QOF Due Diligence: Vetting a Qualified Opportunity Fund Before You Invest

Nobody approved this fund, so the tax tests are yours to verify

Reg. section 1.1400Z2(d)-1 lets a corporation or partnership organized under the law of the United States or a state self-certify as a qualified opportunity fund. The IRS page on certifying and maintaining a fund says the entity does that by filing Form 8996 with its return every year, by the due date including extensions. There is no application and no approval letter.

On the securities side the picture is the same. The SEC explains that Form D is a notice of an exempt offering under Regulation D, filed within 15 days after the first sale and public on EDGAR, and that filing it does not mean the SEC has reviewed or approved the offering. The private placement memorandum is the sponsor's document, written by the sponsor's lawyers.

So the burden is on you and your CPA to confirm the fund can pass the tests that decide whether your deferral holds. The sections below are the tests, each paired with the question it generates.

The asset tests the IRS will apply, and the questions they generate

Section 1400Z-2(d)(1) requires the fund to hold at least 90% of its assets in qualified opportunity zone property, measured as the average of the percentages on the last day of the fund's first six-month period and the last day of its tax year. Section 1400Z-2(f) charges a penalty for each month of a shortfall, computed on the shortfall at the underpayment rate under section 6621(a)(2); the Form 8996 instructions walk through that computation in Part IV. Ask for the last two Forms 8996 and the percentages on each testing date.

Most funds hold interests in zone businesses rather than property directly, and the regulation tests the business: at least 70% of its tangible property, by value, must be zone business property; at least 50% of its gross income must come from the active conduct of business in the zone, met by any of three safe harbors based on hours, compensation or the location of property and management; and less than 5% of its property may be nonqualified financial property. Cash held under a written working capital plan to be spent within 31 months of receipt is excluded from that 5%. Ask for the written plans and the spending schedule against them.

Section 1400Z-2(d)(3) also bars the businesses listed in section 144(c)(6)(B): a private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other gambling facility, or a store whose principal business is selling alcoholic beverages for off-premises consumption. A mixed-use project with such a tenant needs a lawyer's answer on how it is structured.

Where the tracts are and when they were designated now decides what the fund can buy

The 2018 zones expire December 31, 2028, and section 5 of Notice 2026-40 says tangible property acquired after December 31, 2026 cannot be zone business property unless it is for use in a zone designated after July 4, 2025, bought under a working capital plan adopted by December 31, 2026 that was at least 10% funded and 5% spent by then, or acquired as an ordinary-course replacement. The 2027 opportunity zone map covers the new designations.

For a fund raising money in 2027 the questions are concrete: list every tract in the pipeline, state whether each is a 2027 zone or a 2018 zone, and for 2018 zones show the plan adopted by December 31, 2026 and the funding and spending by that date. A fund that cannot answer is asking you to take the acquisition rule on faith.

Used property also has to be substantially improved, with additions to basis exceeding the starting basis within 30 months, or 50% of it in an all-rural zone; the substantial improvement test sets out the rule. Ask for the improvement budget against the building basis, excluding land, for each asset.

Reading the offering: fees, sponsor and reporting

The fee analysis is the same one you would run on any private real estate placement: acquisition fees, asset management fees, development fees paid to affiliates, promote and disposition fees, all disclosed in the memorandum. DST fees and loads and reading a PPM and Form D show how to pull those numbers from the documents, and evaluating sponsors covers track record and conflicts. The fund's Form D lists the issuer, the exemption claimed, the amounts sold and the sales commissions.

Reporting is new. For taxable years beginning after July 4, 2025, section 6039K requires the fund to file an annual return with asset values at each testing date and, for each zone business, the census tract, industry code, residential units and full-time equivalent employees, and to furnish statements to investors; section 6726 penalizes a failure to file at $500 a day. Ask who at the sponsor owns that filing and how the zone businesses will supply the data. OZ fund reporting requirements has the detail.

The exit timeline: a tax bill at five years, an exclusion at ten, a cap at thirty

For money invested after December 31, 2026 the deferred gain is included at the earliest of a sale, another inclusion event or the fifth anniversary, reduced by a 10% basis step-up, 30% in a qualified rural opportunity fund. The fund is under no obligation to distribute cash on that date. Ask the sponsor what it expects the fund to be doing in year five and plan to pay the tax from other assets; the rolling five-year deferral runs the numbers.

The exclusion of the fund's own appreciation requires a ten-year hold and an election under section 1400Z-2(c) on sale, with fair market value fixed at the thirtieth anniversary for post-2026 money. Reg. section 1.1400Z2(c)-1 extends the election to property sales by a fund taxed as a partnership, other than inventory, so a fund that sells assets one at a time after year ten can still deliver the exclusion. Ask what the memorandum says about the intended hold, whether the sponsor can sell assets before year ten, and what happens to investors if it does. The ten-year and thirty-year rules explain the mechanics.

Distributions during the hold are not guaranteed by anything in the statute, and a distribution from a partnership fund that exceeds your basis is itself an inclusion event under Reg. section 1.1400Z2(b)-1(c). Treat any projected distribution in a memorandum as the sponsor's forecast, with the risk factors beside it.

No like-kind requirement, and no 1031: what a fund accepts

Reg. section 1.1400Z2(a)-1(b)(11) defines eligible gain as gain treated as capital gain or qualified section 1231 gain, not arising from a sale to a related person, and the investment must be made within 180 days of the date the gain would otherwise be recognized. The gain can come from a business, stock, collectibles or real estate, and only the gain goes in; the rest of the proceeds stay with you. There is no requirement that the fund hold anything resembling what you sold.

What a fund cannot take is money from a 1031 exchange. A fund interest is not like-kind to real property, so exchange funds that go into one are taxable boot; putting 1031 funds into an opportunity zone fund explains the result, and 1031 versus an opportunity fund versus paying the tax compares the routes for a real estate gain. Our opportunity zone fund page describes how we place clients in funds we have reviewed, and the opportunity zone case study shows a business sale handled this way.