On July 4, the One Big Beautiful Bill Act (OBBBA) became law and included some tweaks to the prior 2017 qualified opportunity zone (QOZ) tax legislation. The original QOZ rules, created by the Tax Cuts and Jobs Act of 2017, were somewhat haphazardly drafted and quickly passed. However, numerous rounds of regulations ultimately brought workable clarity to allow developers and investors to undertake tax planning to fit within the rules. Broadly, the goal of the QOZ program was to spur development in low-income communities by creating tax benefits for investors.
This client alert focuses on the changes made to the QOZ rules which generally take effect as of January 1, 2027. The original QOZ law would have effectively expired for new QOZ investments because QOZ investments were otherwise required to have been made by December 31, 2026. The OBBBA eliminates that sunset date, giving the revamped QOZ program an indefinite life. While explaining the changes brought about by the OBBBA, it is also necessary to review some of the pre-existing QOZ rules.
WHAT IS AN OPPORTUNITY ZONE?
Opportunity zones are tracts of land generally located in low-income communities. Under current rules, a census tract’s eligibility to be part of the QOZ program was measured by reference to the New Markets Tax Credit definition of low-income community, which generally required a census tract to have a poverty rate of at least 20% or that median family income not exceed 80% of the applicable state or metropolitan area median family income. Governors across the country designated these low-income tracts, which were ultimately certified by the U.S. Treasury Department as QOZ tracts. An investor may invest in any of these zones irrespective of the investor’s residency.
Under the OBBBA, state governors will continue to designate new QOZ tracts every 10 years now that the QOZ rules have been made permanent. The OBBBA modifies the requirements applicable to the designation of a QOZ by narrowing the definition of a low-income community. Further, the special designation benefits for Puerto Rico will no longer apply. The OBBBA also eliminated the favorable contiguous tract rule, which previously allowed a census tract contiguous to a low-income community to be designated as a QOZ census tract under more relaxed low-income rules.
INVESTMENT-RELATED RULES
The QOZ rules initially require a taxpayer to sell property and trigger a capital gain that will then be rolled over into a QOZ investment. There were three separate tax benefits originally available for a taxpayer who realized gains from a disposition of an asset under the 2017 QOZ rules:
- deferral of a recognized gain that was recycled into a QOZ;
- permanent exclusion from taxation of a portion of the deferred gain (for investments in a QOZ that was held five or seven years); and
- a permanent exclusion of post-acquisition appreciation of the new investment in the QOZ (if the investment is held for more than 10 years).
The tax due on the realized gain rolled into a QOZ project was generally deferred until the earlier of the disposition of the QOZ investment or December 31, 2026.
Under the OBBBA, for investments made after December 31, 2026, an investor’s realized gains deferred through the rollover of an investment into a QOZ project will be deferred until the fifth anniversary of the investment date. Additionally, a 10% basis step-up in the investment is provided by the OBBBA, which takes effect immediately before the end of the five-year gain deferral period (so long as the gain was not prematurely triggered through a sale or exchange). This 10% basis step-up essentially means that an investor will pay tax on only 90% of its deferred gain if the QOZ investment is held for at least five years. The QOZ rules continue to provide that no tax is paid on the gain from the disposition of a QOZ investment held for at least 10 years. However, the OBBBA eliminates the prior sunset provision terminating QOZ benefits for investments sold after December 31, 2047, which was necessary given the legislation’s permanent extension. There is now provided a 30-year rolling timeline for gain exclusion with respect to qualifying QOZ investments held at least 10 years.
Only the amount of a realized gain from a prior investment recycled into a QOZ project is eligible for the tax benefits. A taxpayer may invest more than the realized gain (that is, the entire amount of proceeds related to the sale of a prior investment, for example). However, the tax benefits are available only with respect to the amount of the previously realized deferred gain that is rolled over into a QOZ.
Only capital gains, and not ordinary gains, are eligible for the QOZ tax benefits (including short-term capital gains and Section 1231 and 1250 gains). Taxpayers that are eligible for the QOZ tax benefits generally are individuals, partnerships, C corporations, S Corporations, trusts, real estate investment trusts, and regulated investment companies.
Timing
Investors must take their realized gain from an asset disposition and invest in a qualified opportunity fund (QOF) within 180 days of the disposition. Gains may be invested in multiple QOZ investments if diversification is desired, so long as the 180-day requirement is satisfied. The 180-day time period may start from multiple starting points if a gain is generated through a pass-through entity. Generally, under the OBBBA, a QOZ investor will want to make an investment after January 1, 2027, but could conceivably use a rollover gain triggered in the second half of 2026 (paying particular attention to the 180-day time period).
Vehicle
In order to qualify for the tax incentives, investors must invest through a QOF. A QOF is an investment vehicle organized as a corporation or a partnership for the purpose of investing in a QOZ. The QOF model enables investors to pool their resources, thereby increasing the scale of capital for re-investment and enabling significant redevelopment projects to be undertaken. An investor in a QOF must obtain an equity interest in order to qualify for the tax benefits, which may be preferred stock or a partnership interest with special allocations. A QOF may not invest in another QOF.
The OBBBA creates a new category of investment vehicle called a Qualified Rural Opportunity Fund (QROF) in an effort to move investments to more rural areas of the country. The tax benefits given to QROFs are more advantageous compared to ordinary QOFs – specifically:
- a rolling 30% basis-step up after holding the investment for five years (compared to a 10% for QOFs); and
- a reduced substantial improvement requirement as compared to QOFs.
A QROF is just like a QOF, except that its 90% good asset test, including with respect to any QOZ business in which the QOF owns an interest, is required to be invested in a QOZ comprised entirely of a rural area. A rural area is any area other than:
- a city or town with a population of greater than 50,000, and
- an urbanized area adjacent to a city or town with a population in excess of 50,000.
PROPERTY ACQUISITION DATES
Very broadly, investments by QOFs originally were geared toward purchasing qualifying property after December 31, 2017, which would be located in the designated low-income communities. The OBBBA updates the acquisition window for acquisitions of qualifying property for QOFs and QROFs to match the new 10-year designation cycle of census tracts as qualifying under the QOZ program. Although qualifying property was originally required to be purchased after December 31, 2017, that date will now reset with each new 10-year designation cycle. Thus, in the next round of QOZ time periods, acquisitions of qualifying property in QOZ projects should occur after January 1, 2027.
NEW REPORTING REQUIREMENTS
QOFs will be required to report to the IRS various pieces of information, such as the value of its total assets, the value of its QOZ property, the North American Industry Classification System (NAICS) codes that apply to its businesses, the QOZ census tract(s) invested in, the amount invested in each qualified opportunity zone business, the value of its tangible and intangible property, the approximate full time employees it employs and other items to be determined based on future regulations. In addition, QOFs will be required to provide reports regarding investors that dispose of an investment in a QOF, and will be required to provide such reporting to those investors. Similarly, a qualified opportunity zone business owned by a QOF will be subject to a similar reporting regime, principally designed to provide the foregoing information to the IRS and to its QOF investors.
