In order to determine if your business may be eligible as a Qualified Opportunity Zone Business (QOZB), it’s important to understand why these investment vehicles were created and what requirements are necessary for eligibility.
With bipartisan support, Qualified Opportunity Zones (QOZ) were established under the Tax Reform Reconciliation Act of 2017. The purpose of this tax code was to encourage long-term investment in economically-challenged communities with the goal of creating jobs and stimulating economic growth. In exchange for investing in these locations, taxpayers are offered deferred tax benefits if they contribute capital into investment vehicles called Qualified Opportunity Funds (QOF). There are 8,764 opportunity zones in all 50 states, the District of Columbia and five U.S. territories. These regions were nominated by each state and approved by the U.S Treasury.
See a map of Opportunity Zones across the US.
There are several requirements to obtain QOZB eligibility.
- A business must own or lease at least 70% of its tangible property to be categorized as a QOZB property.
- At least 50% of a company’s total gross income must come directly from the qualified opportunity zone.
- At least 40% of a business’ intangible property must be used when conducting business as a QOZB.
- Non-qualified financial property must average less than 5% of the aggregate non adjustable basis of the business property.
- “Vice” businesses are prohibited as QOZBs and include: golf courses, sun tan parlors, massage parlors, hot tub facilities, gambling businesses (such as horse tracks and casinos), and businesses operating primarily as liquor stores.
In the tax code, under Section 162, how a property is owned or used will be a deciding factor on how a trade or business operates. Leasing properties have specific criteria, such as a triple net leased property, cannot be classified as a trade or business. There are some caveats to whether a lessor leases a portion of a building and pays fees and has an office in that building. The lessor can claim QOZB if the above requirements are true and there are hired employees operating and conducting business in the building. Simply having an office in the building and paying all fees related to the lease of the building is not enough to qualify the business as a QOZB. Section 162 must be reviewed carefully when a triple-net lease is in play to determine eligibility.
Leased Tangible Property
For purposes of testing whether a QOZ property is eligible, it must meet the guidelines set forth by the 90% QOF asset test and the 70% QOZB property test. The leased property must be leased after December 31, 2017 to qualify. During the time a QOF or QOZB leases the property, the property must be in a qualified opportunity zone for substantially all of the period of time the property is leased. Original use is not a requirement for these leased properties.
A QOZ business property may not be acquired from a related person. If the seller and buyer directly or indirectly own more than 20% of capital interests or profit interests in partnerships, they are considered a related party.
The related party disallowance rule will not be applicable if the lease meets the following criteria:
- The lease must be at fair market value.
- It is presumed that leases between unrelated parties are market-rate and can be entered into leases with state and local governments and Indian tribal governments that are not market-rate.
- It is generally presumed any lease that is not between related parties is established at market rate. A lease cannot allow prepayments over a specific period of time exceeding 12 months.
When considering personal property, the lessee must become the owner of the QOZB property by the last day of the lease or 30 months from acquisition, whichever date comes first. The value of the property must equal the value of the lease. An anti-abuse rule has been established to prevent leases being used as a work-around of the substantial improvement requirement. Personal property that is leased on a short-term basis to lessors using property outside a QOZ may be counted as a QOZB property. When it comes to valuing leases, there are two methods used to determine calculations. The GAAP financial statement is the first method, and the alternative method would be to calculate the sum of the present value of all the lease payments calculated at the time the lease is executed. Whichever method applied must be used consistently on all leased tangible property for that tax year.
If a portion of a parcel located in the opportunity zone is “substantial” when compared to the portion that is located in the non-opportunity zone tract, then the property will be treated as if it were in the Opportunity Zone entirely. The property is measured in square footage when determining how much of the property in question is deemed “substantial.”
Gross Income Test
Three safe harbor provisions were defined to give taxpayers guidelines when determining the 50% gross income test. The first provision states at least 50% of services performed by a QOZB must take place within the QOZ and be measured in hours. The second provision states at least 50% of services performed must be performed by employees and independent contractors, measured by amounts paid for these services. The third, and final provision, states 50% of gross income generated must come from both the tangible property and operational management functions performed by the business in the QOZ.
