New OZ Regs: Substantially Improving the Substantial Improvement Test, Part I

Published by Dawna Steelman, Jerome A. Breed on Thursday, March 5, 2020
Journal cover thumb March 2020

With receipt of the final regulations from the Treasury Department, taxpayers have sufficient guidance to structure opportunity zones (OZ) investments with confidence.

The OZ incentive was enacted as part of 2017 tax reform legislation (H.R. 1). Treasury issued proposed regulations Oct. 28, 2018, and again May 1, 2019, leading to final regulations issued Dec. 19, 2019. Final regulations resolved ambiguities, corrected errors and created clarity on a number of issues that may have been sidelining potential OZ investors. The scope of the final regulations precludes a comprehensive discussion of the significant changes from the proposed regulations, so this article, which will have a second part, will focus exclusively on the revised guidance concerning the “substantial improvement” requirement. The second installment will focus on issues related to property leased to a qualified OZ business operated through a separate entity taxed as a partnership for federal income tax purposes.

The Basics

The OZ incentive encourages investment in property located and used within economically distressed areas designated as qualified OZs. Under the OZ incentive, taxpayers invest in a qualified OZ fund (QOF), an entity organized to invest in qualified OZ property. The QOF must invest at least 90 percent of the aggregate basis of its assets in (1) qualified OZ stock, (2) qualified OZ partnership interests in a qualified OZ partnership, or (3) directly in qualified OZ business property. In our experience, almost all QOFs invest in qualified OZ partnerships. A qualified OZ business is an active business that holds substantially all (at least 70 percent) of its tangible real and personal property within an OZ (the 70 percent test) that is used in the active conduct of a trade or business, subject to some additional requirements not relevant here. This article discusses the substantial improvement test as applied to qualified OZ property.

Qualified OZ Business Property

Qualified OZ business property must either be acquired by purchase from an unrelated seller after Dec. 31, 2017, or leased pursuant to market rate terms after Dec. 31, 2017, as described below. The second installment of this article will deal with leasing issues. Either (i) the original use of the property must commence with the qualified OZ business or (ii) the qualified OZ business must substantially improve the property. Substantially all of the use of the property must occur within the OZ. “Substantially improve” means that the QOF must double its adjusted basis in the property after purchase and during any 30-month period that it holds the qualified OZ business property.

The Final Regulations and Substantial Improvement.

Given the favorable rules provided by the final regulations regarding substantial improvement, it is somewhat surprising that if a qualified OZ business improves nonqualified property located in an OZ, such as property purchased before Dec. 31, 2017, or property purchased from a related party, the improvements themselves do not qualify as qualified OZ business property, despite qualifying as original-use property. The preamble to the final regulations explains that the IRS determined the administrative burdens of bifurcating improved non-qualified OZ business property between its original basis (which would not count for purposes of the 70 percent test) and the subsequent improvements (which would help the taxpayer satisfy the 70 percent test if they were permitted to be treated as qualified OZ business property) outweighed the benefits to be derived from such a bifurcation calculation. The application of this rule may in some circumstances be avoided by leasing the property for a period less than the period that would transfer ownership of the improvements. This and other issues related to leased property will be discussed in the second installment of our OZ article.

First, under the final regulations, if a qualified OZ business purchases a building located within an OZ, the substantial improvement requirement is calculated by reference to the qualified OZ business’s adjusted basis in the building, exclusive of the basis of the land on which the building sits. While the qualified OZ business is not required to separately substantially improve the land upon which the building is located, the land must be used in its business. The final regulations confirm that the land used in the qualified OZ business will be treated as qualified OZ business property, despite not meeting the requirements of being either original-use property or substantially improved property. The final regulations also include an anti-abuse rule prohibiting land banking, i.e., acquiring land solely or primarily for speculative investment.

