The Opportunity Zone (OZ) Substantial Improvement Test

The test is a basis comparison over 30 months, not a construction budget

Section 1400Z-2(d)(2)(D) defines qualified opportunity zone business property as tangible property acquired by purchase, used substantially all of the time in a zone, whose original use in the zone commences with the fund or which the fund substantially improves. Clause (ii) says property is substantially improved only if, during any 30-month period beginning after acquisition, additions to its basis in the fund's hands exceed its adjusted basis at the beginning of that period.

Reg. section 1.1400Z2(d)-2(b)(4) repeats the rule and calls the window the 30-month substantial improvement period. Additions to basis are costs the fund capitalizes into the property, such as construction and renovation; amounts deducted currently as repairs do not add to basis, so they do not count toward the test.

The test applies only where original use does not start with the fund. New construction, and buildings never placed in service in the zone before, meet the original use test instead and need no doubling.

Land is excluded, and the building is measured on its own basis

Rev. Rul. 2018-29 addressed a fund that bought an existing factory and its land. It held that original use of an existing building does not start with the fund, that the original use requirement does not apply to the land under it, that substantial improvement of the building is measured by additions to the building's basis alone, and that the fund need not separately improve the land.

The final regulations adopt the same rules. Reg. section 1.1400Z2(d)-2(b)(4)(iv) says unimproved land acquired by purchase does not have to be substantially improved, and that there is no requirement to improve the land under a building. The exception is land bought with an expectation or intention not to improve it by more than an insubstantial amount within 30 months, which is not qualifying property unless it is substantially improved; grading, clearing and remediation count toward showing that intention.

So for a $5,000,000 purchase with $1,000,000 allocated to land, the fund must add more than $4,000,000 to the building's basis, not $5,000,000. The regulation's own hotel example works the same way.

Rural zones need only 50 percent after the 2025 tax act

Public Law 119-21 inserted a 50 percent threshold into section 1400Z-2(d)(2)(D)(ii) for property in a qualified opportunity zone comprised entirely of a rural area, effective on enactment, July 4, 2025. The statute defines a rural area as any area other than a city or town with a population over 50,000 and any urbanized area contiguous and adjacent to such a city or town.

Notice 2025-50 applies the change to the 2018 zones. For any determination made on or after July 4, 2025, the test is met if additions to basis exceed 50 percent of the adjusted basis at the start of the 30-month period. The notice uses 2020 census data, lists the 3,309 existing zones comprised entirely of a rural area in its appendix, and treats an area as contiguous and adjacent if it shares a boundary or a single point.

Rural zones carry a separate investor benefit from 2027, a larger basis increase for investments in a qualified rural opportunity fund, covered on the qualified rural opportunity funds page.

Aggregation and the 30-month grace period help funds meet the test

Under Reg. section 1.1400Z2(d)-2(b)(4)(iii), a fund may count the cost of newly purchased property that improves the functionality of the building, such as furniture or equipment, toward the building's additions to basis. In the regulation's hotel example the fund met the test by combining structural work with new furniture, gym equipment and restaurant equipment, but those items then do not count separately as original use assets.

Paragraph (b)(4)(v) lets a fund treat a group of buildings on one deeded parcel, or on contiguous parcels operated together, as a single property, so spending can be pooled. Paragraph (b)(4)(ii) treats property still being improved as qualifying for the 90 percent investment standard during the 30 months, if the fund reasonably expects to finish the improvement and use the property in the zone by the end of the period.

Vacancy can avoid the test altogether. Paragraph (b)(3) says real property that was vacant for an uninterrupted year before the zone was designated, or for three years after, and stayed vacant until purchase, begins original use with the buyer. Vacant means more than 80 percent of the usable space is unused.

What the test means for an investor rolling gains into a fund

A fund that misses the test holds nonqualifying property, which can cause it to fail the 90 percent asset test and owe the monthly penalty under section 1400Z-2(f) unless the failure is due to reasonable cause. Investors should ask for the fund's improvement budget measured against building basis, the start and end of each 30-month period and the plan for land. The QOF due diligence page lists further questions.

Gains invested after December 31, 2026 qualify for the rolling five-year deferral, and the ten-year and thirty-year rules govern the exclusion of fund appreciation. Opportunity zone funds carry construction, lease-up and liquidity risk, and returns are not assured; the opportunity zone overview covers the basics.