Qualified Opportunity Zone. The idea arose when the IRS and politicians found themselves with two issues.
Firstly, politicians wanted to help revitalize low-income neighborhoods, crying out for help. Secondly, the IRS noted that there were likely billions of dollars in appreciated property owned by US taxpayers. And that property was sitting on the sidelines, untaxed.
By collaborating and merging these two issues, the government realized that they could incentivize appreciated property owners to sell—triggering a taxable event—but those investors would then have the option to defer that taxable gain by reinvesting those gains into underserved communities. This led to the concept of Opportunity Zones, which were created under the 2017 Tax Cuts and Jobs Act, signed into law by President Trump on December 22, 2017, to stimulate economic development and job creation by incentivizing long-term investments in low-income neighborhoods.
How to do that?
An investor sells an appreciated piece of property for long-term cap gains. This would then trigger the option for the investor to reinvest in an entity or property in an area designated as an opportunity fund. No one wants to pay tax if they don’t have to, and certainly not before it is due. This allows them to defer payment on their gains on the original property until December 31, 2026. Five years into the investment, there is a 10% step-up in basis on the original capital gain. At seven years, the investor could get a 15% step-up in basis when the cap gains were sold, (currently this is not possible as the cut-off date for paying the tax due, December 31, 2026, is less than seven years away). After ten years of investment in the Qualified Opportunity Fund (QOF), investors can sell their interest in the funds at a profit, and all gains on the QOF are excluded from income.
DPM Enterprises have decided to sell their current location in Mount Lebanon–an affluent suburb of Pittsburgh. They get a fabulous offer on their office space and are looking at a capital gain of $5,000,000. This would result in roughly $1,000,000 in capital gains tax for the owners. But do they have to pay it immediately? If they do not need at least the capital gain portion of the sale price, they could reinvest it in a designated Opportunity Zone in either a business or general property.
Unfortunately, it is generally not as easy as just throwing some money at real estate in Hazelwood or Braddock–both older, more depressed areas of Pittsburgh and being able to defer the entire $5M in cap gains. DPM would first need to select an area to reinvest their capital gain. Affluent neighborhoods are generally not going to be options for DPM Enterprises. The Zones were chosen by state governments, in particular the governors — prior to the program’s beginnings. The governors were given some parameters, mostly having to do with socioeconomic measurements. Please visit the Opportunity Zone Database website.
These areas do present particular challenges to investors looking to manage their own funds. Some investors find themselves frustrated with the difficulties involved in finding lucrative opportunities in these areas and find themselves investing in either a publicly managed fund or by contacting local developers and taking more of a back seat role and letting the low-income area developers take the lead.
In this case, DPM Enterprises decided to purchase an old building in Pittsburgh’s Rankin/Braddock area. They hired a local developer to renovate and rehabilitate this building to include housing on the upper floors and a grocery store on the main floor. These are much-needed accommodations in several of the Opportunity Zone areas. Although there are several special circumstances, the general rule is that would need to reinvest the $5,000,0000 within the span of six months into an Opportunity Zone Fund.
This leads us to the various rules and timelines involved in using the Opportunity Zones. Up until now, we’ve mainly used the term “Opportunity Zones,” but the real vehicle through which this is run is called the “Opportunity Zone Fund.” A single individual cannot use this program on their own. Instead, a “Fund” –in the form of a C corporation or a partnership holds the qualified opportunity zone property.
Therefore, DPM Enterprises forms the Partnership “Adding Machine Overachievers, LLC” (AMO, LLC). The owners invest the $5,000,000 into the partnership and shop the market for a possible investment where they find the old building within the confines of the Opportunity Zone. Their work is not complete once they invest in this building. There are various requirements for both property and timing.
For instance, $5,000,000 is more than enough to purchase the building in their designated area. In fact, they have money left over. This causes an issue AMO, LLC because part of the tests with maintaining QOF status is the 90% test. The 90% test requires 90% of the funds’ assets to be invested in Qualified Business Property—This can be either/or– a mix of the basic property located in a QOZ or stock or partnership interest in a qualified opportunity zone business. So to alleviate this, Partner One buys a craft brewery with the excess; Partner Two buys a dance studio, Partner Three buys the HVAC companies in the area, Partner four decides to renovate an abandoned manufacturing site—all of the businesses and property must be within the Opportunity Zone Area.
Another rule that QOF’s must abide by is that any non-original use property placed in service must be “substantially improved” within 30 months—generally understood to mean increasing the value of the property (excluding land) by its original cost. The caveats to this are: The property was vacant for three years upon purchase, the property was acquired directly from the local government, which must have received title through abandonment, bankruptcy, foreclosure, or some other involuntary transfer, or the property qualifies as being part of a Brownfield site. A Brownfield site is a building, or a site qualifies as a brownfield under CERCLA (42 U.S.C. 9601), then any property associated with the site qualifies as “original use” as long as the owner invests enough to ensure the site “meets basic safety standards for human health and the environment.
Additional exceptions to the “substantial improvement” test.
- New Tangible/Personal Property. All “new from the factory property” plus any property not used in an OZ before.
- Business Equipment Moved Into an OZ. Any business that moves into the OZ for the first time will automatically have all of its equipment qualify as “original use” because, even though it has been in use for years, it has never before been “depreciated in the OZ.”
- Ground-Up Construction. As discussed below, the land gets special treatment within the “original use / substantial improvement” test: it is basically ignored, and any new building built from the ground up will be considered “original use” property. As a result, an OZ investor can put capital into a project any time before it is placed into service, after which the property is no longer deemed “original use.”
