On December 25th, 2017, an individual investor sells 1,000 shares of ABC stock that they purchased in 2016 for $250,000. The sale at $1,250 per share results in a $1 million capital gain.
Instead of paying the $238,000 in capital gain tax (assuming 20% rate and 3.8% net investment income tax) in federal capital gains tax on this sale, the investor rolls their $1 million gain into a Qualified Opportunity Fund that invests the capital in newly issued preferred stock shares of various operating businesses or real estate located in Opportunity Zones with a plan to liquidate the fund in 2028. The investor has until June 23, 2019 (180 days from of the sale of the investment) to invest the gains.
If the assumed value of the investment in 2028 is $2 million, then the benefits received by the investor include the following:
- Investing $1 million instead of the $762,000 that would be remaining if the capital was not reinvested into an Opportunity Fund
- Paying $202,300 in taxes in 2026 instead of paying $238,000 in 2018
- Owing no additional tax on the $1 million in capital gains on the Opportunity Fund investment realized in 2028
- Must be certified by the U.S. Treasury Department (self-certify attaching Form 8996)
- Must be organized as a corporation or partnership for the purpose of investing in Qualified Opportunity Zone Property
hold at least 90% in Qualified Opportunity Zone Property
- Qualified Opportunity Zone Property includes newly issued stock, partnership interests, or business property in a Qualified Opportunity Zone business
- Opportunity Fund investments are limited to equity investments in businesses, real estate, and business assets that are in an Opportunity Zone.
- Loans are not eligible for the tax incentives, only equity investments.
- Opportunity Fund investments in real estate are subject to a substantial rehabilitation requirement.
A QOZB is a trade or business that:
- Substantially all (70 percent) of the tangible property owned or leased by the business is QOZB property.
- At least 50 percent of the business’s total gross income is from the active conduct of the trade or business in the Opportunity Zone.
- A substantial portion of the business’s intangible property is used in the active conduct of the trade or business in the Opportunity Zone.
- Less than 5 percent of the average of the aggregate unadjusted bases of the business’s property is attributable to non-qualified financial property (i.e. debt, stock, partnership interest), with exception for reasonable amounts of working capital.
- Cannot be a “Sin” business such as a golf course, country club, massage parlors, any gambling facilities, and any store the principal business of which is the sale of alcoholic beverages for consumption off premises.
Below is a comparison of making direct vs indirect investments:
Direct ownership (single-tier structure): QOF directly owns QOZB property used in a trade or business
|90-percent asset test (90% of all the QOF’s assets is QOZB property)|
|QOZB Property is used in the QOF’s trade or business|
|Intangible property is not QOZB property for the 90-percent asset test|
|No additional restrictions on financial property|
|No working capital safe harbor|
|No prohibition on “sin businesses”|
|No specific reference to the lease of property by a QOF|
Indirect ownership (two-tier structure): QOF owns QOZB property through a QOZB
|Substantially All (70%) of the tangible property owned or leased by the business is QOZB property|
|50% of gross income of the QOZB from active conduct of trade or business within the QOZ|
|A substantial portion of the business’ intangible property is used in the active conduct of the trade or business in the opportunity zone|
|<5% of the average of the aggregate unadjusted bases of the property is attributable to the non-qualified financial property (except for reasonable amounts of working capital)|
|Working capital safe harbor|
|QOZB cannot be a “Sin Business”|
|A QOZB is able to lease property and could possibly qualify as QOZB property|
The investor with the $1 million gain may decide to invest directly in QOZ businesses, providing growth and expansion capital in exchange for business interest. The investor has identified the following QOZ businesses and may consider investing their $1 million directly into these businesses.
Below are a few examples of how an Opportunity Zone Business Investment can be made today:
Child Care Business
Overview: A successful early education child care business that has been operating for over 30 years in the Northeast region. The business provides early education and child care services to children six months to four-year-old and has a great record of being a trusted child center with top notch employees.
Opportunity: The business operates 3 locations within Opportunity Zones and would like to expand their operations to a forth location within a Qualified Opportunity Zone. The owner projects that it will cost roughly $600,000 to acquire and operate the fourth location, and will commit $200,000 of the company’s profits, retain a bank loan for $200,000 and is looking for $200,000 in equity to finance the completion of the expansion.
Execution: The investor decides that they would like to invest $200,000 of their $1,000,000 gain into this investment. The company and the investor agree on terms, the expansion is itemized so the investor can qualify the investment and confirm that the investment will pass the 90% test. The investor will become a minority owner in the business and will receive 33% of the profits.
