On July 4, President Trump signed into law the “One Big Beautiful Bill Act (OBBBA),” more formally known as “H.R.1 – An Act to provide for reconciliation pursuant to title II of H. Con. Res. 14.”
The OBBBA includes provisions that establish a “second tranche” for the qualified opportunity zone (QOZ) and qualified opportunity fund (QOF) program that generally applies beginning on January 1, 2027. This “second tranche” picks up following the conclusion of the initial QOZ/QOF program on December 31, 2026, which marks the end of the original program’s investment period and the date when deferred gain is recognized under current law (the 2017 Tax Cuts and Jobs Act).
This article addresses the principal features of the second tranche and does so in the context of QOZ planning that implicates estate planning. As further discussed, many of the estate planning-specific rules in the context of QOZs and QOFs under the 2017 Tax Cuts and Jobs Act are effectively unchanged under the OBBBA. Accordingly, careful identification of interests in QOFs, and planning with QOF interests, continues to be required. In addition, investors in QOFs under the 2017 Tax Cuts and Jobs Act need to be mindful of the upcoming inclusion event date of December 31, 2026, and carefully consider their liquidity needs to fund the deferred capital gains tax liability that will soon be coming because of this upcoming gain recognition date.
Opportunity Zones
The 2017 Tax Cuts and Jobs Act included in section 1400Z-2[1] a new tax incentive provision that was intended to promote investment in economically distressed communities, referred to as “Opportunity Zones.” Through this program, investors could achieve the following three significant tax benefits:
- The deferral of gain on the disposition of property to an unrelated person generally until the earlier of the date on which the subsequent investment is sold or exchanged, or December 31, 2026, so long as the gain is reinvested in a QOF within 180 days (or 180 deemed days) of the property’s disposition. (Note that there is no interest charge on this deferral.)
- The elimination of up to 15% of the gain that has been reinvested in a QOF, provided that certain holding period requirements are met.[2]
- The potential elimination of tax on gains associated with the appreciation in the value of a QOF, provided that the investment within the QOF is held for at least 10 years.
An Opportunity Zone is an economically distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment. Localities qualify as Opportunity Zones if they have been nominated for that designation by the state and if the nomination has been certified by the Internal Revenue Service (IRS).
Qualified Opportunity Funds
A QOF, in turn, is an investment vehicle that is established as either a domestic partnership or a domestic corporation for the purpose of investing in eligible property that is in an Opportunity Zone and uses investor gains from prior investments as a funding mechanism.
To become a QOF, the entity self-certifies itself. The entity must meet certain requirements. In particular, a general requirement is that at least 90% of its assets be “qualified opportunity zone property” used within an Opportunity Zone, but no approval or action by the IRS is required. To self-certify, the entity completes Form 8996 and then attaches it to the entity’s timely filed federal income tax return for the taxable year (taking into account extensions).[3]
Deferral of Gain Through Timely Reinvestment in QOFs
To qualify for these tax benefits, the investor’s reinvestment in the QOF must occur during the 180-day period beginning on the date of the sale. Special timing rules apply to, among other things, certain gains from real estate investment trusts, partnerships, and other flow-through entities.
Under IRC section 1400Z-2(a)(2), the taxpayer may elect to defer the tax on some or all of that gain. If, during the 180-day period, the taxpayer invests in one or more QOFs an amount that was less than the taxpayer’s entire gain, the taxpayer may still elect to defer paying tax on the portion of the gain invested in the QOF. If, in contrast, an amount more than the taxpayer’s gain is transferred to the fund (a so-called “investment with mixed funds”), the taxpayer is treated, for tax purposes, as having made two separate investments. One that only includes amounts as to which the investor’s deferral election is made, and a separate investment consisting of other amounts.
Importantly, the law requires only that the gain be reinvested in the QOF and not the total sales proceeds. The final regulations that were issued in 2019 clarified that, in general, only capital gains are eligible to be invested in a QOF. Additionally, in contrast to Section 1031 “like-kind” exchanges (another mechanism of gain deferral through reinvestment), in the QOF context, the cash from the sale does not need to be specifically tracked or escrowed. Instead, the requirement is merely that an amount of cash equal to the gain on the sale be reinvested in a QOF within the relevant 180-day time period.
