Making sense of opportunity zones: How to achieve the tax benefits in 3 steps
Columbus Business First June 21, 2019
A tax-free exit may sound like the stuff of fantasy, but the Congressional promise of opportunity zones is law, and as of April 2019, the Treasury Department has provided sufficient guidance for entrepreneurs to make it a reality. With a little help from professional advisors, entrepreneurs should be able to achieve these very real tax benefits by following three steps to avoid liability traps.
Step 1: Structuring an investment for regulatory compliance
The first step is to structure an attractive investment for eligibility to receive the intended tax treatment. An investment can be made into (a) any tangible business property or (b) any company, with some exceptions.
If the investment is made into tangible business property, merely being located in a qualified opportunity zone (QOZ) is not enough. The property must be "QOZ business property," which means that it must be (1) purchased from an unrelated party, and (2) at least 70% of the property's use must be located in the opportunity zone.
For already-existing business property that has been placed in service, such as an apartment building, the property must be substantially improved after the investment, meaning the cost of renovations must at least equal the cost of purchase, minus the land. An already-existing property that has not been depreciated or amortized — such as a new commercial build or a homeowner’s primary residence — would qualify as a QOZ business property under an "original use" exception.
If the investment is made into a company, then the company must be a "QOZ business," which is a business entity organized for that specific purpose and treated as a corporation or partnership for tax purposes. After formation, the company must satisfy four elements:
- At least 70% of the tangible property owned or leased by the company must be QOZ business property (as defined above);
- At least 50% of the company's total gross income, services, or amounts paid for services must occur within a QOZ;
- At least 40% of its intangible property must be used in the active conduct of such business; and
- The company must have a written schedule to spend working capital to the extent that more than 5% of its property is attributable to nonqualified financial property, such as long-term debt.
Failure to satisfy one or more of these elements may result in a penalty or ineligibility to receive the intended tax treatment. A corporate attorney specializing in the Treasury's opportunity zone rules can advise on how to structure an investment to mitigate this risk.
Step 2: Forming and capitalizing a qualified opportunity fund with eligible gain
The second step is to make the investment through a qualified opportunity fund (QOF). A QOF is a business entity organized for the purpose of investing in QOZ business property or a QOZ business, and treated as a corporation or partnership for tax purposes. It must hold at least 90% of its assets in QOZ property and, critically, it must make a tax certification as an opportunity fund in the first month that it receives any contribution of eligible gains.
"Eligible gains" are gains realized from the sale of property to an unrelated person and treated as capital gains for federal income tax purposes. To invest eligible gains into a QOF, the taxpayer-investor must make a tax election to defer capital gains tax liability within 180 days from the date of realization (for individuals), or within 180 days from the date of recognition (for partnerships or partners).
While a determination of what constitutes eligible gains depends on the taxpayer's individual facts and circumstances, a CPA who specializes in the opportunity zone rules and their effect on corporate and pass-through taxation can mitigate the risks of making a non-qualifying investment, as well as triggering an inclusion event that would terminate deferral.
Step 3: Offering qualified opportunity fund investments for sale
Having formed and capitalized a QOF, it might make sense to reach out to friends and acquaintances, or even strangers on the internet, to pool together investments to achieve an economy of scale. However, federal and state securities laws generally require all offers and sales of stock and partnership interests to be either registered or exempt from registration. Registration is cost-prohibitive for most start-ups, so entrepreneurs seeking to raise venture capital typically rely on an exemption that provides a safe harbor from federal and state registration.
The rules for exempt offerings contain specific requirements on solicitation, and quantity and type of investors. Additionally, there are specific restrictions on transferability, material misstatements or omissions, and manipulative and deceptive devices. Thus, it is imperative to seek securities counsel to mitigate the risk of liability under the securities laws.
Although the statutory tax benefits are clear and the implicit tax benefits are compelling, compliance with the opportunity zone corporate, tax, and securities laws is not entirely straight forward. However, with a little help from professional advisors, savvy entrepreneurs can mitigate the risk of these liability traps.
An interactive map of national QOZs is available online at the Treasury Department’s website and requires Adobe Flash to view.
This article originally appeared in Columbus Business First.