IRS Proposes Regulations Implementing Certain Parts of the Rules for Qualified Opportunity Zone Funds  

White Paper

November 1, 2018

On Friday, October 19, the Internal Revenue Service published proposed regulations and a revenue ruling addressing a number of issues under Code Sec. 1400Z-2, the rules for investing in a Qualified Opportunity Zone Fund (a QOZ and a QOZ Fund). The QOZ Fund provisions were added to the Code by the 2017 Tax Act and the guidance is expected to unlock QOZ Funds as a source of capital investment in economically depressed areas. The proposed regulations and ruling provide direction on several issues that are important to organizing and raising capital for a QOZ Fund itself. Guidance on virtually all of the important issues relating to the operation of such investment vehicles is reserved or awaits further consideration by the Treasury. The IRS solicited taxpayer comments on a number of the unresolved issues. 

One focus of these rules is on measuring the amount of a taxpayer’s gains that are eligible for deferral (Eligible Gains), determining when the taxpayer’s 180-day investment period begins and ends (taxpayers must make a cash investment in an eligible fund within 180 days of the date the taxpayer recognizes the Eligible Gain), and establishing rules for the deferral of Eligible Gains for passthrough entities such as LLCs and partnerships. These rules will facilitate the efforts of sponsors to raise funds to be deployed in QOZ investments. 

This publication discusses the proposed regulations, highlighting those rules that should be important to investors and sponsors of QOZ investments, and points out several key areas under the proposed regulations where guidance is lacking and where the absence of guidance could create obstacles to successfully implementing investments in a QOZ.

Taxpayers are permitted to rely on the proposed regulations with respect to investments made before the publication of final regulations, provided the taxpayer applies the rules in the proposed regulations “in their entirety and in a consistent manner.” 


A QOZ is an economically distressed community (generally, a particular census tract) where certain investments in new or substantially rehabilitated property may be eligible for tax benefits. The QOZ benefits include the temporary deferral of tax on some or all of a taxpayer’s Eligible Gain where an amount of money equal to the Eligible Gain to be deferred is invested in a QOZ Fund, the permanent elimination of federal income tax on up to 15 percent of the taxpayer’s Eligible Gains rolled into a QOZ Fund, and the permanent elimination of all gains on the QOZ Fund investment post-contribution, to the extent that the investment in the QOZ Fund is held more than 10 years by the taxpayer. Localities qualify as QOZs if they have been nominated for that designation by the state and that nomination has been certified by the Secretary of the U.S. Treasury. The IRS completed the designation of more than 8,700 eligible census tracts on behalf of the Treasury earlier this year, but uncertainty about the organization and operation of QOZ Funds has delayed the wide-scale deployment of investor capital into the funds. 

An Eligible Gain for this purpose is gain that: (x) is otherwise taxed as capital gain, regardless of holding period, (y) is recognized after December 31, 2017 and before January 1, 2027 (as if Code Sec. 1400Z-2 did not apply), and (z) does not arise from a sale or exchange of property between certain related persons. 

The tax benefits available from investing in a QOZ Fund are three-fold: (x) the deferral of the tax on the Eligible Gain for a period of time (ending on the earlier of the date the taxpayer sells or exchanges her interest in the QOZ Fund or December 31, 2026) where the amount of gain on which tax is deferred equals the amount of money contributed to the QOZ Fund within 180 days of the date the property was sold or treated as sold under these rules; (y) the permanent exclusion of a portion of the Eligible Gain, provided that the taxpayer holds her investment in the QOZ Fund for a period of five years (exclusion for 10 percent of the Eligible Gain) or seven years (an additional 5 percent of the Eligible Gain for a total 15 percent permanent exclusion), and (z) the permanent exclusion of the post-acquisition appreciation in the value of the investment in the QOZ Fund, provided that investment in the QOZ Fund is held for at least 10 years. Because the 15 percent permanent exclusion referred to in clause (y) (above) requires that the investment in the QOZ Fund be held at least seven years and the taxpayer is required to recognize all of the deferred taxable gain attributable to the QOZ Fund investment no later than December 31, 2026, investment in a QOZ Fund by December 31, 2019, is critical for taxpayers trying to achieve the full 15 percent permanent exclusion. For property acquired after December 31, 2019, the permanent exclusion for Eligible Gain is reduced to only 10 percent of the deferred gain provided the interest in QOZ Fund is held at least five years. Although there is no statutory limit on the amount of the tax that can be deferred by investing in a QOZ Fund, the deferred gain is required to be recognized for income tax purposes (without any additional realization event), no later than December 31, 2026. Therefore, the tax on the deferred gain (as reduced by any eligible permanent exclusion) must be paid by April 15, 2027, for a calendar year taxpayer. For taxpayers intending to hold their QOZ Fund investments for 10 years, it is likely that the amount of the taxes required to be paid in 2027 will have to be paid from sources other than the QOZ Fund. QOZ Fund investors must plan and provide for that cash-needs event.

