Opportunity Zones: Develop and Invest Capital Gain in Your Business
The Tax Cuts and Jobs Act of 2017 (TCJA) includes a new tax incentive designed to steer long-term capital investments into economically distressed communities. Investments in these areas, called Opportunity Zones, are eligible for the temporary deferral and potential exclusion of capital gains.
Re-investment of capital gains in a Qualified Opportunity Zone Fund (QOF) allows taxpayers to defer a portion of the appreciation of the investment, and when the investment is held for at least 10 years, exclude the post-acquisition gains from gross income.
With the issuance of guidance from Treasury on October 19, 2018, in the form of Proposed Treasury Regulations and Revenue Ruling 2018-29, taxpayers have begun to put development plans into action. And while there are many different ways that investments can be made by Qualified Opportunity Zone Funds (QOF), many of our clients who own property located in an Opportunity Zone are asking, “Can I invest in my own project or company?”
While there is no definitive answer, in many instances, the answer appears to be yes. But doing so may be tricky, and you will want to engage both legal and tax advisors to help with structuring and modeling.
John and Joe look to benefit from opportunity zones*
John and his brother Joe (J&J) own real estate located in an Opportunity Zone, which they acquired in 2010 for $1 million. The property is held by a Limited Liability Company (LLC) taxed as a partnership. The LLC operates a manufacturing plant, and J&J are the members of the partnership. The brothers have plans to expand their manufacturing facility, which will require construction of a new manufacturing building as well as purchase and installation of new equipment totaling $20 million. The expansion of the facility will require hiring an additional 50 employees. Each partner recognized $3 million of capital gain from the sale of a building sold to an unrelated party on August 15, 2018, and both partners want to invest this capital gain in their existing company.
Ultimately, this sounds like a project that was intended for the Opportunity Zone benefits, as it is in the right location and designed to stimulate economic growth and new jobs. At this point, J&J have three tricky decisions to make.
1. Should J&J form a new QOF, or elect for their existing LLC to be treated as a QOF?
The current thinking is that J&J will choose to form a new entity, likely a LLC, which will be taxed as a partnership and into which they will invest their capital gain of $6 million. This entity is intended to be treated as a qualifying QOF.
2. When should J&J fund QOF with the capital gain?
The answer to this depends on many different factors, including:
- When the corporation or partnership to be invested in will meet its requirements to be considered a QO Zone Business (QOZB)
- How financing is arranged for the expansion
- Availability of the cash to make the contribution
- The date that J&J each recognized their capital gain.
All of these factors must be considered, making consultation with tax and legal advisors critical. Generally, J&J have 180 days from the date that they recognize their capital gain to invest in their QOF, and the QOF must invest in a QOZB. Accomplishing this means meeting several requirements.
3. When should the QOF invest the $6 million of capital, and how should the investment be structured? Do they invest directly in their business, or do they invest in a new entity?
These decisions are critical and impact how and when the Opportunity Zone testing computations are applied. As currently written, the proposed regulations apply a “substantially all” test, which requires that 70 percent or more of the tangible property held by the Opportunity Zone business meet the definition of being Opportunity Zone Business Property (OZBP). This test is applied for existing corporations and partnerships at the time the Opportunity Zone capital is contributed.
This requirement creates a dilemma, as the OZBP must be held by the corporation or partnership at the time the Opportunity Zone capital is contributed to the corporation or partnership (if the corporation or partnership is an existing entity). Keep in mind that, generally, OZBP must be acquired after December 31, 2017, and includes cash and cash equivalents to the extent such cash meet the “working capital safe harbor” which generally provides that the cash will be expended pursuant to a written schedule for deployment for the project within 31 months. Therefore, it’s critical to compute and plan to have enough cash on the date of the OZ capital contribution in order to meet the 70 percent “substantially all” test to make a qualifying investment by the OZF.
The following examples illustrates the challenge of investing in an existing corporation or partnership.
Investing in an existing business can be tricky, and the need for up-front cash can be substantial. These examples illustrate the need for modeling your project, since these outcomes are not obvious. The two examples highlight the potential “foot-fault” that might occur if you don’t carefully follow the rules.
Example one highlights two things: First, that the company holds assets acquired prior to January 1, 2018, which are deemed to be non-qualifying assets for purposes of the 70 percent test. Second, that the 70 percent test is failed because the company did not, as of the date that the OZF contributed capital, have sufficient qualifying assets to meet the 70 percent test. In this case, “cash,” which is a qualifying asset for purposes of the 70 percent test, is less than would be necessary to meet the test. Thus, the OZF would not be making a qualifying investment in OZBP.
Example two highlights the total cash that will be required to meet the 70 percent test as of the date that the OZF capital contribution is made. Practically speaking, this may necessitate the need to borrow funds well before qualifying expenditures are incurred.
An alternative approach that may be a “workaround” is investing into a newly formed partnership or corporation instead of investing into the existing business. This could reduce the need for cash because the new entity may not hold any non-qualified OZ assets (essentially any asset acquired prior to December 31, 2017, will be a non-qualifying asset) at the time the OZF invests in the new entity and to the extent that is the case then the project may require less up-front cash.
How we can help
When it comes to self-developing and self-investing, the answer may be, “Yes,” you can develop and invest your capital gain in your business, take advantage of the new deferral, and ultimately gain exclusion benefits of the Opportunity Zone statutes. However, the guidance is confusing, and in many cases it is temporary and subject to change.
Whatever road leads you to Opportunity Zones, CLA is right there with you. Our wealth advisors are working closely with our business tax planning professionals to fully understand the guidance, so we can bring investors and developers together to fully realize the benefits of the program. Together, we can help you create opportunities for your organization.