The taxpayer’s basis in the QOF is initially zero but will be increased by 10% of the deferred gain if the investment in the QOF is held for five years. Under the 2017 Tax Cuts and Jobs Act, it will be increased by an additional 5% (to 15% of the deferred gain in total) if the investment in the QOF is held for seven years. In each case, the determination is made as of December 31, 2026.
Thus, through December 31, 2026, if a gain on the sale of property is timely reinvested in a QOF, the taxpayer may be able to decrease the taxable portion of the originally deferred gain by 15% (through a corresponding basis step-up) if the investment in the QOF is held for at least seven years. The taxpayer makes an election to defer the gain, in whole or in part, when filing the tax return on which the tax on that gain would otherwise be due if it were not deferred.
Exclusion of Gain on Appreciation in the Value of QOF if Held for at Least 10 Years
The tax incentives of this program go well beyond tax deferral (even putting aside the potential basis adjustments discussed above), as subsequent gain on the appreciation in the value of the QOF is capable of being fully excluded from income. To qualify, the investor must hold its investment in the QOF for at least 10 years.
QOF Requirements
An entity must meet certain requirements to qualify as a QOF. Specifically, a QOF must meet the90% Asset Test whereby 90% of its assets, measured every six months and averaged for each year, must be qualifying “QOZ Property.” To meet this requirement, a QOF may (1) directly own “QOZ Business Property” or (2) own an interest in a “QOZ Business” that in turn owns QOZ Business Property. A QOF may not, however, own (as a qualifying asset) an interest in another QOF. A QOZ Business must (1) have “substantially all” of its tangible assets invested in QOZ Business Property, (2) meet certain requirements under Section 1397C regarding permissible assets (including a general prohibition against owning more than 5% nonqualified financial assets such as cash), and (3) comport with certain “sin business” prohibitions under section 144(c)(6)(B).
QOZ Business Property generally means tangible property acquired by the purchase from an unrelated party. This property is either “originally used” in the QOZ by the QOF or QOZ Business, or is “substantially improved” by the QOF or QOZ Business. “Substantially improved” generally means improvements over a period of 30 months that result in a 100% increase to the adjusted basis of the property. “Relatedness,” for this purpose, is generally determined by a 20% or greater common ownership test taking into account certain constructive ownership rules.
Effect of Death
Section 1400Z-2(e)(3) provides that, “[i]n the case of a decedent, amounts recognized under this section shall, if not properly includible in the gross income of the decedent, be includible in gross income as provided by section 691.” Section 691 sets forth the rules that apply to a person’s receipt of income in respect of a decedent (IRD). IRD refers to income earned by a decedent who was a cash basis taxpayer prior to his or her death, but that is not properly includible in income until after the decedent’s death. IRD is not reportable on the decedent’s final income tax return. Rather, it is reportable by the recipient of the IRD item (e.g., by the decedent’s estate or some other person). Importantly, under Section 1014(c), there is no step-up in basis on death in the case of IRD.
Special Rule That Caps Gain at Fair Market Value at Date of Triggering Event
Section 1400Z-2(b)(2) contains a special rule that caps the amount of the gain so as not to exceed the fair market value of the investment as of the date that the gain is included in income. It provides as follows:
1400Z-2(b)(2) AMOUNT INCLUDIBLE.—
1400Z-2(b)(2)(A) IN GENERAL.— The amount of gain included in gross income under subsection (a)(1)(A) shall be the excess of—
- (i) the lesser of the amount of gain excluded under paragraph (1) or the fair market value of the investment as determined as of the date described in paragraph (1), over
- (ii) the taxpayer’s basis in the investment.
The final regulations modified this rule to potentially limit discounts for lack of control and lack of marketability in determining fair market value.
Gifts and Bequests
Under the final regulations, gifts (other than to a grantor trust) are treated as a disposition of the QOZ investment triggering inclusion of the deferred gain in income. In contrast, gifts to grantor trusts are not treated as a deemed disposition of the QOZ investment, and therefore will not trigger inclusion of the deferred gain in income.