To qualify as a QOZ Fund, the fund must: (x) be organized as a U.S. corporation or partnership (including an LLC), and (y) invest at least 90 percent of its assets either in QOZ business property or in a QOZ business that invests in QOZ business property. The 90 percent amount is determined by averaging the percentage of QOZ business property held by the fund. The proposed regulations provide certain taxpayer-friendly rules for making these averaging calculations, particularly as they relate to holding cash raised from investors and held by the QOZ business pending investment in qualified property or a qualified improvement of property. They also provide guidance concerning what proportion of a QOZ business’s assets must constitute QOZ business property (70 percent). The rules are silent on how a QOZ Fund must account for capital contributions accumulated by the fund pending the identification of, and investment in, eligible assets or businesses. That uncertainty may make raising so-called “blind pool” QOZ Funds problematic pending further guidance.

QOZ business property is tangible property used in a trade or business in a QOZ if: (x) the property was acquired by the fund by purchase from an unrelated party after December 31, 2017, (y) the “original use” of the property in the QOZ commences with the fund (obviously, the original use of land and an existing building does not commence with the QOZ Fund) or the fund “substantially improves” the property, and (z) during substantially all of the fund’s holding period for the property, substantially all of the use of the property was in a QOZ. Under the last requirement, a business cannot purchase QOZ property and then relocate the property outside of the QOZ without disrupting the deferral. 

Because of the original use requirement, the QOZ fund’s investment in land generally would not be an investment in QOZ property, a conclusion that is borne out by the proposed regulations. There is some significant commentary regarding the use of a QOZ Fund as a “land bank.”

Under the Code, property is substantially improved only if, during any 30-month period beginning after the date of its acquisition, the additions to the basis of the property in the hands of the fund exceed the adjusted basis of the property at the beginning of the 30-month period. Substantially improving an existing building in a QOZ is the only path to qualifying an existing building as QOZ property because, by definition, the first user of an existing building cannot be the QOZ Fund. 

These proposed regulations provide some relief on issues regarding the calculation of Eligible Gain, and the time within which the investment must be made to qualify for deferral, but leave many areas needing guidance unaddressed. The focus of the proposed regulations seems to be on answering questions that help “get the money in the door,” i.e., mostly fund sponsor issues confronted in organizing multi-property funds and raising capital from numerous investors. Nevertheless, the QOZ Fund rules do not require extensive public or private capital-raising activity. A single corporation, partnership, or LLC owning a single property or business in a QOZ, organized and funded by a single taxpayer, can qualify as a QOZ Fund and the taxpayer’s investment in the partnership or corporation can constitute an investment in a QOZ Fund without the need to layer on fees for a sponsor, an asset manager, or to raise capital from a pool of investors. For real estate projects in a QOZ in particular, the familiar strategy of raising capital within a closely knit group of friends, family, and frequent co-investors remains a strategy that can allow the investors to take full advantage of the deferral and permanent exclusion benefits of the QOZ Fund provisions. To be fully successful, the project must be a fundamentally sound business opportunity that most taxpayers would pursue without the Code Sec. 1400Z-2 benefits, because, in order to obtain the maximum tax benefit, the fund must remain invested for 10 years in QOZ properties. The proposed regulations even permit the investment to be structured to accept tax-deferred cash from some investors and after-tax cash (as to which no Sec. 14002-2(a) deferral election was made) from other investors. 

