Written by Raymond V. Owens, CPA
The Tax Cuts and Jobs Act, which was signed into law in the waning days of 2017, provides for a unique investment opportunity. Qualified Opportunity Zones are generally economically-depressed areas where the Federal Government is attempting to spur investment. Eligible areas have a calculated poverty rate of 20% or a median family income not exceeding 80% of the statewide or metropolitan-wide median family income. Investors can potentially defer or reduce taxable capital gains by reinvesting them into such zones, subject to certain requirements. At present, New Jersey has 169 designated zones. Coincidentally, three of these jurisdictions have publicized their willingness to host businesses in the cannabis industry. 1 This could provide a potentially exciting opportunity to the right group of entrepreneurs.
When Donald Trump signed the Tax Cuts and Jobs Act into law on December 22, 2017, the country experienced a dynamic shift in tax policy; the likes of which had not been seen since the Reagan administration. Amongst the changes were lower corporate and individual tax rates, provisions for the repatriation of income, and provisions to bolster economic growth in areas in need of a boost. One such provision is IRC §1400Z-1, which provides for Qualified Opportunity Zones (“QOZ’s”).
The mechanism by which investment is encouraged is relatively straightforward. In exchange for their investment, investors in QOZ’s are allowed to temporarily defer capital gain recognition on investments sold in the current year. After initially realizing the gain, investors have 180 days to reinvest their gains into a qualifying zone via a Qualified Opportunity Fund (“QOF”). 2 Per IRC §1400Z-2(d), a QOF can be organized as either a corporation or a flow-through entity, but it must hold at least 90% of all of its assets within the QOZ and make an election to be treated as an eligible entity. 3
If the aforementioned investment is held for five years, the investor will benefit from a 10% step up in basis to use against the gain. If the investment is held for seven years, the investor will benefit from another 5% step up on top of that. If the investment continues to be held at December 31, 2026, the investor will be forced to recognize the remaining 85% of the gain invested. 4 This becomes limited to the lower of the original investment or 85%, should the investment fail to appreciate in value. Investments held in excess of ten years will benefit from a full exclusion of gain recognition. The regulations have no maximum on how much can be contributed to an investment vehicle, and an investor may be permitted, under current law, to hold the investment while it appreciates up until December 31, 2047. 5
Now, it is important to note that not every business can be eligible for this treatment. When Congress wrote the law, they specifically exempted certain businesses from the program. These so-called “sin businesses” include casinos, liquor stores, racetracks, and country clubs – to name a few. 6 Luckily for those eyeing the cannabis industry as their next possible venture, cannabis enterprises are not listed and should therefore qualify.
So why is this a potential opportunity for those who are looking to participate in the cannabis industry?
At present, cannabis is still federally illegal to buy or sell under the Controlled Substances Act of 1970. As a Schedule I narcotic, any business engaged in trafficking cannabis is subject to IRC §280E. This means that despite all of a business’s gross profits being subject to federal income taxation under IRC §61, none of their ordinary business expenses (e.g., rent, repairs, etc.) will be deductible. Therefore, investors may be hesitant to invest directly into plant-touching companies as, even if they are profitable, they may be cash-poor after taxes and unlikely to distribute earnings.
By forming a Qualified Opportunity Fund and investing in real estate, which may be leased to an operating cannabis company depending on the jurisdiction, investors may be able participate in the growth of the industry. This strategy could potentially offer investors the ability to defer recognition on their current taxable capital gains, while also making available capital for them to invest in the “secondary cannabis market.” Additionally, as the industry grows and the property values surrounding a profitable business appreciate in value, investors may benefit from a potentially tax-free appreciation on their initial investment.
As mentioned before, New Jersey may be a perfect market to employ this strategy. On February 5th, 2019, New Jersey released guidance indicating their conformity with the federal opportunity zone provisions. 7 The cities of Jersey City, Asbury Park, and Trenton have all expressed interest in allowing ‘alternative treatment centers’ (New Jersey’s name for medical dispensaries) in their cities. Each of these three municipalities contain Qualified Opportunities Zones within their borders which could host a cannabis enterprise. 8
Preliminary estimates predict that if cannabis were to be legalized for adult use in New Jersey (in addition to medicinal-use, which is already legal), it would likely grow into a $1 billion-a-year industry. 9 There is potential for approximately 343,000 consumers; possibly more from a spike in tourism from nearby states where cannabis may remain illegal. 10 Given the industry growth that has already taken place in states like California and Colorado, the populous state of New Jersey appears poised for growth.
Contact our Cannabis Advisory Group at Citrin Cooperman to discuss whether this tax strategy could be right for your business.
1 Guion, Payton. Two N.J. Towns Just Announced They Want Weed Sales. NJ.com., Feb 23, 2018. and Gusciora, Reed - Trenton Mayor (Oct 24, 2018). Panelist at NJ Cannabis Media Event.
2 IRC §1400Z-2(a)(1)(A)
3 IRC §1400Z-2(f)
4 IRC §1400Z-2(b)(2)(A), IRC §1400Z-2(b)(2)(B)(iii), IRC §1400Z-2(b)(2)(B)(iv)
5 Prop. Reg. §1.1400Z-2(c)-1(b)
6 IRC §1400Z-2(d)(3)(A)(iii) referencing IRC §144(c)(6)(B)
7 Federal Tax Cuts and Jobs Act (TCJA) – Opportunity Zones. State of New Jersey, Division of Taxation, Feb 05, 2019.
8 Opportunity Zones. State of New Jersey, Department of Community Affairs, Dec 19, 2018.
9 Report: Marijuana Could Bring in $300 Million in Revenue to NJ... Archer Law, Dec 6, 2018.
10 Same as Citation #7 above.