Overview of the Qualified Opportunity Zone Program
The Qualified Opportunity Zone (QOZ) program, established under the Tax Cuts and Jobs Act of 2017, created a powerful incentive structure for investors to deploy capital gains into economically distressed communities. By investing unrealized capital gains into a Qualified Opportunity Fund (QOF), investors can defer and potentially reduce their tax obligations while directing investment toward designated census tracts across the United States.
For private lenders and fund managers, the QOZ program intersects with lending activities in multiple ways, from financing QOF-owned real estate projects to structuring funds that directly qualify as QOFs. Understanding the regulatory framework governing these investments remains essential for advisors and participants in the private capital markets.
Qualifying Investments: Capital Gains Only
A fundamental limitation of the QOZ program is that only capital gains qualify for deferral through QOF investment. Ordinary income, regardless of source, cannot be invested into a QOF for tax deferral purposes. This distinction has significant implications for structuring:
- Short-term and long-term capital gains both qualify
- Gains from any asset class (real estate, securities, business interests) are eligible
- Ordinary income recapture portions of a gain do not qualify
- The investment must be in cash, not contributed property
Investors who attempt to contribute appreciated property directly into a QOF, rather than first selling the property and investing the resulting capital gain proceeds, will not receive QOZ tax benefits on that contribution.
The 20% Related Party Test
Section 1400Z-2(e)(2) imposes a related party restriction that limits the ability of investors to receive QOZ benefits when transacting with entities in which they hold significant ownership. Specifically, if an investor owns (directly or indirectly) more than 20% of a QOF or its subsidiary qualified opportunity zone business (QOZB), certain transactions between the investor and the fund may trigger disqualifying dispositions or prevent gain deferral.
This threshold applies broadly:
- Ownership attribution rules apply (family members, controlled entities)
- The test examines both direct and indirect ownership
- Transactions between related parties may constitute inclusion events
- Fund managers structuring QOFs must carefully evaluate investor ownership percentages relative to other business relationships
For fund sponsors who are also investors, the 20% test requires careful structural planning to avoid inadvertently disqualifying the fund or individual investments.
Section 1231 Asset Contributions
Capital gains arising from the sale of Section 1231 assets (depreciable business property held more than one year) present unique timing considerations for QOF investment. Unlike standard capital gains that are determined at the time of sale, Section 1231 gains are subject to netting at the end of the taxable year.
This means the 180-day investment window for Section 1231 gains does not begin on the date of sale. Instead, it begins on the last day of the taxable year in which the net Section 1231 gain is determined. Investors selling Section 1231 property early in a calendar year may have a significantly extended window to identify and fund their QOF investment compared to investors with standard capital gains.
The Original Use Test
QOFs must invest in qualified opportunity zone property that satisfies either the original use test or the substantial improvement test. Under the original use requirement, property acquired by a QOF must have its “original use” commence with the fund. For real estate investments, this generally means new construction.
However, the regulations provide important exceptions for existing structures:
- Vacant buildings: A building that has been vacant for a specified period may satisfy original use when acquired by a QOF. The final regulations reduced the required vacancy period:
- Originally proposed at 5 years of vacancy
- Reduced to 3 years in certain circumstances
- Further reduced to 1 year for buildings in federally declared disaster areas
- Previously owned property: Property that was never placed in service by a prior owner may still satisfy original use with the QOF
These vacancy rules significantly expanded the universe of existing real estate that qualifies for QOF investment without requiring the substantial improvement alternative.
The Substantial Improvement Test
When existing property does not meet the original use test, the QOF may alternatively satisfy the substantial improvement test. This requires the fund to invest additional capital into the property equal to or exceeding the fund’s adjusted tax basis in the acquired building (excluding land value) within a 30-month period following acquisition.
Key considerations for the substantial improvement calculation:
- Land is excluded: The basis of land is not included in calculating the substantial improvement threshold. Only the building basis triggers the improvement requirement.
- 30-month window: The improvement period is measured from the date of property acquisition, not the date of QOF formation or the date of the investor’s contribution.
- Tax basis, not purchase price: The threshold is measured against the fund’s adjusted tax basis in the building, which may differ from the acquisition price depending on allocation between land and improvements.
- Aggregation permitted: Improvements across an entire property can be aggregated to meet the threshold; there is no requirement that each individual building on a multi-structure property independently satisfy the test.
For private lenders financing QOF real estate projects, the substantial improvement test creates predictable capital deployment timelines. A QOF acquiring a $2 million building (excluding land) must invest at least $2 million in improvements within 30 months, creating a defined construction lending opportunity.