The value of being located in a QOZ for real estate projects should not be overstated. Economically, the benefit for QOZ real estate is the additional yield provided by the deferral of the Eligible Gain and the permanent exclusion of either 10 percent or 15 percent of the Eligible Gain. That incremental yield may not offer much of an inducement to make an investment given that Code Sec. 1031 is still available for real estate investments to provide essentially unlimited gain deferral amounting to effectively a permanent exclusion. Although the value of deferring short-term capital gains is higher than the value of deferring long-term gain, the Eligible Gain, when required to be included in income retains the attributes as if the gain had not been deferred. For most real estate investors, the QOZ Fund provisions are a very poor substitute compared with using a like-kind exchange to defer taxable gain from the sale of real estate: (x) rather than an indefinite deferral (provided that the gain is rolled over in successive like-kind exchanges), the deferred gain invested in a QOZ Fund must be recognized by the taxpayer no later than December 31, 2026 and earlier if the interest in the fund is disposed of, (y) the deferred gain is classified as “income in respect of a decedent” so that a taxpayer who dies before the gain is required to be recognized will not get a basis step-up to the property’s date of death value (which, in the usual case, achieves permanent deferral of the rolled over Code Sec. 1031 gain), and (z) if the taxpayer has a deficit capital account with respect to the property, the taxpayer would have to invest an amount of cash equal to the entire deficit balance in order to fully defer the gain from the sale. 

Important Takeaways from the Proposed Regulations

  • There are important differences between a QOZ Fund investing directly in QOZ business property (or through a disregarded entity) and a QOZ Fund investing through a lower-tier entity that qualifies as a QOZ business, e.g., a corporation, partnership, or LLC lower-tier subsidiary. As drafted, the proposed regulations seem to favor a QOZ Fund investing through one or more lower-tier subsidiaries and, absent some change in the regulations, it is likely that most QOZ investments will be made through lower-tier subsidiaries.
  • The proposed regulations do not provide any solution to the problem of a startup QOZ Fund holding cash and cash equivalents pending investment of the assets in QOZ business property. There is no safe harbor for the fund that would permit it to avoid the restriction on holding nonqualified financial property and that would enable it to meet the 90 percent asset test. This will make the process of timing the capital raise with the realization of capital gain income by investors more difficult.
  • With the requirement that any deferred gain must be recognized on the earlier of the disposition of the investment in the QOZ Fund or December 31, 2016 (subject to some adjustment in the amount of the gain), investment in a QOZ Fund is likely to be judged a very poor substitute for real estate investors to defer gains from real estate investments where they otherwise have the ability to execute a Code Sec. 1031 rollover. In fact, the net fair market value of the ability to defer taxation of a current gain is likely to be of too small a benefit to serve as an inducement to invest in a QOZ Fund, unless the taxpayer expects the underlying project to grow substantially in value and is prepared to hold the QOZ Fund investment for at least 10 years. Taxpayers with short-term gains from financial instruments may have a greater incentive to participate in a rollover transaction that is engaged in only for the short-term rollover. 
  • Significant additional guidance is required, particularly regarding the integration of the QOZ rules with the partnership rules under Subchapter K, before taxpayers should feel comfortable modeling the after-tax consequences of an investment in a QOZ Fund.

Outline of the Proposed Regulations

The Proposed Regulations provide guidance on the following questions:

What taxable gains are eligible for deferral and when must the eligible taxpayer elect to defer the recognition of some or all of its Eligible Gains?

Taxpayers eligible to elect to defer their gains include individuals, C corporations, including regulated investment companies (RICs) and real estate investment trusts (REITs), partnerships, S corporations, and trusts and estates. The proposed regulations have a very granular set of rules to deal with the timing and recognition of Eligible Gains.

A taxpayer’s taxable gains are eligible for deferral under Code Sec. 1400Z 2 if: (x) the gain is capital gain income, regardless of the holding period, (y) the gain would have been recognized after 12/31/2017 and before 1/1/2027 if Code Sec. 1400Z-2(a)(1) did not apply to the gain, and (z) the gain did not arise from a sale or exchange of property between certain related persons. Gain from the sale or exchange of property that would not be capital gain income, e.g., gain from the sale or exchange of property held for sale to customers, is not Eligible Gain.