In addition, the final regulations clarified that this treatment also applies to all transactions with grantor trusts, which would include sales or other transactions with grantor trusts, such as swaps. The final regulations further clarified that it does not matter whether the investment or capital gain is by the grantor or the grantor’s grantor trust.
Further, 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. There is no step-up in basis upon death with respect to QOF interests. In addition, the five-year, seven-year, and 10-year holding period benefits tack to the transferee in the case of gifts to grantor trusts and bequests upon death.
Pass-Through Entities
The final regulations include special provisions where gain recognized by a partnership may (except to the extent the partnership elects to rollover the gain itself) flow through to the partners and be reinvested by those partners into QOFs. In addition, there is the potential for such partners to have an increased period to reinvest gain into a QOF.
The partnership’s 180-day period begins on the date of its sale, but if the gain flows through to the partners, the partners’ 180-day period begins on the last day of the partnership’s taxable year. Partners may instead elect to use the partnership’s 180-day period if they so desire (e.g., if the desired investment is already lined up).
The final regulations provided an additional option under which investors may elect to start their 180-day period for their share of gain from the pass-through entity on the due date (without extensions) of the pass-through entity’s tax return for the taxable year in which the sale or exchange took place (generally, either March 15 or April 15 of the following year).
The following additional aspects of the final regulations are noteworthy.
No Inclusion Event on Contributions of QOF Interests to Partnerships
The final regulations provide that contributions of QOF interests to entities taxed as partnerships that are not taxable transactions under section 721(a) are not inclusion events.
Meanwhile, Contributions of QOF Interests to Corporations Are Inclusion Events
In contrast, contributions of QOF interests to entities taxed as C corporations or S corporations that would otherwise be tax-free under section 351 are inclusion events.
Transfers of Interests in Partnerships That Hold QOF Interests Are Inclusion Events
In addition, transfers of interests in partnerships that hold QOF interests (i.e., indirect interests in QOFs) are inclusion events (unless they are to grantor trusts). The final regulations provided that the inclusion event rules generally “apply to transactions involving any direct or indirect partner of the QOF to the extent of that partner’s share of any eligible gain of the QOF.” In addition, page 48 of the preamble to the final regulations notes that “[a]n inclusion event is a transaction that reduces or terminates the QOF investor’s direct (or, in the case of partnerships, indirect) qualifying investment for federal income tax purposes … .”
Transfers of Interests in Corporations That Hold QOF Interests Are Not Inclusion Events
In contrast, transfers of interests in corporations that hold QOF interests are not inclusion events. As noted above, the final regulations provide that the inclusion event rules generally apply to transactions involving any direct or indirect partner of the QOF. No similar rule applies to C corporations or S corporations.
QSST and ESBT Conversions
The final regulations confirmed that neither a conversion from a qualified subchapter S trust (QSST) to an electing small business trust (ESBT), nor vice versa, is an inclusion event if the person who is both the deemed owner of the “grantor portion” of the ESBT holding the qualifying investment and the QSST beneficiary is the person taxable on the income from the qualifying investment both before and after the conversion.
There would, however, be an inclusion event upon conversion if the qualifying investment is in the grantor portion of the ESBT and the ESBT’s deemed owner under the grantor trust rules is a nonresident alien.
QOF and QOZ Changes Under the OBBBA
Against this backdrop, the OBBBA includes the following changes pertaining to QOFs and QOZs.
The QOZ Program Has Been Extended Indefinitely With a New Second Tranche Starting on January 1, 2027
The original QOZ program was scheduled to expire for new investments on December 31, 2026. The OBBBA creates a second tranche starting on January 1, 2027. In this second tranche, every 10 years, state governors will propose QOZs, and the Secretary of the Treasury will certify those zones with the effective date for new QOZ designations to be July 1, 2026 (and every 10 years thereafter).
Stricter Eligibility Criteria Will Apply to QOZ Designations
The OBBBA tightens the rules under which census tracks can qualify as QOZs. The definition of a “low-income community” has been tightened. Now, a census tract qualifies if its median family income does not exceed 70% of the state or metropolitan median family income, or if it has a poverty rate of at least 20% and a median family income not exceeding 125% of the relevant median family income.
The OBBBA also repeals the much criticized “contiguous tract” rule, which allowed a census tract contiguous to a “low-income community” to be designated as a QOZ census tract so long as its median family income did not exceed 125% of the median family income of the low-income community to which the tract was adjacent.