At least 40% of a QOZB’s intangible property must be used in the active conduct of a QOZB’s trade or business. QOZB property is tangible if:
1) It was acquired by purchase after Dec 31, 2017 by an unrelated party, using a 20% related party standard;
2) It is an “original use” property which commenced when the QOZB was established OR “substantial improvement” if the QOZB substantially improves the property, and;
3) During substantially all of the holding period of the property, the property is in an opportunity zone.
Working Capital Safe Harbor
A QOZB can use Working Capital Safe Harbor (WCSH) as a compliance tool if they properly documented the WCSH as reasonable. The QOZB must prepare a statement saying the Working Capital Assets are designated for the development of a trade or business in an opportunity zone. They must also provide a written schedule showing expenditure of the working capital assets for the startup of a trade or business. All working capital must be spent within 31 months of receipt by the business. These provisions can be used for real estate improvement projects and the development of a trade or business within a QOZ.
Other guidelines to note include the following:
- WCSH is not available for QOZ trade or businesses operated by or directly invested in by a QOF.
- Startups are given extra considerations, including an additional 62 month safe harbor allowance to accommodate the extra time needed to establish their business, while allowing time for asset testing, gross income testing and any other requirements.
- An extra 24 months in safe harbor allowance for working capital is also granted to businesses that fall within a federally-declared disaster zone.
- The maximum amount of time safe harbor can be applied is 62 months, and any remaining time cannot be counted towards tangible property when calculating the 70% tangible property standard.
- Any tangible property that is improved may be considered when determining if a QOZB is engaged in a trade or business.
- If a QOZB is not using the safe harbor allowance, the tangible property may be used when a substantial improvement takes place, and at that time, it may be considered used as a trade or business.
As inventory may be difficult to track, especially when goods are in transit or temporarily out of a warehouse facility, guidelines state it may be carved out entirely when considering assets as part of asset testing. As long as it is applied consistently for the taxable year. Inventory would normally be considered an asset when considering QOZ asset testing, but final regulations have permitted either excluding inventory or including inventory. Carving out inventory as described above, for purposes of calculating the 90% asset test at the QOF level and 70% tangible property test at the QOZB level.
While many businesses across multiple industries can qualify for QOZB, businesses considered to be “vice” businesses are not eligible for deferred tax exclusions.
There has been recent discussion whether cannabis businesses should qualify for QOZB. It’s been advised these businesses should not be considered, as the precedent has been set restricting other federally prohibited and controlled substances. Cannabis may legally be sold and used in several states who have legalized its use, however, federal guidelines would trump any set forth at the state level when determining eligibility for QOZB status.
In addition, a guideline exists which would allow companies who have less than 5% of gross assets in a property that include a vice business to retain the QOZB eligibility. A QOZB cannot lease more than a de minimis amount of property (less than 5% of the net rentable square feet of its property) to any vice business. An example of this is a grocery store that sells alcohol. The store would not be restricted, so long as it could prove no more than 5% of its assets are linked to the sale of alcohol.
At the sale of a property by the QOF or QOZB , QOF investors can elect to exclude all capital gain (other than the sale of inventory) if they have held their investment in the QOF for 10 years. Depreciation of the property cannot be recaptured. In the case of partnership businesses, a basis step-up can be calculated for sale of partnership interest. This is not applicable to C corporations. In a qualified opportunity zone, if a QOZB or investor sells an asset before the 10 year holding period is reached, there is a 12 month safe harbor period to reinvest the cash. Once that period passes, the sale will be taxed and excluded from the QOZB guidelines indicated above. If you would like to know whether your company qualifies as a QOZB business, we want to hear from you. Our QOZB Expert team can help your company determine eligibility and manage and monitor compliance of all QOZB requirements.