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Opportunity Zones Are Open For Business

December 6, 2019
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Opportunity Zones Are Open For Business

Investing in a Qualified Opportunity Zone (QOZ), as created by the Tax Cuts and Jobs Act of 2017, offers multiple tax benefits as well as the possibility of substantial returns. Tax on realized capital gains may be deferred by investing in a QOZ, some of the deferred tax may be reduced, and any appreciation on the QOZ investment may be tax-free, if all the rules are followed.

To date, most QOZ attention has focused on real estate. However, other paths to taking
advantage of this program are available. Proposed regulations provide some guidance as to how non-real estate businesses can participate in the program. This article will discuss three of the requirements an investment must meet in order to be considered a Qualified Opportunity Zone Business (QOZB), and how the latest proposed regulations offer guidelines for success.

Trade or business and the 50% gross income test

To qualify for the benefits of the QOZ program, a business must be located in one of the thousands of economically distressed communities that have been designated by the federal government for this purpose. The company must actively conduct a trade or business and avoid certain prohibited businesses such as a golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack, casino, or liquor store. Otherwise, virtually any type of legal active enterprise can qualify.

To be eligible for QOZ tax benefits, the business must derive at least 50% of its total gross income from active conduct within a QOZ. Fortunately, this requirement can be met if a QOZ meets at least one of three specific tests spelled out in the proposed regulations, which will eliminate the need to analyze the facts and circumstances (which can be done, if none of the three foregoing tests are met):

  • 50% of the services (based on hours) of employees and independent contractors are performed a QOZ; or
  • 50% of the amount paid to employees and independent contractors are for services performed in a QOZ; or
  • The tangible property of the business that is located in a QOZ and the management or operational functions performed in that QOZ are each necessary to generate 50% of the gross income of the business.

Original use requirement

Having tangible property located within a QOZ may help a business qualify for the tax benefits of this incentive. For such property to be recognized as Qualified Opportunity Zone Business Property (QOZBP), it must be purchased from an unrelated party (less than 20% common ownership) and either be substantially improved or have its original use in a QOZ.

It has been clear since the QOZ program incentive was introduced, “substantial improvement” would require a doubling of the basis attributable to the non-land portion of the tangible assets. Substantial improvement is more likely to be associated with real estate development, and thus difficult to attain for an operating business. Therefore, the “original use” requirement may be crucial in order for a business to meet the requirements as a QOZB. Fortunately, the proposed regulations provide guidance here.

The proposed regulations would allow property to be deemed to have its original use in a QOZB if it was never used in a QOZ previously. This effectively allows used property that has been purchased by a QOZB to qualify, as long as it was never used in a QOZ.

Moreover, if a structure has been vacant for at least five years, a QOZB could acquire that
structure and meet the original use test. The proposed regulations even allow a QOZ structure purchased just prior to receiving its certificate of occupancy to qualify under the original use test.

Property leased by a QOZB

Many companies may prefer to lease necessary assets rather than purchase all of those assets outright. However, the first set of proposed regulations caused concern over how leases would be treated, especially if the leases involved a related party. The second set of proposed regulations clarify that leased property will be QOZBP if:

  • The property is acquired by a lease beginning after December 31, 2017;
  • The lease calls for market rate payments; and
  • The property will be used in the QOZB for substantially all (90%) of the lease term.

Furthermore, related party transactions qualify if the following additional criteria are met:

  • The lessee does not make a prepayment of more than 12 months in connection with the lease; and
  • For all leased tangible property where the use in the QOZ does not commence with the lessee, the lessee needs to purchase qualified property for an amount not less than the value of the leased property

These requirements are critical for owner-operators who intend to collect rent or use ground leasing to run their businesses, if they seek QOZ tax advantages.

Other key points

The proposed regulations also shed light on the structuring of a Qualified Opportunity Fund (QOF) arrangement in order to access QOZ tax benefits. A QOZB is required to have only 70% of its tangible assets be QOZP, while a QOF must hold 90% of its assets in either QOZBP, Qualified Opportunity Zone Stock or Qualified Opportunity Zone Partnership interests. This is one of the major reasons for a QOF to deploy a tiered structure, with a QOF holding an ownership interest in a QOZ partnership or a QOZ corporation while the lower-tier entity operates within the QOZ.

As a final thought, if investors are comfortable operating as a C corporation, it may be possible to structure deals in a manner that allows owners to pair the QOZ program with Qualified Small Business Stock exceptions pursuant to section 1202. That could facilitate a tax-free exit from the QOF investment after 5 years.

Please contact Citrin Cooperman to learn more about the Qualified Opportunity Zone program and discuss any of the issues discussed above.