skip to main content

April 19, 2019

Stroock Special Bulletin

On April 17, 2019, the Treasury Department and the Internal Revenue Service (the “IRS”) released the second set of proposed regulations[1] (the “New Proposed Regulations”), which provide guidance on a number of uncertain aspects of the Qualified Opportunity Zone (“QOZ”) provisions added as Sections 1400Z-1 and 1400Z-2 of the Internal Revenue Code (the “QOZ Statute”) by the tax reform legislation enacted in December 2017. An initial set of proposed regulations[2] was issued in October 2018 (the “Original Proposed Regulations”) along with a Revenue Ruling[3] (such Original Proposed Regulations and Revenue Ruling, together with the QOZ Statute and the New Proposed Regulations, the “QOZ Rules”), which provided helpful guidance but left significant unaddressed issues

Among the major open items for which further guidance has been requested[4] are (i) whether partnership debt provides tax basis enabling distributions in light of the QOZ Statute’s “zero basis rule,” (ii) whether and how vacant land may qualify as QOZ Business Property, (iii) interpretation of the “original use” requirement under the QOZ Statute (for which the Original Proposed Regulations promised further guidance), (iv) certain aspects and mechanics of the “working capital” safe harbor added by the Original Proposed Regulations, and (v) the structuring of a disposition of a QOZ investment, specifically whether assets in a Qualified Opportunity Fund (“QOF”) or Qualified Opportunity Zone Business (“QOZB”) may be sold directly (as opposed to a sale by an investor of the interest in the QOF).

The New Proposed Regulations address some but not all of these (and other important) questions. The IRS has indicated that it will consider comments to the New Proposed Regulations, but does not necessarily intend to provide any further sets of regulations.

We are preparing a more detailed bulletin to provide further analysis of the New Proposed Regulations, but want to highlight some of the key aspects in this Stroock Special Bulletin.

What’s Addressed:

Treatment of Partnership Liabilities & Permissibility of Distributions

The New Proposed Regulations provide important clarification surrounding the interaction between the “zero basis rule” and the partnership taxation rules of Subchapter K of the Internal Revenue Code. The QOZ Statute provides that an investor that elects to “roll over” gains into a QOF will have a tax basis in the QOF interest of zero; under general partnership taxation principles, however, partners generally receive tax basis for their share of partnership debt.

The New Proposed Regulations address this interaction by providing that a taxpayer’s initial basis in a QOF partnership will be increased by the taxpayer’s share of partnership indebtedness. As a result, investors in a QOF taxed as a partnership will, subject to general partnership taxation rules, be able to receive certain debt-financed distributions without incurring present tax or any deemed disposition of their QOZ investments. This will no doubt be a relief for many investors in QOFs owning real estate joint ventures, in which the ability to refinance and distribute proceeds is an important strategy. This provision may additionally allow a QOF partnership to provide liquidity for investors to pay the tax on their deferred gains at or prior to the end of 2026 without incurring additional tax on the distribution of the proceeds to pay such tax.

Because of differences in their tax treatment generally, the New Proposed Regulations do not provide similar leniency for QOFs that are treated as corporations or REITs. For these entities, as a general matter, any distributions (including distributions of refinancing proceeds prior to January 1, 2027) that are not treated as dividends (e.g., if the corporation has insufficient earnings and profits) will result in the inclusion of all or a portion of the investor’s deferred gain and be treated as a constructive disposition of the investor’s QOZ investment.

Master Funds

Under the QOZ Statute and the Original Proposed Regulations, investors were required to dispose of their interests in the QOF directly in order to receive the QOZ benefits, effectively preventing the QOF or QOZ Business (“QOZB”) from selling its assets. As a result, an investor in a QOF with multiple assets would not be able to recognize the tax benefits of the QOZ provisions with respect to the direct sale of one or more assets by the QOF.

The New Proposed Regulations permit the QOZ benefits to apply to a sale by the QOF (or possibly the QOZB) of its assets so that QOFs can potentially own multiple assets while still maintaining a tax-efficient exit strategy for its investors with respect to any specific asset. Similarly, a REIT QOF may sell an individual asset and make a capital gain dividend of the proceeds to enable an investor in the QOF to obtain the QOZ benefits (specifically, the basis increase) with respect to that asset. These provisions may effectively permit QOFs to be structured in a manner similar to a typical “master fund,” where multiple investments are owned by a single fund entity, but can be disposed of individually (although such structuring may remain subject to potential “tiering” and other restrictions applicable specifically to QOFs).