A special rule applies with respect to gain from Code Sec. 1256 regulated futures contracts. Only the amount of the net capital gain with respect to Code Sec. 1256 contracts in the year is eligible for deferral, i.e., on an aggregated basis and not contract-by-contract, and the 180-day period commences on the last day of the taxpayer’s taxable year. 

If the capital gain is from a position in stock or securities that was part of an offsetting position, e.g., a straddle as defined in Code Sec. 1092, the taxable gain is not Eligible Gain that can be deferred. The taxpayer cannot unwind a straddle, claiming deferral for their gains and the ability to claim the offsetting capital losses to offset other capital gain income. The offsetting position rule can apply even where the positions are not composed of actively traded personal property.

The 180-day investment period commences on the date that the gain would be recognized for income tax purposes assuming that the taxpayer did not elect to defer the gain under Code Sec. 1400Z-2. In the case of a “regular-way” sale of stock, the 180-day period begins on the trade date for the sale of the stock. In the case of a capital gain dividend attributable to a distribution from a RIC or a REIT, the 180-day period commences on the last day of the RIC or REIT’s taxable year. The RIC investment commencement rule could be problematic for taxpayers that are not careful about tracking the fiscal year of their mutual funds, something that probably is not second nature to most investors. RICs often have taxable years that end other than on December 31. If a taxpayer was planning to defer a large Eligible Gain derived from a mutual fund, inattention to the fund’s fiscal year could cause the taxpayer to miss the end of the rollover period. For example, if the RIC’s fiscal year ended on October 31, the 180-day reinvestment period for a gain derived from the RIC would end April 29, rather than June 29, the date that is 180 days from December 31, 2018. 

What special accounting rules govern when interests in a QOZ Fund have been disposed of by the taxpayer?

Generally, where the taxpayer owns identical interests in a QOZ Fund that were acquired at different times and amounts, the taxpayer must apply the first-in-first-out (FIFO) method to account for the interests disposed of. This rule applies even to interests in corporations consisting of stock with identical rights. There is no specific identification rule that would permit a taxpayer to identify a particular stock position, e.g., the shortest held, in the QOZ Fund.

Specifying use of a FIFO rule for partnership interests is curious here. Generally, partnership interests do not have a basis that is separated by lots or date of acquisition. The IRS position has been that a partner’s basis is unitary. It is unclear how the FIFO rule will interact with the other Subchapter K rules that make no distinction based on the date of acquisition of the interests. For example, if a partner takes into account her distributive share of the partnership’s taxable income on Day 10 and acquires an additional interest in the QOZ Fund on Day 200, does the partner need to segregate the Day 10 income and apply it to increase her basis in the first lot of partnership interests acquired? The Subchapter K rules are no help because the distributive share is an undifferentiated increase to the partner’s adjusted basis for her interest. The drafters of the regulations may have to create new rules for addressing increases and decreases to the adjusted basis of a partner’s interest in the QOZ Fund.

Further, there is no guidance under the proposed regulations relating to how a partner that disposes of a partial interest in a QOZ Fund organized as a partnership accounts for its share of the partnership’s debt, or the effects of partnership operations, on the adjusted basis of its interest. That is, do the ordinary Subchapter K rules apply or do some type of hybrid rules apply. The lack of guidance could create confusion for investors and sponsors. It is likely that the QOZ Fund organized as a partnership will have to take the lead in sorting out any allocation questions under the rules of Code Sec. 6222, which require that partners or members of partnerships and LLCs must report all partnership related items consistent with the treatment (which includes allocations) of those items on the tax returns of the partnership or LLC.

How are Eligible Gains of passthrough entities, i.e., partnerships and LLCs, handled?

The Eligible Gains of a partnership or similar passthrough entity are subject to a “two-bites-at-the-apple” type of rule. The partnership can elect to defer some or all of its Eligible Gains by reinvesting an amount of cash equal to the deferred gain in a QOZ Fund. Eligible Gains of a partnership are included in income by the partnership under Code Sec. 1400Z-2 “in a manner consistent with recognition at that time,” presumably on December 31, 2026, or the earlier disposition of an interest in the QOZ. There is no guidance on the treatment of deferred gains attributable to partnerships in which interests in the partnership are transferred during the deferral period. The transferring partner is required to recognize gain under Code Sec. 1400Z-02 at the time of the disposition, but there is no guidance on the effectiveness of a Code Sec. 754 election to eliminate the taxation of that gain on December 31, 2026. 

