Property Test. As described in our prior client alerts, at least 70% of a QOZ Entity’s tangible property must be QOZ Business Property. The Final Regulations provide that working capital that is to be spent on the acquisition, construction, or improvement of QOZ Business Property is treated as a qualifying asset for purposes of the tangible property test.
    4. Federally Declared Disaster Areas. For a QOZ Entity located in a federally declared disaster area, the working capital safe harbor period may be extended up to an additional 24 months, if the working capital is ultimately invested as planned.
  6. Straddle Rules. The Final Regulations provide that real property that is “substantially located” within a QOZ is QOZ Business Property. Specifically, real property that straddles a QOZ and a non-QOZ is considered to be “substantially located” within a QOZ if the portion of the property within the QOZ is greater than the portion located outside the QOZ. An entity may elect to use square footage or cost basis for purposes of making this determination.
  7. Leasing Property to Sin Business. The Final Regulations allow for a QOZ Entity to lease no more than 5% of its real property to a “sin business.”
  8. Mergers.
    1. QOF Mergers. The Final Regulations allow for a QOF Partnership to merge with another QOF Partnership without causing an inclusion event for investors, provided no other distributions are made in respect of the merger. Further, the rules from the Proposed Regulations which excepted tax-free reorganizations of QOFs structured as corporations (including REITs and RICs) in which no boot is received were retained in the Final Regulations.
    2. QOZ Entity Mergers. The Final Regulations similarly also allow QOZ Entities structured as partnerships and corporations to merge without causing an inclusion event, subject to the same rules as the preceding paragraph.
  9. QOZ Entity 90% Holding Period Test. The Proposed Regulations provided that a QOF’s ownership in a QOZ Entity is a qualifying asset for the 90% Asset Test only if the QOZ Entity qualifies as a QOZ business for at least 90% of the QOF’s holding period in the entity. The Final Regulations provide that the 90% holding period is tested semi-annually, based on the cumulative amount of time the QOF has held the QOZ Entity. The Final Regulations also contain a special rule allowing the QOF to measure compliance with the holding period test on the June 30th testing date by looking to the holding period as if it ended at the end of the QOZ Entity’s prior taxable year.
  10. One-Time Cure. The Final Regulations provide a one-time cure if a QOZ Entity owned by a QOF does not qualify as a QOZ business. Specifically, the Final Regulations adopt a 6-month cure period pursuant to which, if a QOZ Entity is not a QOZ business on a particular testing date, the QOF may nevertheless treat such QOZ Entity as a QOZ business as long as the failure is cured within 6 months.
  11. QOF Decertification.
    1. Voluntary Decertification. The Final Regulations contain provisions allowing a QOF to self-decertify effective the month following the month specified by the QOF. As previously noted, a QOF Decertification constitutes an inclusion event for investors in the QOF.
    2. Involuntary Decertification. Although the Proposed Regulations broached the topic of involuntary decertification, Treasury punted and reserved this as an area for future guidance in the Final Regulations.


The Final Regulations will not be in effect until January 1, 2021. However, taxpayers may rely upon them currently provided they are applied consistently within each section (i.e., no cherry-picking). Alternatively, taxpayers may continue to rely on the Proposed Regulations until 2021, again provided that they are relied upon consistently within each section.

Visit our website to learn more about V&E’s Transactional Tax and REITs practices. For more information, please contact Vinson & Elkins lawyers Chris Mangin, George Gerachis, Jim Meyer, Joe Garcia, David Peck, Debra Duncan, or Paige Anderson.

Join V&E lawyers for “REITs: IRS Ruling Opens Door for Midstream Assets” on February 12. To read more or register, click here.

1 As indicated in our prior client alerts, QOZ Property includes (a) QOZ partnership interests or corporate stock (a “QOZ Entity”) and (b) QOZ trade or business property (“QOZ Business Property”).


This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.