My experience in the nightlife industry while developing JoonBug showed me that every new opportunity has two sides - one that complements the status quo, and the other that opens up avenues for innovation. I see Opportunity Zones as the perfect example, because while most entrepreneurs are focused on the tax cuts offered by the program, there is also a way for businesses to earn multiple benefits by becoming the cornerstone of the initiative, relocating or re-focusing their business to these Opportunity Zones.
Opportunity Zones (OZs) are a novelty, introduced barely more than two years ago back in December of 2017 with the Tax Cuts and Jobs Act. But they’re also well-known in the sense of being a good idea turned utterly convoluted by heaps and heaps of limitations, exceptions and requirements. In fact, some say that merely understanding the inner workings of the opportunity zones mechanism is the biggest barrier for entry.
That’s right - it’s not the financial status that prevents people from becoming a part of the initiative, or the line of business they’re in. It’s the fact that unless they happen to be an accounting enthusiast fluent in legalese, they’ll most probably have no clue about how OZs work. So they’re left with two options - spend hefty fees for lawyers and accountants to make sense of it to them or trust an investment firm blindly hoping they’ll make the investment worthwhile. Doesn’t sound like such a sweet deal.
Nevertheless, investors who have had the means to wrap their heads around the OZ regulation are enthusiastic. Real estate is the flagship industry with funds sprawling up left and right. As Tony Nitti of Forbes puts it, “not a week goes by that there isn’t a conference or three on the topic somewhere in the country”.
Crash Course in Accounting, Legislation and Investing
The vision behind OZs is to bring investment pouring into low-income and distressed communities. Each state nominates areas, which are then certified by the Secretary of the U.S. Treasury. The areas have either a poverty rate of at least 20 percent or a median household income lower than 80%, compared to its neighbors. It’s not always poverty-stricken areas - sometimes it’s just places that have lower income than its neighbors, but could still be well above the poverty line. All in all there’s more than 8700 OZs around the U.S. and you can find a map of all them here (adobe flash required).From there, Qualified Opportunity Funds (QOFs) are created to serve as the investment vehicle in these areas, offering substantial tax cuts to those who jump the bandwagon. I won’t go into much detail about the regulations regarding QOFs, but an important aspect you should know is that they must hold 90% of their assets in Opportunity Zones, for reasons that I will explain later.
There’s three key benefits to investing in a QOF:
1. Deferred income gains tax
If you sell an asset and have an income gain, you have 180 days to opt to invest it into a QOF. Your income gains tax is then deferred until December 31, 2026, or until you happen to sell the Opportunity Fund investment – whichever is earlier.
2. Reduction in income gains tax
Here’s where the tangible financial incentive appears. If you hold your assets in the QOF for at least 5 years, you are eligible for a 10% decrease in the capital gains tax for those assets. It’s currently the second phase of the initiative, as the potential reduction of the tax was even higher until the end of 2019. If you hopped in before 2020 - congratulations, it’s 15% for you.
3. Exclusion of gains
This is the gem of the OZ incentive, the golden nugget that has investors excited. If you hold your capital in the QOF for more than 10 years, you don’t pay any tax on any further capital gains. This means that in addition to a deferred and reduced capital gains tax for any sale of an asset, you are also eligible for tax exemption on any additional gains.
So, there are a few things to unpack here. First, it’s that if you sell any assets, you have 6 months to reinvest the gains in a QOF. Whether you operate with real estate, stocks, bonds, bitcoins or golden geese - if you sell it, you can reinvest the gains in QOF and qualify for tax reduction. You can not, however, qualify, if you enter into a QOF with cash or property, or anything other than capital gains from a transaction.
If you’re an investor, you probably knew most of this. So why am I telling all this? It’s because I think there’s more opportunity in Opportunity Zones than most would realize. It’s not just a tool for investors to boost their profits but it’s also a great new profit avenue for entrepreneurs.