If a partnership does not elect to defer its Eligible Gains, the individual members of the partnership can make separate deferral elections with respect to the partners’ shares of the partnership’s Eligible Gains. When the partnership does not elect to defer, the individual partner’s 180-day investment period begins on the last day of the partnership’s taxable year (generally December 31), provided that the partner can elect to start the partner’s 180-day investment period on the same day that would be the start of the partnership’s 180-day period. The optional rule would be useful if the taxpayer wanted to complete the investment before the close of the partner’s taxable year. Taxpayers wanting to use this optional rule may run into issues with the partnership or LLC, however. In most cases, the partners do not have a contractual right to specific, partnership-level, transactional information. Some partnerships and LLCs may be willing to provide that information, but larger entities with multiple members may find the demands for specific information could overwhelm their compliance staffs at a time when they are otherwise trying to collect and publish year-end financial information for all members.

We expect to see some use of this optional rule for partnership gains in 2019 where an investment in a QOZ by December 31, 2019, provides an additional 5 percent permanent deferral for investments in QOZ Funds held through December 31, 2026. If the general rule applied in a case where a calendar year partnership made did not elect to defer its Eligible Gain, the partner would have a single day in 2019, December 31, 2019, in which to make the investment in a QOZ Fund.

One question that inevitably will come up is whether the partnership can elect to invest an amount equal to only a portion of its Eligible Gain and allocate all of the deferral to one partner, or a subset of its partners (those who want the rollover), and allocate the balance of its Eligible Gain to its remaining partners (who have not chosen deferral). This could arise, for example, where certain partners were tax-exempt entities and would not benefit from the deferral. In other areas in Subchapter K, the regulations take the position that, where substantially all of the economic and tax attributes of a partnership asset are allocable to a single partner or subset of all of the partners, there has been a constructive distribution of the asset to the identified partners. Attempts by the partners to shuffle their economic interests with respect to particular assets might be frustrated if the IRS were to treat the cash from the asset disposition or the interest in the QOZ Fund as having been constructively distributed. In addition, the economic consequences of rolling over some portion of the partnership’s gain into a QOZ Fund for the benefit of a limited group of partners raises the question whether the partnership should account for the rollover as a division of the partnership into two entities or the spin-off of the QOZ investment to the group that wanted the rollover. Again, the regulations offer no guidance on what may be a complicated problem for allocating the taxable gain that is rolled over and the ongoing results of operations. The flexibility of the partnership rule (which is equally applicable to S corporations and their shareholders, and trusts, estates, and their beneficiaries) will create some interesting drafting, governance, and election provisions in partnership and LLC agreements.

The proposed regulations confirm that a partner’s or member’s constructive cash contribution, under Code Sec. 752 to an entity classified as a partnership does not create or increase an investment in a QOZ Fund. As noted above, there is no guidance about how the adjusted basis rules of Subchapter K, which increase/decrease a partner’s adjusted basis for her interest by her share of the income/loss of a partnership, are integrated with the Code Sec. 1400Z-2 rules. In particular, guidance is needed to address the tax consequences for Code Sec. 1400Z-2 purposes of distributions to partners of the proceeds of a borrowing by the QOZ Fund or business. One particular transaction that should be identified and addressed is where the QOZ Fund raises cash from investors, invests the cash in unleveraged property that it will substantially improve, incurs debt with respect to the property, and distributes the net financing proceeds to the members as a return of capital distribution that would ordinarily be non-taxable under the Subchapter K rules. The likelihood of the future borrowing may be relatively certain and, in the case of most real estate projects, is certainly expected. Should the contribution and distribution be stepped together to reduce the taxpayer’s net cash investment in the QOZ Fund?

In general, the foregoing rules are designed to provide certainty regarding the timing of elections and the identity of taxpayers that are eligible to make the elections. Insofar as the rules facilitate the ability of funds to bring in capital contributions by giving taxpayers flexibility to make their elections and plan for the date on which their 180-day period commences, the rules meet their purpose. What these rules fail to do is to facilitate the investment by a QOZ Fund in a particular project by providing guidance about the tax consequences of making the investment and operating the property following the investment. To the extent that guidance is provided, the guidance is found in the rules of Proposed Regulations Sec. 1.1400Z-2(d)-1.