In addition, the blanket QOZ designation for all low-income communities in Puerto Rico has been repealed after December 31, 2026.
New Rolling Five-Year Gain Deferral and Permanent 10% Basis Step-Up
For investments made after December 31, 2026, gains deferred through investment in the QOZ program will now be recognized on the fifth anniversary of the investment date (unless there is an earlier sale or exchange), rather than a fixed date.
OBBBA also makes permanent a 10% basis step-up benefit, which takes effect immediately before the end of the five-year deferral period. This means that, after December 31, 2026, all gains that are not prematurely triggered (i.e., through a sale or exchange of an investment in a QOF) will have the benefit of a 10% basis increase. Notably, OBBBA eliminates the additional 5% basis step-up (which previously applied where there was a seven-year holding period) and caps the benefit at 10%.
New Qualified Rural Opportunity Funds With Heightened Benefits
The OBBBA creates a new category of fund knows as a “Qualified Rural Opportunity Fund” (QROF) that provides investors in rural communities with additional tax benefits.
A QROF is a QOF in which its 90% asset test (including with respect to any QOZ Business in which the QOF owns an interest) is comprised entirely of rural area property.
A “rural area” is defined as any area other than(1) a city or town that has a population greater than 50,000 and (2) an urbanized area adjacent to a city or town that has a population more than 50,000.
The tax benefits obtained by QROFs are significantly enhanced relative to those available to “regular” QOFs. Such as:
- A 30% basis step up after five years (compared to a 10% basis step up for “regular QOFs”).
- A reduced “substantial improvement” requirement. Only in excess of 50% of adjusted basis must be reinvested in property improvements (as compared to in excess of 100% of adjusted basis for “regular QOFs”). (Note that this provision is effective immediately.)
Gain Elimination Frozen After 30 Years
OBBBA eliminates the sunset provision terminating QOZ benefits for QOF investments liquidated after December 31, 2047, and establishes in its place a 30-year rolling horizon on gain elimination with respect to post 10-year dispositions of QOF investments. For investments sold or exchanged before 30 years, the step-up will reflect the fair market value of that investment as of the date such investment is sold or exchanged. In contrast, for investments held 30 years or more, the basis step-up will be frozen at the fair market value on the 30th anniversary of the investment.
New Reporting Requirements and Penalties for Non-Compliance
OBBBA introduces a detailed reporting regime and a new penalty provision.
January 1, 2027, Effective Date for Tranche 2 – However, Rules That Implicate Estate Planning Are Generally Unchanged
Nearly all of the new QOZ provisions take effect after December 31, 2026, which marks the end of original program’s investment period and the date when deferred gain is recognized under current law. It is expected that regulations will be issued by Treasury prior to January 1, 2027, to fill in the legislative gaps.
Very importantly, the estate planning-specific provisions discussed above are effectively unchanged by the OBBBA. So careful identification of interests in QOFs, and planning with QOF interests, continues to be required.
In addition, investors in QOFs under the 2017 Tax Cuts and Jobs Act must be mindful of the upcoming inclusion event date of December 31, 2026. Accordingly, investors in QOFs under the 2017 Tax Cuts and Jobs Act should carefully consider their liquidity needs to fund the capital gains tax liability that is soon coming due to this upcoming gain recognition date.
[1] Unless otherwise stated, references herein to “section(s)” are to the Internal Revenue Code (IRC) of 1986, as amended. References in this memorandum to “§” are to relevant sections of the US Department of the Treasury regulations promulgated under the code.
[2] This is accomplished through basis adjustments. Section 1400Z-2(b)(2)(B)(iii) provides that in the case of any investment in a QOF that is held for at least five years, the basis of such investment shall be increased by 10% of the deferred gain. In addition, section 1400Z-2(b)(2)(B)(iv) provides for an additional 5% increase in the basis of the QOF investment if it is held by the taxpayer for at least seven years.
[3] The IRS Form 8996 and the instructions thereto are set forth at the following links: https://www.irs.gov/pub/irs-pdf/f8996.pdf and https://www.irs.gov/pub/irs-pdf/i8996.pdf.