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How a Qualified Opportunity Zone Business Qualifies: The Asset Tests, Substantial Improvement, and the Working Capital Safe Harbor
Updated August 2026 • Educational resource from Urban Catalyst
Key Takeaways
- The Opportunity Zone rules impose requirements at two levels. A Qualified Opportunity Fund (QOF) must generally hold at least 90% of its assets in qualified opportunity zone property, tested twice a year. Most QOFs meet that test by holding interests in one or more qualified opportunity zone businesses (QOZBs), which face their own set of tests.
- At the QOZB level, the principal requirements include a 70% tangible property test, a 50% gross income test tied to active conduct in the zone, a 40% intangible property test, a less-than-5% limit on nonqualified financial property, and exclusion of certain enumerated businesses.
- Tangible property generally qualifies only if its original use in the zone begins with the fund or business, or if the property is substantially improved — historically, additions to basis exceeding the property’s adjusted basis within a 30-month period. For property in a zone comprised entirely of a rural area, 2025 legislation reduced that threshold to 50% of adjusted basis.
- The working capital safe harbor lets a business hold cash for a development plan without that cash counting against the nonqualified financial property limit, provided the business has a written designation and a written spending schedule and follows them — generally 31 months, with a documented path to as much as 62 months for multiple deployments.
- These are fund-level and business-level compliance requirements, not investor elections. They bear on execution risk, and none of them is a measure of investment performance. Whether any particular property or business satisfies them is a legal and factual determination for the fund’s own tax and legal advisers.
Urban Catalyst and its affiliates do not provide tax, legal, or financial advice. The information below is general and educational in nature. This article discusses federal income tax treatment. State and local tax treatment may differ materially. For example, California does not currently conform to the federal Opportunity Zone gain-deferral and exclusion provisions, so a California taxpayer may recognize gain for California purposes even where federal treatment is deferred or potentially excluded. Every investor’s situation is different. Please consult your own tax professional regarding the laws applicable to your residence and circumstances.
Why the Qualification Rules Matter to an Investor
The investor-side mechanics of an Opportunity Zone investment — the eligible gain, the 180-day period, the elections — are covered in our guide How to Potentially Defer Capital Gains Tax With an Opportunity Zone Fund. This guide covers the other half: the requirements the fund and its underlying businesses have to satisfy on an ongoing basis for the investment to remain a qualifying one.
The distinction is worth drawing because the two sets of rules fail in different ways. An investor-side failure generally goes to whether a particular gain was eligible and timely invested. A fund-side failure goes to whether the vehicle itself continues to meet the statutory standard, which carries a monthly penalty at the fund level under Section 1400Z-2(f). Whether and how a fund-level failure affects a particular investor’s qualifying investment depends on facts addressed in the fund’s own documents and by its advisers. For an investor reading fund materials, these rules are also the vocabulary in which a sponsor describes its development timeline, its cash deployment plan, and its compliance posture.
Level One: The Qualified Opportunity Fund and the 90% Asset Test
A Qualified Opportunity Fund is a corporation or partnership organized for the purpose of investing in qualified opportunity zone property. Under Section 1400Z-2(d)(1) of the Internal Revenue Code, a QOF must generally hold at least 90% of its assets in qualified opportunity zone property, determined by averaging the percentage held on two testing dates: the last day of the first six-month period of the fund’s taxable year, and the last day of the taxable year.
Qualified opportunity zone property comes in three forms: qualified opportunity zone stock, a qualified opportunity zone partnership interest, and qualified opportunity zone business property held directly by the fund. Real estate development funds commonly use the first two — the fund holds an interest in a subsidiary business, and the subsidiary holds and develops the property.
A fund self-certifies as a QOF and reports on the 90% test annually on IRS Form 8996, filed with its federal return. There is no IRS pre-approval process. Where a fund fails the test for a month, Section 1400Z-2(f) imposes a monthly penalty calculated on the shortfall at the underpayment rate under Section 6621(a)(2), and provides that no penalty applies where the failure is shown to be due to reasonable cause.
Treasury Regulation Section 1.1400Z2(d)-1 also gives funds two practical mechanisms. Assets are valued using either an applicable financial statement method or an alternative valuation method, applied consistently within a taxable year. And a fund may exclude from the test certain property contributed within the preceding six months that has been held continuously in cash, cash equivalents, or debt instruments with a term of 18 months or less — the rule that allows newly raised capital a window before it must be deployed.