What conventions are provided for determining the valuation of the QOZ Fund assets for the purposes of the 90 percent asset test of Code Sec. 1400Z-2(d)(1) and the requirement that “substantially all” of the tangible assets of a QOZ business qualify as QOZ business property?

At least 90 percent of a QOZ Fund’s assets must be QOZ property. QOZ business property is QOZ stock, a QOZ partnership or LLC interest, or QOZ business property. Satisfaction of this test is measured by averaging the assets of the fund over two, half-year periods in a year and testing compliance for each period. A fund that does not comply and lacks reasonable cause for its noncompliance is subject to a penalty.

The fund can avail itself of one of two methodologies for determining the value of its assets:

  • If the QOZ Fund files financial statements with the SEC or other federal agency (but not the IRS) or has audited financial statements, the values in the financial statements can be used for the purpose of the 90 percent test. 
  • If the QOZ Fund does not have qualified financial statements, the values taken into account are the cost of the assets, evidently without taking into account deductions for depreciation or amortization. 

The fund determines the average of the percentages of the assets at the end of the first measuring period and the second measuring period (the last day of its taxable year) and determines the average of those percentages. If the QOZ property percentage is 90 percent or greater, there is no penalty. It does not appear that the 90 percent test must be met on each of the two separate computation dates. The calculation set forth in the draft IRS Form 8996 is relatively mechanical. The judgment about what is qualifying tangible property may not be.

It appears that borrowing by the fund to acquire assets will impact the computation of the QOZ property percentage on a dollar-for-dollar basis. That is, the percentage is not designed to trace the assets to only the dollars contributed to the QOZ Fund.

Because QOZ property is limited to “tangible” property, an investment in too much land or intangible assets by the QOZ Fund could be detrimental to the fund meeting the 90 percent test. If the QOZ Fund uses the cash raised from investors to fund business operations conducted on leased premises with mostly leased, rather than owned, tangible property, holding even a small amount of working capital or accounts receivable could result in issues under the 90 percent test. The proposed regulations have elaborate rules for determining the average percentages for the first taxable year of the Fund.

Some direction has been provided on the interpretation of the “substantially all” requirement for the assets of a QOZ business, i.e., a business in a QOZ conducted through a partnership or a corporation where the QOZ Fund owns an equity interest in the business entity. In order to meet the requirements to be a QOZ business, substantially all of the tangible property owned or leased by the business enterprise must be QOZ business property. Although the Code is silent on the definition of “substantially all,” the proposed regulations set the substantially all threshold at 70 percent. For the purpose of valuing the QOZ business to determine if the QOZ Fund meets the 90 percent-of-assets test, the QOZ Fund can rely on the financial statements used for the 90 percent test, if available, and, if not, the regulations prescribe a somewhat more cumbersome procedure.

What guidance is provided to assist taxpayers in structuring the QOZ Fund and making investments in eligible properties?

Taxpayers are permitted to self-certify their status as QOZ Funds. This will be accomplished by filing IRS Form 8996, specifying the first taxable year, and the month in that taxable year, in which the entity is a QOZ Fund. Investments made before the first month as a QOZ Fund are not eligible for the Code Sec. 1400Z-2 deferral or other benefits.

As noted above, there is no special rule that permits a QOZ Fund to raise cash for investment in properties or businesses without accounting for the cash under the 90 percent test. At one level, this could make raising money for projects with a longer-term development period problematic. The absence of a pending investment rule suggests that QOZ Funds with investments having a more than six-month funding plan might have to be continually raising capital throughout their improvement phase. That cannot lead to an economically efficient model for development. 