The 180-Day Investment Window
Investors must deploy capital gains into a QOF within 180 days of the gain recognition event. However, the starting point for this 180-day clock varies depending on the nature of the gain:
Standard Capital Gains
The 180-day period begins on the date of the sale or exchange that generated the gain.
Pass-Through Entity Gains
For gains recognized through partnerships, S corporations, or other pass-through entities, investors have a choice:
- Begin the 180 days on the date the entity recognized the gain, OR
- Begin the 180 days on the last day of the entity’s taxable year in which the gain was recognized
This election provides pass-through investors with additional time to identify QOF investment opportunities.
Installment Sales
For gains recognized through installment sales under Section 453, the 180-day period begins on the date each installment payment is received, not the date of the original sale. This allows investors to make sequential QOF investments as installment payments are received over time.
Publicly Traded Securities
For gains from publicly traded stock or securities, the 180-day period begins on the trade date (the date the sale order is executed), not the settlement date.
Inclusion Events: When Deferred Gain Must Be Recognized
An inclusion event occurs when circumstances require an investor to recognize previously deferred capital gains before the end of the deferral period. Common inclusion events include:
- Sale or disposition of the QOF investment (including partial dispositions)
- Gifts of QOF interests (the donor recognizes deferred gain)
- Distributions from the QOF that exceed the investor’s basis
- Loss of QOF qualification by the fund (failure to maintain 90% asset test)
- Related party transactions that effectively transfer economic benefit
- Certain partnership transactions affecting the investor’s interest
Understanding inclusion events is critical for investors planning liquidity events or restructuring their QOF holdings. Inadvertent inclusion events can accelerate tax liability at unexpected times.
Securities Law Considerations for QOF Formation
Forming a QOF requires compliance with federal and state securities laws in addition to the tax qualification requirements. QOF interests are securities, and their offer and sale must either be registered with the SEC or qualify for an exemption from registration.
Most QOFs rely on Regulation D exemptions:
- Rule 506(b): Allows unlimited capital raising from accredited investors and up to 35 sophisticated non-accredited investors, but prohibits general solicitation
- Rule 506(c): Permits general solicitation and advertising, but restricts sales exclusively to verified accredited investors
The choice between 506(b) and 506(c) has significant implications for QOF marketing and investor qualification procedures. Fund managers must also navigate state blue sky laws, anti-fraud provisions, and ongoing reporting obligations.
For fund managers combining QOF tax benefits with private lending strategies (such as a QOF that makes loans within opportunity zones), the securities analysis must address both the fund-level offering and the nature of the underlying lending activities.
2025 Program Status and Current Viability
The QOZ program has undergone significant legislative and regulatory development since its 2017 enactment:
- Capital gains deferral deadline: The original deferral period for invested gains was set to expire on December 31, 2026, at which point all deferred gains become taxable regardless of whether the QOF investment has been sold.
- Step-up benefits reduced: The 15% basis step-up (for investments held 7+ years) is no longer available for new investments made after 2019, and the 10% step-up (for investments held 5+ years) is unavailable for investments made after 2021.
- 10-year exclusion remains: The most powerful benefit, the permanent exclusion of gains on appreciation in the QOF investment itself (for investments held 10+ years), continues to be available for qualifying investments.
As of 2025, legislative proposals to extend, modify, or make permanent various QOZ provisions have been introduced in Congress, but the program’s long-term future beyond the current statutory sunset dates remains uncertain. Investors considering new QOF investments should evaluate:
1. Whether the 10-year gain exclusion benefit alone justifies the investment (since basis step-up benefits are no longer available for new investments) 2. The 2026 deadline for recognizing all deferred gains 3. Whether pending legislation may extend or modify the program before sunset 4. The underlying investment merit independent of tax incentives
Private lenders financing QOF projects should assess whether the tax-driven timeline pressures (30-month improvement deadlines, 10-year hold requirements) align with their lending parameters and risk tolerance.
Conclusion
The Qualified Opportunity Zone program created meaningful tax incentives that have driven billions of dollars in investment toward designated communities. For private lenders and fund managers, the program presents both direct participation opportunities (structuring QOFs) and indirect financing opportunities (lending to QOF-owned projects). The regulatory framework is technically demanding, with multiple tests, timing requirements, and disqualification risks that require careful legal and tax planning.
As the program approaches its statutory sunset provisions, investors and their advisors must weigh the remaining available benefits against the complexity and restrictions inherent in QOF compliance.
For guidance on Qualified Opportunity Fund formation, securities compliance, or lending to QOZ projects, contact Geraci LLP at (949) 403-3488.
Geraci LLP | 90 Discovery, Irvine, CA 92618 | (949) 403-3488