QOF Asset Test Flexibility

One perhaps less conspicuous but very significant provision in the New Proposed Regulations provides that a QOF may exclude, in calculating its compliance with the 90% asset test, amounts received in the last six months provided those amounts have been kept in cash or certain short-term debt instruments. This may provide QOFs greater flexibility in accelerating the receipt of capital contributions from new investors, particularly where the timing of such investments may be influenced by the investors’ 180-day period. In addition to providing QOFs with more time to determine a deployment strategy for the invested cash, the new provision may also reduce pressure on QOZBs to immediately devise working capital schedules.

Relatedly, a QOF that sells one or more assets may hold the proceeds, as cash or certain short-term debt instruments, for up to a year without such assets causing it to violate the 90% asset test. This gives QOFs that sell assets (but do not wish to distribute the proceeds) a significant period of time in which to redeploy the sale proceeds into qualifying assets.

QOZ Business Income

The New Proposed Regulations contain many provisions focused on the ability of manufacturing, service, technology-related and other operating businesses to meet the QOZ requirements, including safe harbors for the treatment and amount of business assets or business income which must be connected to the QOZ. Many were concerned, for example, that conducting a business in a QOZ but selling to customers outside the QOZ would fail to qualify. The provisions in the New Proposed Regulations should provide some useful guidelines for making these determinations.

Similarly, the New Proposed Regulations provide additional flexibility to the working capital safe harbor, most notably the ability for a written working capital schedule to provide for expenditures for broader costs of business operation, rather than only for the acquisition of qualifying QOZ Business Property. The safe harbor is also not violated if the 31-month period is exceeded as a result of delays in receiving governmental approvals.

Other Items

Other items addressed by the New Proposed Regulations include the following:

  • Buying a QOF Interest. The New Proposed Regulations provide that an investor may purchase an interest in a QOF from an owner of the QOF (for example, purchasing a partnership interest from a partner in the QOF), rather than investing directly into the QOF by contribution, and treat that as an investment in the QOF eligible for QOZ benefits.
  • “Substantially all” requirements for QOZ Business Property. In addition to the requirement by which a QOZB must have 70% of its tangible property qualify, the IRS clarified that for property to qualify, 70% of the property’s use must be in the QOZ, and this must be the case for 90% of the period in which the QOZB held the property.
  • Land. Vacant land, if acquired by purchase, does not need to be substantially improved in order to be a qualifying asset. The New Proposed Regulations provide that the land merely must be used in the QOF’s or QOZB’s trade or business, although the IRS indicated that it would scrutinize such purported use and intended to prevent potential “land banking” through the anti-abuse rules. We note, however, that the New Proposed Regulations do not include provisions addressing the treatment of vacant land which is contributed to (rather than purchased by) a QOF or QOZB from an existing owner.
  • Original Use. The New Proposed Regulations provide certain additional guidance on the “original use” requirements, including permitting unused, abandoned or vacant property to qualify for a new original use if it has been unused for a period of five years or more.
  • Leases. The New Proposed Regulations contain a number of provisions addressing the treatment of property leased by QOZBs, including safe harbors and valuation methodologies.
  • Trade or Business. In general, the New Proposed Regulations refer to the Internal Revenue Code Section 162 provisions to determine whether an activity qualifies as a trade or business for purpose of the QOZ rules. It should be noted that the New Proposed Regulations allow ownership and operation of real property, including leasing, to qualify, but contain a specific provision disqualifying as a trade or business a (single) triple-net lease. It remains unclear whether (i) a single, non-triple-net lease or (ii) multiple triple-net leases would be permissible as the sole business activity of a QOZB.
  • Mixed Investments. The New Proposed Regulations contain additional guidance on the treatment of investments in a QOF where part of an investor’s investment in the QOF consists of qualifying deferred gain and part does not.
  • Gifts and Bequests. The New Proposed Regulations provide that, in general, gifts (other than to a grantor trust) will be treated as a disposition of the QOZ investment triggering inclusion of the deferred gain in income, but a bequest upon death permits the transferee to step into the transferor’s shoes and continue to hold the QOZ investment as if the transferee were the original investor.

[1] REG-120186-18.

[2] REG-115420-18.

[3] Rev. Rul. 2018-29.

[4] “Six Burning Questions on the New Qualified Opportunity Zone Guidance,” Stroock Special Bulletin, Nov. 6, 2018. (See:

Related Services