The proposed regulations provide something of a solution in the special safe harbor for the “reasonable working capital” of a QOZ business. As noted, this working capital safe harbor is available for an investment in a QOZ business but cannot be utilized directly by a QOZ Fund. It is one of the reasons that sponsors may feel compelled to invest through lower-tier subsidiaries that are QOZ businesses. The special working capital safe harbor permits certain cash and cash items held by a QOZ business (a lower-tier partnership or corporation, not a disregarded entity wholly owned by the QOZ Fund) to be treated as reasonable working capital and avoid being treated as nonqualified financial property. (In the case of a QOZ business, less than 5 percent of its average assets can be held in nonqualified financial property.) In order to avail itself of the safe harbor, the QOZ business must: (x) have a plan, in writing, to hold the cash or cash items for use in a project in a QOZ, (y) have a written schedule for the expenditure of the cash or cash items within 31 months of receipt by the QOZ business, and (z) use the items in the working capital reserve substantially in accordance with the plan and the schedule. Although not stated in so many words, the identification requirement in (x) appears to require the identification of a specific project and not a generalized business plan.

There is a difference in the application of the working capital safe harbor between a QOZ Fund and a QOZ business. This difference is also manifested in the application of other provisions of the Code and the regulations. Under the proposed regulations, the working capital safe harbor applies only to the assets in a QOZ business and not to the assets of the QOZ Fund, itself. Frankly, that limitation seems indefensible as a matter of tax policy and, hopefully, will be addressed as the regulations are finalized. There are other asymmetries in the rules applicable to QOZ Funds and QOZ businesses that must reflect drafting deficiencies in the statute. The differences cannot be a product of any sensible income tax policy.

At least 50 percent of the gross income of a QOZ business must be derived from the “active conduct of a trade or business” in the QOZ. The “active conduct” requirement does not apply to direct investments by a QOZ Fund. The proposed regulations have reserved guidance on the definition of an active trade or business for this purpose although, under other provisions of the Code, income derived from the net lease of real property has historically been treated as other than income derived from the conduct of an active trade or business.

The prohibitions against the conduct of certain business enterprises, e.g., massage parlor, hot tub, or gaming facility, apply to activities conducted by a QOZ business but not to the QOZ Fund itself. 

In one of the more important provisions affecting virtually all longer-term projects, the proposed regulations have created a series of rules intended to provide a QOZ business, but not a QOZ Fund, with the time and flexibility to accept capital contributions from a fund investor within the 180-day investment period and to hold the funds pending investment in an underlying property without violating the 90 percent rule.

Cash that is held as part of reasonable working capital accounts is treated as part of a QOZ investment by the QOZ business if the following three requirements are met:

  • The amounts are designated in writing for the acquisition, construction, and/or substantial improvement of tangible property in a QOZ;
  • There is a written schedule consistent with the business plan of a startup calling for the expenditure of the funds within 31 months of their receipt by the fund, and
  • The working capital assets are substantially used in accordance with the written plan and schedule.

As a consequence of this important safe harbor, a QOZ Fund could raise cash, contribute the cash down to a QOZ business organized as a corporation, a partnership, or an LLC, and the QOZ business could hold the cash pending investment without violating the rules that prohibit a QOZ Fund from having more than 5 percent of its assets in nonqualified financial property. During the improvement of the property, the cash in the working capital fund and the work in process are treated as QOZ business property.

One thing that the working capital rules may accomplish is to create significant uncertainty for taxpayers who believed they could contribute cash to a QOZ Fund in an effort to achieve short-term deferral for the taxation of their gains without ever pursuing a legitimate development project. Some commentators suggested that a taxpayer with a large Eligible Gain could create a captive QOZ Fund, deposit the cash proceeds of the sale of capital assets into the fund, claim to be pursuing QOZ investments and, more than two taxable years later, dissolve the fund without having made any investment. Although the taxpayer would recognize taxable gain on the dissolution of the QOZ Fund, the taxpayer might also have achieved a short-term deferral of the recognition of the original gain at small incremental cost and with no real loss of control over the proceeds. The working capital rules probably require too much specificity in the identification of the project for a taxpayer to rely on them to shield the holding of the cash. With the absence of any working capital safe harbor at the QOZ Fund level or temporary investment of “new capital” rule, taxpayers attempting the use of a captive QOZ Fund as a pure deferral play are likely to be frustrated.

