By: Ryan Beethoven-Wilson, CPA, Tax Manager | Emerging & Growth Business Team
The Opportunity Zone secret is out. Introduced as part of the 2017 Tax Cuts and Jobs Act, Qualified Opportunity Zones (QOZ’s) offer an array of tax benefits to taxpayers with capital gain events who reinvest these gains in certain low-income communities. While much of the buzz surrounding QOZ’s has been targeted to investors and real estate, entrepreneurs and proprietors of other operating businesses located within the designated communities should be aware of how the incentive may attract capital and how businesses can maintain an investor’s QOZ tax benefits. This article will address the basics of the QOZ tax incentive and focus on how operating businesses can qualify.
Opportunity Zone Tax Incentives – The Basics
- Gain deferral – Taxpayers realizing capital gains from sales or exchanges of property (real estate, investment property, securities, etc.) can defer recognition of those gains by reinvesting in a Qualified Opportunity Fund (QOF) within 180 days. By doing so, the initial gain will not generally be recognized until the earlier of 1) disposition of the QOF investment or 2) December 31, 2026 (mandatory recognition date). A QOF is a self-certified corporation, partnership, or LLC that holds at least 90 percent of its assets in QOZ business property, stock of a QOZ business organized as a corporation, or an interest in a QOZ business organized as a partnership.
- Gain reduction – If a taxpayer defers gain through a QOF investment, their initial basis in the fund is reduced by the gain deferred. However, if the taxpayer holds the QOF investment for 5 years, they will receive an automatic 10 percent basis increase. If they hold for two additional years they will receive an additional 5 percent basis increase (percentages are of the initial deferred gain). Assuming the holding periods are met, this means that when the QOF investment is sold (or mandatorily recognized on December 31, 2026), only 85 percent of the initial deferred gain will be recognized, resulting in a 15 percent permanent gain reduction.
- Gain exclusion – If the taxpayer holds the QOF investment for at least ten years, then on the date the investment is sold or exchanged, the taxpayer’s basis in the fund is automatically increased to the current fair market value. This works to completely eliminate any gains attributable to appreciation of the QOF investment during the taxpayer’s holding period.
Operating Businesses (Other Than Real Estate) Within a Qualified Opportunity Zone
As mentioned above, a QOF is permitted to operate a trade or business directly within a QOZ. Most likely however, a QOF can also invest in a QOZ by obtaining the corporate stock or a partnership interest of a separate operating entity. There are several things to consider with regards to how equity in a QOZ business is obtained and how to measure the actual business conducted within a QOZ, all of which are necessary to maintain eligible tax benefits for fund investors.
The 90% Test – Applicable to Qualified Opportunity Funds
In order to maintain its status as a QOF, the fund must hold at least 90 percent of its assets as QOZ property, of which corporate stock or a partnership interest in a QOZ business will qualify. Whether the operating business is a corporation or a partnership, the equity interest must be issued to the QOF after December 31, 2017, directly from the entity itself (or through an underwriter) and must be acquired solely for cash. The operating entity must maintain its status as a QOZ business (will be defined below) for substantially all of the QOF’s holding period of the stock or partnership interest. If the stock or partnership interest meets the above criteria, then all of the operating entity’s assets will count towards the QOF’s requirement to satisfy the 90 percent test.
Three Tests Applicable to Qualified Opportunity Zone Businesses
In order for an operating entity to be considered a QOZ business, and therefore have all of its own assets count toward a QOF’s 90 percent test above, the entity must meet three separate tests on its own – a property test, an income and assets test, and a prohibited business test. All three tests are defined below:
- The 70 percent property test: At least 70 percent of an operating entity’s tangible property (whether owned or leased) must meet the following requirements: 1) acquired by purchase or lease after December 31, 2017, 2) the original use of the property must begin with the operating entity or be substantially improved by the operating entity, and 3) substantially all of the tangible property is located within a QOZ for substantially all of the time held by the operating entity.
- The income and assets test: Every year after December 31, 2017, the operating entity must meet the following requirements: 1) at least 50 percent of the entity’s gross income must be earned from the active conduct of business in a QOZ, 2) a substantial portion of any intangible property must be used in the active conduct of a business in a QOZ, and 3) no more than 5 percent of the entity’s property is attributable to nonqualified financial property (debt, stock, partnership interest, options, futures, warrants, annuities, and other similar property). Working capital assets are generally not considered financial property for purposes of this test if held in short-term cash or debt instruments and if there is a documented plan that the funds will be for acquisition or improvement of tangible property within a QOZ.
- The prohibited business test: An operating entity may not be any of the following: private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises.
Entrepreneurs and proprietors doing business in a QOZ should be aware of the tax incentives available in return for their businesses helping to revitalize low-income communities. The tax incentives are powerful enough to attract available capital and should be considered by businesses looking for additional funding. Once a QOF has gotten involved, there must be a continued focus on meeting the required measurement benchmarks to ensure the outside investors realize the tax benefits that helped make their investment decision.
While the Opportunity Zone tax benefits are powerful and attractive, careful consideration must continue to be paid to entity formation, deal structure, future tax rates, pricing, discount rates, risk, and long-term economic outlook. The QOZ designation can and should factor into the investment decision, but only in conjunction with broader factors that will impact the feasibility of any particular deal. The applicability of the QOZ incentive is heavily dependent on each taxpayer and each transaction’s independent facts and circumstances and should be given careful planning with a professional advisor.
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- Revenue Recognition Changes for Private Companies
The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.