Second, as mentioned above, it is the adjusted tax basis of the property that must be doubled during the 30-month period, not the original cost. Before the final regulations, it appeared the substantial-improvement test applied to the original cost. Some qualified OZ businesses may see that as an opportunity to delay commencement of construction or rehabilitation to allow for depreciation to reduce the property’s adjusted basis. However, the final regulations provide that substantially improved property will qualify as qualified OZ business property during the 30-month period it is being improved, not before the 30-month period. A delay in improving the property could jeopardize the 70 percent test.

Third, a qualified OZ business may substantially improve property by purchasing other property that satisfies the original-use test and aggregating the basis of the original-use property with the improvements so long as that original-use property improves the functionality of the property being substantially improved. The non-original use real property must be improved by more than an “insubstantial amount” as a prerequisite to the inclusion of additional tangible property in the substantial rehabilitation test. Before the final regulations, the calculation of substantial improvement was to be done on an asset-by-asset basis, but that was impractical in many situations. While the aggregation permitted by the final regulations has limitations, they are both reasonable and understandable. The example given in the final regulations is of a hotel:

For example, if a QOF purchases and intends to substantially improve a hotel, the QOF may include “original use” purchased assets in the basis of the purchased hotel to meet the substantial improvement requirement if those purchased assets are integrally linked to the functionality of the hotel business. These “original use” purchased assets could include mattresses, linens, furniture, electronic equipment, or any other tangible property. However, for purposes of the substantial improvement requirement, the QOF may not include in the basis of that hotel an apartment building purchased by the QOF that is operated in a trade or business separate from the hotel business.

These rules would permit the purchase of a warehouse and its conversion into a manufacturing facility or other comparable use, if the warehouse was more than insubstantially improved and the cost of the rehabilitation plus the cost of the equipment installed in the building exceeded the adjusted basis of the purchased warehouse at the commencement of the rehabilitation.

Fourth, the final regulations permit a qualified OZ business that owns several buildings within an OZ (or a series of contiguous parcels) to aggregate the basis and improvements made to the buildings treating them as a single piece of property for purposes of measuring substantial improvement. The result is that the amount of basis required to be added to those buildings via improvements will equal the sum of adjusted basis calculated by adding the adjusted basis of each such building comprising the single property and additions to the adjusted basis of each building comprising the single property are aggregated to determine satisfaction of the substantial improvement requirement. This rule resolves any issues with respect to purchase of multiple buildings when one building does not require rehabilitation but the cost of rehabilitation and outfitting the remaining buildings exceeds the adjusted basis of the purchased assets.

The final regulations permit a qualified OZ business to treat all buildings located upon a parcel of land described in a single deed as a single property and buildings that are located upon contiguous parcels of land described in separate deeds as a single property to the extent each building is operated as part of one or more trades or businesses that meet the following three requirements:

the buildings must be operated exclusively by the qualified OZ business;

the buildings must share either facilities or other resources, i.e., accounting, human resources, legal, manufacturing, purchasing, technology or personnel; and

the buildings must be operated as part of one or more of the trades or businesses.


The final regulations provide several favorable rules related to qualification of property as qualified OZ business property. Land does not have to be substantially improved to qualify as qualified OZ business property. During the 30-month period, the qualified OZ business must increase the adjusted basis, not the original cost, of the property by 100 percent. In calculating the adjusted basis of property, a qualified OZ business can aggregate improvements with original-use property that is integrally linked to the function of the qualified OZ business. Additionally, the qualified OZ business can aggregate buildings on the same parcel or contiguous parcels if they are operated by a qualified OZ business, they share facilities and they operate pursuant to an integrated plan. The final rules are mostly favorable to taxpayers and should answer questions about a number of OZ investment issues.

Part II of this article will appear in the April 2020 issue and will discuss leasing issues.

Disclaimer: This is for general information and is not intended to be and should not be taken as legal advice for any particular matter. It is not intended to and does not create any attorney-client relationship. The opinions expressed and any legal positions asserted in the article are those of the author and do not necessarily reflect the opinions or positions of Miles & Stockbridge, its other lawyers or the Novogradac Journal of Tax Credits.

Dawna Steelman and Jerome Breed are principals at Miles & Stockbridge.