Level Two: The Qualified Opportunity Zone Business Tests
Where a fund invests through a subsidiary, that subsidiary must be a qualified opportunity zone business. Section 1400Z-2(d)(3) sets out three requirements, two of which incorporate tests from Section 1397C. The regulations then put numbers on the statute’s general language.
| Test | General standard |
|---|---|
| Tangible property | Substantially all of the tangible property owned or leased by the business must be qualified opportunity zone business property. Treasury Regulation Section 1.1400Z2(d)-1 defines “substantially all” for this purpose as at least 70%, measured against all tangible property owned or leased, whether located inside or outside a zone. |
| Gross income | At least 50% of the entity’s total gross income must derive from the active conduct of the business. The regulations provide three safe harbors — based on hours of services performed in the zone, on amounts paid for services performed in the zone, or on tangible property and management functions located in the zone being necessary to generate the income — plus a facts-and-circumstances alternative. |
| Intangible property | A substantial portion of the entity’s intangible property must be used in the active conduct of the business. Treasury Regulation Section 1.1400Z2(d)-1 defines “substantial portion” as at least 40%. |
| Nonqualified financial property | Less than 5% of the average of the aggregate unadjusted bases of the entity’s property may be attributable to nonqualified financial property — broadly, financial instruments and similar assets. Reasonable working capital held in cash, cash equivalents, or debt with a term of 18 months or less is excluded from that definition. |
| Excluded businesses | The business may not be one described 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 the sale of alcoholic beverages for consumption off premises. |
These tests are applied on the fund’s semiannual testing dates. Where a subsidiary loses its status as a qualified opportunity zone business, Treasury Regulation Section 1.1400Z2(d)-1 provides a cure period of six months from the date the interest lost qualification.
Qualified Opportunity Zone Business Property: Original Use or Substantial Improvement
Tangible property counts as qualified opportunity zone business property only if it is acquired by purchase after the applicable date, is used in a zone, and satisfies one of two conditions: its original use in the zone commences with the fund or business, or the fund or business substantially improves it.
Original use
Original use generally begins when a person first places the property in service in the zone for depreciation or amortization purposes. Newly constructed property placed in service by the fund or business is one common application. Treasury Regulation Section 1.1400Z2(d)-2 also includes a vacancy rule: property that has been vacant for an uninterrupted period of at least one year before the zone designation, or at least three years after designation, may be treated as having original use commence with the acquiring entity.
Substantial improvement
For property that does not have original use in the zone — an existing building, for instance — Section 1400Z-2(d)(2)(D)(ii) requires that additions to basis during any 30-month period beginning after acquisition exceed the property’s adjusted basis at the beginning of that period. In general terms, the improvement spend has to exceed what the building was carried at.
Federal legislation enacted July 4, 2025 amended this requirement to substitute 50% of adjusted basis in the case of property located in a qualified opportunity zone comprised entirely of a rural area. The reduced threshold is written to key off the character of the zone in which the property sits, not off the character of the fund holding it. IRS Notice 2025-50, released September 30, 2025, addressed substantial improvement of property in rural areas and identified a subset of the existing designated zones as entirely rural. Whether a particular zone or property falls within that provision is a determination for the fund’s own tax advisers.
Several rules in Treasury Regulation Section 1.1400Z2(d)-2 shape how the calculation is run. Substantial improvement of a building is measured by additions to the basis of the building, and there is no separate requirement to substantially improve the land beneath it; unimproved land acquired by purchase in a zone is not required to be substantially improved. Purchased original-use property that improves the functionality of other property may count toward the improvement of that property. And in defined circumstances — buildings located entirely within a parcel described in a single deed, or buildings that share facilities or significant centralized business elements — two or more buildings may be treated as a single property for this purpose.
The two “substantially all” percentages
The regulations use the phrase “substantially all” at more than one point with different numbers behind it. At the business level, substantially all of the tangible property means at least 70%. At the property level, the use requirement means that at least 70% of the property’s total utilization by the business occurs within the geographic borders of a zone, and the holding-period requirement means that the property satisfies that use test during at least 90% of the period the fund or business has owned or leased it.
The Working Capital Safe Harbor
A development business raises capital before it spends it, and cash is nonqualified financial property. Without relief, a business holding an undeployed construction budget could fail the less-than-5% test on a testing date for no reason other than the ordinary sequence of development. The working capital safe harbor in Treasury Regulation Section 1.1400Z2(d)-1(d)(3)(v) addresses that.
The safe harbor has three requirements, all of which must be satisfied:
- A written designation. The amounts must be designated in writing for the development of a trade or business in a qualified opportunity zone, including where appropriate the acquisition, construction, or substantial improvement of tangible property.
- A written schedule. There must be a written schedule, consistent with the ordinary start-up of a trade or business, under which the working capital assets are to be spent within 31 months of the business’s receipt of the assets.
- Substantial consistency. The assets must actually be used in a manner substantially consistent with the writing and the schedule. Delay attributable to waiting for government approval of a completed application does not cause a failure.