Real Estate and Beyond
In many discussions the emphasis seems to first and foremost on how the OZ system intertwines with real estate investment. Criticisms of the initiative also seem to focus on the real estate aspect; for example, how funds invest in luxury condos in distressed areas that seem to be of no benefit to the local community.
There are two ways for a piece of real estate to qualify for the tax benefits. Either the property qualifies for the “original use” test, where it had been vacant for at least five years prior to being purchased, or it has to pass the “substantial improvement” test. This requires that you double the basis of the property over the period of 30 months. In effect, this is the biggest roadblock in the operations of QOFs and investors looking to participate in the OZ system.
There are, however, creative ways to meet the “substantial improvement” test. Instead of doing expansion or massive construction, you could improve the property in ways that bring an additional non-obvious return on the investment. For instance, installing solar power, upgrading to LED lights and updating the HVAC systems are a good way to meet the OZ property requirements. At the same time, you’ll be recapturing your investment through federal tax credits for going green, as well as reduced energy and utility bills.
But there’s the other side of the coin - real estate is only one of the ways in which a QOF may decide to invest its capital. As of March 5, 2020 statistics, the NCSHA reports $47.7 billion in investment scattered across 211 funds, while only 63% of the funds target investment in affordable housing and community development (source).Where are the other 37%, you might ask? These are invested in the so-called Qualified Opportunity Zone Businesses or QOZBs. And I believe this is most the overlooked opportunity. Instead of focusing on real estate, I think the maximum profit from OZs is to be gained through entrepreneurial activities. For example, by purchasing local businesses and attaining the QOZB status by relocating them, you hit two birds with one stone - you capture the tax benefit of the OZ program and you can invite funds to invest in your business for considerable benefit. The best part is that after holding the business for 10 years you can sell it, exempt of any tax on capital gains. In many cases successful businesses are worth much more than just a piece of real estate after a decade.
The biggest challenge in order to become a QOZB is to ensure that at least 50% of the company’s gross income is derived from conduct of business in the Opportunity Zone. The IRS has clarified that the requirement is met if:
a) 50% of all employee and contractor hours are spent inside the OZ,
b) resources and property needed to generate 50% of your gross income are located inside the OZ,
c) 50% of the company's services are performed in opportunity zones.
On top of that, the business has to hold at least 70% of its tangible property in the OZ.
In effect, this means a startup could easily locate its headquarters inside an OZ and satisfy all the requirements, regardless of whether they do business inside or outside the zone. With impressive benefits to both you as the business owner, as well as your potential investors, there is very little reason not to locate your startup in an OZ.
On the flip side, a business located outside an OZ could meet the criteria if they held their tangible property inside the zone, and if the employees spent most of their working time inside the OZ. This is perfect for all service-oriented industries like software development, consulting or even accounting, because moving these companies to an OZ would have little impact on client acquisition and day-to-day operations.
Putting the pieces together, we’ve arrived at the following conclusions:
Investors are incentivized to put their capital gains into QOFs.
QOFs deal in either real estate or investing into QOZBs.
Qualifying as a QOZB is not a difficult process.
So, while QOFs are hard-pressed to find investment options that fit the bill and keep their investors happy (and compliant), QOZBs are a prized commodity. By restructuring your business to be a QOZB, you’re inviting investors to gain regular profits, topped off by reductions in capital gains tax. What’s more - you can reinvest your own capital gains through a QOF in your own business, and sell your shares after 10 years without any tax applied to the gains whatsoever.
I think the golden nugget in Opportunity Zones is not necessarily the tax incentives, but more so the opportunities presented to businesses and entrepreneurs. Whether it’s through relocation, acquisition or founding a startup, becoming a QOZB seems like a no-brainer. From additional funding acquisition and financially sound reinvestment options through QOFs to favorable selling options after 10 years, there are all the prerequisites for a business strategy to work perfectly. And the best part is that very few entrepreneurs are approaching Opportunity Zones from this perspective.
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