To encourage economic growth and investment in distressed communities, the 2017 tax reform act commonly known as the Tax Cuts and Jobs Act contains tax incentives that are tied to investments in businesses or property located within opportunity zones. Tax incentives include both the deferral of, and exclusion from, income tax.
The Department of Treasury has certified nearly 9,000 of these districts across all U.S. states and its territories, including the entire island of Puerto Rico. Opportunity zones, also commonly referred to as O-Zones, are generally areas with low income and high poverty levels.
An O-Zone designation has the potential to trigger an influx of investment activity and is intended to help revitalize areas that were left behind after the depression. Restaurants built in O-Zones can help vitalize underserved communities and attract local talent, all while offering their owners a highly valued tax incentive.
What is a Qualified Opportunity Zone Fund (QOF)?
A QOF is an investment vehicle that must invest at least 90 percent of its assets in “zone property.” Zone property investments can take the form of direct investments in qualified O-Zone business property, or investments in corporations or partnerships that are qualified O-Zone businesses. In other words, a QOF can invest in land and buildings that it intends to rehab or in a business that operates within an O-Zone.
What is a Qualified Opportunity Zone Business Property?
Under proposed regulations issued on October 19, 2018, zone business property is new or substantially improved tangible property acquired after December 31, 2017, that is located in an O-Zone and is used in the trade or business of a qualified O-Zone business or QOF.
What is a Qualified Opportunity Zone Business?
Among other criteria, a trade or business is a Qualified O-Zone Business if:
- At least 70 percent of its tangible property is qualified O-Zone property as defined above.
- It derives at least 50 percent of its total gross income from the active conduct of its trade or business in the qualified O-Zone (more information related to this requirement is below).
What are the Tax Incentives for Investors in O-Funds?
Incentives include potential deferral (and reduction) of tax attributable to the capital gains from asset sales that are reinvested in a QOF and potential permanent exclusion from tax for capital gains generated upon the sale of an investor’s interest in an O-Fund.
- To qualify for O-Zone tax incentives, taxpayers that generate capital gains from asset sales made to unrelated parties must reinvest an amount equal to the capital gain from such sales into a QOF during the 180-day period beginning on the date on which the gain would be recognized for federal income tax purposes.
- Investors in a QOF can defer paying tax on the original capital gain until the earlier of the date the fund is divested or December 31, 2026.
- Investors receive a 10 percent basis step up after the investor has held his or her interest in the QOF for at least five years.
- An additional 5 percent basis step up (for a total basis step up of 15 percent) is available after the investor has held his or her interest in the Fund for at least 7 years.
As a result of these basis step ups, investors that hold interests in O-Funds until at least December 31, 2026, will defer and pay tax on only 85 percent of the capital gain generated from the original asset sale.
In addition to tax breaks applicable to the gain generated by the original asset sale, investors that hold their interest in the O-Fund for at least 10 years will permanently exclude from income the capital gains generated upon the sale of his or her interest in the O-Fund.
Let’s Look at an Example:
A restaurant group which operates as an LLC sells assets and generates a capital gain of $4,000,000 in 2018. The assets sold were not located within a qualified O-Zone. Within the requisite 180 days, the group invests $4,000,000 into a QOF. The fund uses $1,000,000 to purchase land in a qualified zone and constructs a $3,000,000 restaurant on the land. Assume the restaurant group retains its investment in the Fund until 2030, at which time it sells its investment for $15,000,000.
Since the restaurant group retains its investment in the fund until at least December 31, 2026, it can defer paying tax on its original capital gain until that date, and it receives the maximum basis step up of 15 percent. As a result, the group only has to pay tax on 85 percent of the original gain, or $3,400,000.
Because the restaurant group retained its investment in the fund for at least 10 years, the $11,000,000 gain attributable to the appreciation in its investment is permanently excluded from income, and thus escapes taxation.
What are we Hearing About Opportunity Zones?
It is estimated that over 100 QOFs have been created. Further, it is estimated that over $20 billion is being raised for investments in O-Zones. Some critics have expressed concern that investments in O-Zones will be focused in areas that were already experiencing development. This would have the unintended result of neglecting the communities that that need revitalizing the most, such as rust-belt cities and rural areas. While the legislation is intended to deliver new jobs and higher wages in the underserved areas, we may not know for a decade or more if the program was impactful.
O-Zones are not for everyone. For example, Boulder, Colorado enacted a moratorium intended to limit development of the O-Zone that is located within its city limits after citizens expressed concern that an influx of development could drastically alter the character of Boulder.
What’s Next for Restaurants?
Additional IRS guidance is needed to clarify certain portions of the proposed regulations. In a letter sent to Treasury Secretary Mnuchin on January 24, 2019, the original co-sponsors that created the O-Zone tax incentives asked for clarity regarding the following issues:
The proposed rule requiring an O-Zone business to derive 50 percent of its gross income from the active conduct of a trade or business “in the qualified opportunity zone”: The concern is that businesses often derive income from the sale of goods and services both within and without single census tracts. By imposing a 50-percent threshold, the ability of local businesses to receive O-Fund investment would be severely limited. As the authors of the letter point out, this is contrary to congressional intent. The authors suggest that the 50 percent threshold be removed, and instead require that a qualifying business derive at least 50 percent of its total gross income from the active conduct of its trade or business.
The lack of guidance regarding timing flexibility for O-Funds: Flexibility is needed to ensure that O-Funds have adequate time to make qualifying investments after either receiving capital from their investors, or the disposition of a portfolio holding. This is especially true for funds that are formed to hold a portfolio of qualified O-Zone businesses to spread risks and costs across multiple investments, as intended by Congress.
Clarification that O-Zone tax incentives are tied to the length of an investor’s stake in an opportunity fund, and not to a fund’s stake in a specific portfolio investment: This clarification is necessary because Congress recognized that many O-Funds would experience “churn” in their underlying investments and would hence need adequate time to reinvest capital that has been returned to the fund from the disposition of a portfolio investment. The letter to Secretary Mnuchin asks for clarification that this type of fund-level activity would not impact the tax incentives available to the investors in the O-Fund, so long as they do not take distributions from the fund or sell their investment in the fund prior to meeting the 10-year holding period.
To maximize the potential benefits, taxpayers must invest in a qualified O-Fund before December 31, 2019.
It is important for an investor to treat an O-Zone investment just like any other deal. Investors should consider the fund manager’s past track record, diversity of assets and reputation of the developer. There should be a focus on investment fundamentals including the geographical location of the property, market demand for that type of property, comparable property values, income levels of residents and infrastructure. While the tax incentives are appetizing, a bad investment will remain a bad investment, whether it is in an O-Zone, or not.
Though restaurant owners and investors alike shouldn’t bite into O-Zones without caution, the clock is ticking to take full advantage of the tax savings. Potential investors should assess the investment with the same level of due diligence they would use for any other deal.
This article originally appeared in BDO USA, LLP’s Selections Blog (March 8, 2019). Copyright © 2019 BDO USA, LLP. All rights reserved. www.bdo.com
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