Two extensions sit on top of that. A business located in a federally declared disaster area may receive not more than an additional 24 months to consume its working capital assets. And where a business receives multiple infusions of working capital, the regulations permit the safe harbor to apply for a total of 62 months through overlapping or sequential applications — provided each tranche independently satisfies the three requirements, each infusion is an integral part of the plan, and each includes a substantial amount of working capital. The 62-month figure is a ceiling reached by stacking qualifying tranches, not an extension a business can elect on its own.
Where the safe harbor applies, the covered assets are treated as reasonable working capital and are therefore excluded from nonqualified financial property, and gross income derived from property covered by the safe harbor counts toward satisfaction of the 50% gross income test during the safe harbor period.
What the 2025 Amendments and IRS Notice 2026-40 Changed
Federal legislation enacted in 2025 made the Opportunity Zone program a permanent part of the tax code and revised its terms. For convenience, this article refers to the original program rules as “OZ 1.0” and the amended rules as “OZ 2.0.” These are informal shorthand used by practitioners, not formal IRS designations.
Two points about scope. First, the 2025 amendments to the qualification rules discussed above were narrow: the acquisition-date references in the definition of qualified opportunity zone property were revised, and the rural substantial-improvement threshold was added. The 90% asset test, the 70% tangible property test, the 50% gross income test, the intangible property test, the nonqualified financial property limit, and the excluded-business list were not amended, and the working capital safe harbor is a regulatory rule that the legislation did not change. Second, the legislation added new information-reporting obligations for funds and for qualified opportunity zone businesses, with an associated penalty framework, effective for taxable years beginning after July 4, 2025.
IRS Notice 2026-40, issued June 18, 2026, provides current transitional guidance and describes rules that Treasury and the IRS anticipate including in proposed regulations, although the proposed and final regulations may clarify or modify particular details. Two sections bear directly on the qualification rules discussed here:
- Section 5.01 — property acquired after December 31, 2026. The Notice describes a general rule under which property acquired after that date would not be qualified opportunity zone business property unless it is acquired for use in a zone designated after July 4, 2025 or an exception applies. It then describes two exceptions: one for acquisitions substantially consistent with a working capital safe harbor plan adopted on or before December 31, 2026, where the business has received and expended stated minimum percentages of its designated working capital by that date; and one for property acquired in the ordinary course of business to replace existing tangible business property, which the Notice states does not include property acquired pursuant to the expansion of a trade or business.
- Section 5.02 — compliance testing after a designation period ends. The Notice describes safe harbors under which a fund or business could continue to treat a previously designated zone whose designation has expired as a zone, for specified compliance purposes, through December 31, 2047.
Notice 2026-40 provides current transitional guidance, and the proposed and final regulations may clarify or modify particular details, so funds and their advisers should confirm the current status and the precise conditions of each exception.
Questions Investors Sometimes Ask Sponsors
Urban Catalyst does not suggest that any of the following is dispositive, and they do not substitute for reviewing a fund’s offering documents and risk factors with professional advisers. They are examples of the diligence questions that touch on the rules above. Our guide Five Considerations When Reviewing an Opportunity Zone Fund covers the broader review framework.
- How the sponsor documents and monitors working capital plans, and what happens to the schedule when entitlement or construction timelines move.
- How the fund tracks the 90% asset test between semiannual testing dates, and who prepares Form 8996.
- For rehabilitation projects, how the substantial improvement calculation is performed and what basis is included in it.
- How the fund and its businesses expect to handle the new information-reporting obligations.
- What the sponsor’s disclosure says about the consequences of a compliance failure, including the fund-level penalty and any effect on investors.
Continuing Coverage of the Opportunity Zone Program
Educational resources on the Opportunity Zone program, the 2026 recognition event, and Opportunity Zones 2.0.
Explore Opportunity Zones 2.0Frequently Asked Questions
What is the difference between a Qualified Opportunity Fund and a qualified opportunity zone business?
A Qualified Opportunity Fund is the investment vehicle — a corporation or partnership that self-certifies on IRS Form 8996 and must generally hold at least 90% of its assets in qualified opportunity zone property, tested on two dates each year. A qualified opportunity zone business is an operating subsidiary in which a fund holds stock or a partnership interest. Many funds hold their real estate through such a subsidiary, and the subsidiary must satisfy its own tests, including a 70% tangible property test, a 50% gross income test, a 40% intangible property test, and a less-than-5% limit on nonqualified financial property.
What does “substantial improvement” require?
For tangible property whose original use in the zone does not begin with the fund or business, the statute generally requires that additions to basis during any 30-month period beginning after acquisition exceed the property’s adjusted basis at the start of that period. Legislation enacted July 4, 2025 substitutes 50% of adjusted basis for property located in a qualified opportunity zone comprised entirely of a rural area, and IRS Notice 2025-50 addressed that provision. Substantial improvement of a building is measured by additions to the basis of the building, and the land beneath it is generally not separately subject to the requirement. Whether particular property meets the standard is a factual and legal determination for the fund’s own advisers.