Investment in real estate assets attracted some special attention under the proposed regulations and the revenue ruling. The need to account for the acquisition and ownership of land in redevelopment projects in QOZs is of importance for real estate investors and developers. Of most interest to real estate owners and developers considering projects in a QOZ are the rules delineating when a property has been “substantially improved.” Property, the original use of which does not begin with the QOZ Fund, must be substantially improved by the QOZ Fund in order to qualify as QOZ business property. Property is substantially improved if the additions to the capital with respect to the property equal its adjusted basis, determined at the start of any 30-month period following its acquisition. Under a special, real estate-favorable rule, the test of whether a property consisting of land and a building in a QOZ is substantially improved is determined by reference solely to the improvements to the building. No separate capital expenditures are required to be made to the land. Commentators had been concerned that the test would have required some form of proportional improvement to the land and the buildings. Logically, any capital improvements made to the land are not taken into account in determining whether a building has been substantially improved.

As noted above, and in a blow to some real estate projects, the proposed regulations do not provide any guidance on what constitutes the “active conduct of a trade or business” as it applies to rental real estate owned by a QOZ business. Commentators have noted that, in other parts of the Code, property that is subject to a triple net lease is commonly thought not to constitute the operating of a trade or business. If that interpretation were adopted by the IRS, or at the very least not repudiated for QOZ Fund purposes, the use of the QOZ Funds to make significant commercial real estate improvements in a QOZ may be impacted adversely.

What issues must be addressed in integrating the QOZ rules with the rules of Subchapter K?

As noted in a number of places above, the QOZ rules need to be integrated into the operating rules of Subchapter K in order that development projects funded with the proceeds of deferred Eligible Gains will be able to function as seamlessly as possible. In the case of a QOZ formed as a partnership or an LLC (classified as a partnership), among the most important places where the QOZ rules and the Subchapter K rules intersect without any guidance are the following.

How are income and gains recognized by the QOZ Fund taxed when the partners are required to include their distributive shares of the partnership income or gains on their tax returns? How does passing through the gain on the disposition of a QOZ asset before the end of the 10-year period and requiring the partners to pay tax implement the deferral and permanent gain elimination provisions of the QOZ Fund rules?

What is the adjusted basis of the QOZ property that is acquired with the proceeds of the $0 basis capital contributions of the partners? In other circumstances, the Code has relied on a rule that the entity acquires $0 basis in the assets acquired with the proceeds of contributions that have a $0 basis. Will the IRS propose a similar rule here? If not, the creation of a QOZ Fund taxed as a partnership would inevitably create an inside/outside basis disparity. Assuming that the basis of property acquired with the proceeds of Deferred Gains is not reduced to account for the deferral of the recognition of gain, do the partners receive a capital account balance that includes the full amount of the deferred gain? How are deductions attributable to the $0 basis cash proceeds to be allocated among the members, particularly where the partnership has partners that have elected to defer their gain and partners that have invested after-tax dollars?

How will the IRS address the issues presented by the requirement that partners include their shares of partnership liabilities in the adjusted income tax basis of their interests and account for changes in the share of the liabilities as constructive cash contributions by, and distributions to, the partner? As a question posed above notes, could a QOZ Fund organized as a partnership collect cash from its investors, invest the cash in eligible assets and meet the 90 percent test, and then borrow based on the assets and distribute the proceeds of the borrowing to the partners, thereby reducing the net amount invested in the partnership? How will the rules dealing with the impact of debt of the partnership on the adjusted basis for Code Sec. 1400Z-2 of a partner for her interest in the partnership address actual distributions of cash? Could the IRS propose some sort of rule that treats distributions within two years as a reduction in the amount of the gain that is deferred, i.e., a disposition event, or could the rules simply prohibit such distributions? How will any such rule integrate with real estate development transactions where one of the business objectives is to leverage the property as soon as possible and withdraw as much cash for distribution to the partners? There is much to look forward to on this issue.

Finally, should a partnership with tax-deferred capital contributions and tax-paid capital contributions be taxed as if there were two partnerships rather than a single partnership? 



Thomas J. Gallagher


(215) 665-4656

Related Practices

To discuss any questions you may have regarding the proposed regulations or how they may apply to your particular circumstances, please contact any of the following lawyers: Dennis L. Cohen at or 215-665-4154, James Forsyth at 412-620-6529 or jforsyth@cozen.comThomas J. Gallagher at or 215-665-4656, Rory Moore at or 215-665-4658, Richard J. Silpe at or 215-665-2704, or Joshua C. Weinberger at or 215-665-2173.