Transaction summary: In the year 2028, the investor will sell their 33% share in the business to the owner and hopefully make a market rate return and meaningful impact to the community that the business serves.
Steel Manufacturing Business
Overview: A successful steel manufacturing business that has been operating for over 80 years on the East Coast. The business manufactures niche steel component products to several companies that service large commercial buildings and has a great product and service record within the industry.
Opportunity: The business manufactures its products within an Opportunity Zone and the owner would like to purchase new manufacturing equipment that is estimated to cost $200,000. The owner has offered the investor 10% of the company’s equity and profits for a $200,000 investment.
Execution: The investor decides they would like to invest $200,000 of their $1 million gain into this project. The company and investor agree on terms, the expansion is itemized so the investor can qualify the investment and confirm that the investment will pass the 90% test. The investor will become an equity partner in the business and will receive 10% equity and target a market rate return with meaningful impact to the community that the businesses serves.
Transaction summary: At year 2028, the investor will sell their 10% share of the business to the owner and its employees.
Food Manufacturing Business
Overview: A successful wholesale food manufacturing business that has been owned and operated by the same family for over 30 years. The business manufactures fresh food products and is well known regionally for their fresh high-quality baked goods.
Opportunity: The owner would like to increase their products and services by expanding the manufacturing facility. The company is in an Opportunity Zone and has room for expansion. The owner has planned to expand the facility and purchase additional manufacturing equipment estimated to cost $600,000. The owner has offered the investor 10% of the company’s equity and profits for a $600,000 investment.
Execution: The investor decides they would like to invest $600,000 of their $1 million gain into this investment. The company and investor agree on terms, the expansion is itemized so the investor can qualify the investment and confirm that the investment will pass the 90% test. The investor will become a minority owner in the business and will receive 10% of the equity and profits of the company.
Transaction summary: At year 2028, the investor will sell their 10% share of the business to the owner and hopefully make a market rate return and meaningful impact to the local community.
For hands on investors a Direct Investment QOF may be their preferred choice for investing. If the investor elects to proceed with a Direct Investment Opportunity Fund, then there are several steps that need to be addressed:
- Identify and retain a Qualified Opportunity Zone Advisor
- Certify the Qualified Opportunity Fund
- Identify Qualified Opportunity Zone investments
- Conduct in-depth investment diligence to identify investment risk
- Structure investment terms
- Deploy capital
- Monitor investment to assure performance (6-month testing)
- Exit strategy
The $1 million gain investor may decide to invest indirectly in the businesses from the example through a General Partner (GP) or Managing Member (MM).
If the investor elects to invest indirectly in an Opportunity Fund, then there are several steps that need to be addressed:
- Identify Qualified Opportunity Zone Attorney and Accountant
- Identify Qualified Opportunity Fund Managers (GP or MM)
- Conduct in-depth investment management diligence
- Deploy capital
- Monitor investment performance
- Exit strategy
QOZ Real Estate Investment Example
Overview: The investor has identified a 4-unit building that consist of 1-commercial unit and 3-residential units located in an Opportunity Zone. The property is completely vacant and requires full renovation.
Opportunity: The current owner is willing to sell the property for $400,000. After an in-depth analysis on the investment, the investor gets a proposed plan to expand the property and add an additional unit which is estimated to cost $450,000. Due to the substantial improvement ruling in the regulations, this investment should be a Qualified Opportunity Zone property.
Execution: The investor will spend a total of $850,000 for the acquisition and improvements, then be able to rent the building’s units and collect rental income. In year 2028, the investor will have to sell the property in order to receive the full tax benefits from the program.
Transaction summary: At year 2028, the investor will sell the entire property for a market rate return and meaningful impact to the community that the business serves.
“The real estate aspect is a great catalyst to attract new businesses”
– Steve Case, Founder, AOL (Forbes, 7/17/18)
If the investor elects to directly invest in real estate, there are several steps that need to be addressed:
- Proper representation by Qualified Opportunity Zone Attorney and Accountant
- Certify the Qualified Opportunity Fund entity
- Assess the property to verify it will pass the 90% test and the substantial improvements ruling
- Verify that the renovation will be completed within the allotted time
- Create a cost itemization list for tax record purposes
- Manage property
- Sell property
It is important to note that there is additional cost to owning property including taxes, maintenance, and other unforeseen charges, it is important to hold enough cash in reserves.
Investors may be able to leverage debt financing in conjunction with equity investments.