How long does a fund have to spend the capital it raises?
At the business level, the working capital safe harbor generally contemplates spending within 31 months of the business’s receipt of the assets, under a written designation and a written schedule that the business then follows. A business in a federally declared disaster area may receive not more than an additional 24 months. Where a business receives multiple qualifying infusions, the regulations permit the safe harbor to apply for a total of 62 months through overlapping or sequential applications, with each tranche independently meeting the requirements. Separately, at the fund level, certain property contributed within the preceding six months and held in cash, cash equivalents, or short-term debt may be excluded from the 90% asset test.
What happens if a fund fails the 90% asset test?
Section 1400Z-2(f) imposes a penalty for each month the fund fails the test, calculated on the shortfall at the underpayment rate under Section 6621(a)(2), and provides that no penalty applies where the failure is shown to be due to reasonable cause. Where a subsidiary loses its status as a qualified opportunity zone business, the regulations provide a cure period of six months. Consequences beyond the penalty depend on the facts and are addressed in the fund’s own documents and by its advisers.
Which businesses cannot be qualified opportunity zone businesses?
Section 1400Z-2(d)(3) excludes any business described in Section 144(c)(6)(B): a private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or a store whose principal business is the sale of alcoholic beverages for consumption off premises. Separately, a business that does not satisfy the tangible property, gross income, intangible property, or nonqualified financial property tests would not qualify, regardless of its industry.
The Bottom Line
The Opportunity Zone incentive is built on a compliance structure that runs continuously for the life of a fund: a semiannual asset test at the fund level, a set of percentage tests at the business level, a property-by-property qualification standard, and a documented plan governing how and when capital is deployed. Those requirements shape development timelines and cash management, and they are part of the execution risk in any Opportunity Zone investment. The 2025 amendments left most of the framework in place while adding a rural substantial-improvement provision and new reporting obligations, and IRS Notice 2026-40 describes transitional rules the IRS anticipates proposing for property acquired after 2026. How any of it applies to a particular fund, business, or property is a question for that fund’s tax and legal advisers, and for an investor, a question worth raising with their own.
About Urban Catalyst
Urban Catalyst is a private equity real estate firm and developer focused on Opportunity Zone investment in downtown San Jose. As of August 2026, Urban Catalyst has launched two Opportunity Zone funds and has advanced a portfolio of seven downtown San Jose projects, serving as both fund manager and developer — a structure that involves operational involvement in its projects as well as related-party fees, potential conflicts of interest, concentration of execution responsibilities in one organization, and concentration in a single market. This article does not describe, and is not connected to, any Urban Catalyst offering.
Disclosures: Urban Catalyst and its affiliates do not provide tax, legal, or investment advice. This material is for informational and educational purposes only, is general in nature, and does not consider the specific circumstances of any individual investor. It is neither an offer to sell nor a solicitation of an offer to buy any security, and no offering is being made or identified by this article; any future offering, if made, would be made only through definitive offering documents describing its terms, fees, and risk factors. Nothing in this article should be construed as a recommendation to pursue, defer, or refrain from any investment or tax strategy, or as an indication that an Opportunity Zone investment is appropriate for any particular reader. Descriptions of statutory and regulatory requirements in this article are simplified summaries current as of August 2026, omit numerous rules, exceptions, definitions, and elections, and may not reflect subsequent legislation, regulations, guidance, or judicial decisions; IRS Notice 2026-40 provides current transitional guidance and describes rules Treasury and the IRS anticipate proposing, and the proposed and final regulations may clarify or modify particular details. Whether any fund, business, or property satisfies these requirements is a factual and legal determination that depends on circumstances not addressed here. This article discusses federal income tax treatment; state and local tax treatment may differ materially, and California does not currently conform to the federal Opportunity Zone gain-deferral and exclusion provisions. Potential tax benefits are subject to limitations, eligibility requirements, holding periods, elections, and applicable tax regulations, which are subject to change; eligibility for deferral depends on the type of gain, the applicable reinvestment period, the elections made, and other statutory requirements, and is not automatic. The 10-year holding period is a condition for potential favorable federal tax treatment, not an assurance of any outcome, and there is no guarantee of any particular tax result; the original deferred gain generally remains taxable. Investments in real estate and in Opportunity Zone funds are speculative, illiquid, involve significant risk, and may result in partial or total loss of investment. Nothing herein describes the terms, status, or distribution policy of any particular fund or offering. Third-party data referenced herein is believed to be reliable, but its accuracy and completeness cannot be guaranteed. Past performance is no guarantee of future results. Prospective and current investors should consult their own tax, legal, and financial professionals regarding their particular circumstances.
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