It’s important to note that if the work improves the assets can reasonably be completed within 30 months, they can count towards the 90% test.
5 Tests for a Business in a Qualified Opportunity Zone
- At least 70% of the property in an Opportunity Zone Fund must be a Qualified Opportunity Zone Business Property.
- At least 50% of Gross Income of the business much be derived from the active conduct of a QOZB within a QOZ. This includes hours worked, cost of services, and business function.
- 40% of Intangible property must be used in the active conduct of a qualified business in a QOZ.
- No more than 5% of the average of the aggregate unadjusted basis of the business property must be attributed to the nonqualified financial property.
- Cannot be a “sin business,” i.e., racetrack, liquor store, massage parlor.
For these exceptions, let’s use Partner Three and his various HVAC companies as examples:
- Brand new HVAC Company: The HVAC company sets up a site in a brand new building within the confines. “New” is defined as never having been depreciated before—this could include a building that has been completely renovated but has never been placed into service.
- The second one would be where an existing HVAC company moves staff and operations from Mt. Lebanon to Braddock—everything will be considered brand new and exempt from the substantial improvement test.
- This is where we have a piece of land and build, your standard new building. The land will never be a part of the substantial improvement test.
These funds work well directly owning property. If the fund did nothing but renovate the property and rent it out (excluding triple net leases), as long as 90% of the funds’ assets were used in holding OZ business property, that should satisfy the requirement of the QOF.
Partners Three and Four were running various businesses—some of these included manufacturing, retail, or service. Since various business models would not work out well with only 10% in cash or financial instruments, Qualified Opportunity Zone Fund Businesses (QOZFB) are only required to keep 70% of their assets as in-use business property. They have to be careful, though—even though there are less strict rules for its assets, there are still a few tests for QOZFB to maintain.
In Use Explained
Section 3B: “Use” of Assets in an OZ. In general, 70% of the business’s tangible assets (excluding inventory) need to be “in use” at least 70% of the time in any Opportunity Zone. Here are a few details and extensions of this test:
“In use” in an OZ means
- located within the geographic borders of any OZ and
- used to make money in trade or business. Therefore, the relevant metric is the number of days between the two 180-day testing periods, in which this is true.
Two safe harbors are built into this definition, which we call the “Delivery Truck” and “U-Haul” exceptions.
Delivery Truck Safe Harbor: up to 20% of a business’ property automatically passes the “in use” test if the business
- has an office in an OZ,
- manages the employees using the property in question from an OZ office, and
- does not let the property in question stay out of an OZ for more than 14 consecutive days.
U-Haul Safe Harbor: Leasing businesses (like U-Haul or an equipment rental shop) qualify if
- the equipment is normally parked in the OZ when not in use and
- the typical lease duration does not exceed 30 days.
“In use” is an asset by asset determination. Thus, real property-heavy businesses (e.g., single-purpose real estate development companies) typically have an easier time meeting this test than operating companies with lots of moving assets like vans or laptops.
Special note about inventory: As a result, the final regulations permit QOZBs to EITHER
- totally exclude inventory from the asset tests, or
- include inventory but carve it out entirely while in transit or temporarily warehoused outside an OZ. As long as 50% of the services performed by the qualified OZ business are performed in an OZ, it should satisfy the “active conduct” requirement.
You can measure whether 50% or more of your services were performed in an OZ by looking at one of three tests:
- Time Test: percent of employee/contractor hours spent in any zone;
- Payments Test: percentage of salary/contractor payments allocable to any zone; or
- “Nexus” Test: whether the tangible property and management functions of the business in any zone generate 50% or more of business revenue. For example, a landscaping business that has its headquarters and key management at an office in an OZ and that stores all its equipment at its headquarters is a QOZB even though most of its work is done outside the OZ. The intangible 40% is used mainly to avoid a patent-holding company. Sin businesses are private or commercial golf courses, country clubs, massage parlors, hot tub facilities, suntan facilities, racetrack or other facilities used for gambling, or any “store the principal business of which is the sale of alcoholic beverages for consumption off-premises” (like liquor stores but not manufacturers or bars dedicated to on-premises consumption). This allows a hotel to have a spa or a brewery to sell growlers or other direct-to-consumer alcoholic products, as long as those activities remain below the 5% threshold.
Investor Tax Consequences
So what can QOF investors expect over the next few years? Assuming they’ve met both the property and timeline tests, what favorable tax consequences are on the table?
In 2026, all taxes on the original capital gain must be paid. If the interest in the QOF is still held, however, the partners will only pay capital gains tax on $4,500,000 instead of paying capital gains taxes on the original $5,000,000. There was also an additional step-up of another 5% when this program was originally made, but that opportunity ended with 2019 investments.
The real carrot here, though, is if the partners manage to stay all in for ten years—they follow their rules, they pass their tests, and manage to keep positive equity without overdrawing (resulting in a negative basis), if they stay all in and that $5,000,000 investment is now worth $15,000,000, the entire $10,000,000 gain will be a nontaxable event to the partners—it is important to note that selling the property within the funds will not be the impetus for the exit from the fund, but the selling of their partnership interests.
If you are considering an Opportunity Zone to relocate your business or reinvest your money to diversify your investments, we would love to help you succeed in that endeavor. Contact us today for your appointment.
Written by Tara Korey
Tara is a tax manager and business advisor at Wilke & Associates. She currently serves and has enjoyed working with small businesses throughout her career. Her resume includes serving clients in the small business community in various business sectors through tax advice, planning, and financial organization.