The 2017 Tax Cuts and Jobs Act created the Opportunity Zones program with the purpose of helping economically distressed communities by encouraging investment of capital within these communities. The Opportunity Zone program accomplishes this goal by allowing investors to defer paying capital gains taxes on capital gains by placing those gains into a Qualified Opportunity Fund (QOF). Investors are further incentivized to invest—and hold their investments—by being able to take advantage of further tax savings after holding their investments in QOFs for periods of 5, 7, and 10 years. For example, after the 10-year holding period an investor would not pay any capital gains tax on the sale or exchange of Opportunity Zone property within their QOF. To qualify for these tax benefits, the fund must place the original gains into a business or property that is located in what are known as Opportunity Zones. These terms can get a bit complicated, so they are discussed in greater detail below.
What are Opportunity Zones?
An opportunity zone is a low-income community that has been designated as a Qualified Opportunity Zone (QOZ) by the “chief executive officer” of the state (i.e., the governor) and certified as such by the Secretary of the Treasury. Information and resources on opportunity zones—including an interactive map—can be found on the Community Development Financial Institutions Fund website.
There are currently 320 QOZs in Ohio and 43 in Franklin County. For example, QOZs in Columbus include Franklinton and most of Olde Town East. As for Cleveland and Cincinnati, Hamilton County currently has 30 QOZs while Cuyahoga County boasts 64. There are also a number of QOZs in smaller cities across Ohio, as well as in rural communities.
In Colorado, on the other hand, there are 126 QOZs, with over fifty percent of those (66) falling within the Front Range. Examples of these QOZs include parts of eastern Boulder along Pearl Parkway and much of Commerce City in northeast Denver. Other Colorado cities with QOZs include Lafayette, Englewood, and Longmount.
What Are Qualified Opportunity Funds?
The term Qualified Opportunity Fund (QOF) means any corporation or partnership whose assets are comprised of at least 90% of equity interest (or property) in QOZ businesses. This, of course, raises the question, “What is a QOZ business?”
What are QOZ Businesses?
QOZ businesses must have substantially all of their tangible property located in a QOZ (whether owned or leased) and must derive at least 50% of their gross income from the active conduct of a trade or business in the QOZ in which the business is located. This gross income rule is found only in proposed IRS regulations, so it may change before these rules are finalized.
Another limit on QOF investment is that QOZ property must either (1) have an original use that begins at the same time as the QOF or (2) the QOF must substantially improve the property. This substantial improvement issue has already been addressed in an IRS Revenue Ruling, which states that land can never have its original use beginning at the same time as the QOF because the permanence of land. The Revenue Ruling also states that the “substantially improving” requirement does not apply to land. For real estate development, this means that QOFs either need to build new buildings—or substantially improve existing buildings—within QOZs in order to take advantage of the tax benefits of the Opportunity Zone program.
How Can Opportunity Zones be Utilized by Startups?
Opportunity Zones have the potential to attract new sources of capital for startups that are located within QOZs. Treasury Secretary Mnuchin has predicted $100 billion in new capital investment due to the Opportunity Zone program, and many VC firms are interested in utilizing the program to raise more money for startups.
Opportunity Zones also present opportunities for socially conscious startups who desire to be present in and bring new jobs to low-income communities by providing a tax incentive for investors. New proposed IRS regulations have clarified previous concerns with the gross income requirement that had some worried about the types of businesses that could benefit from the Opportunity Zone Program. Essentially, if a startup is headquartered in an QOZ, it likely will qualify as a QOZB. The new regulations provide three safe harbors for QOZBs for meeting the 50% gross income test:
(1) at least 50% of employee and independent contractor working hours come from within the QOZ;
(2) at least 50% of the amount paid to employees and independent contractors are services performed in the QOZ; or
(3) the tangible property (in the QOZ) of the QOZB and the management or operational functions performed in the QOZ are necessary for the generation of at least 50% of the QOZB’s gross income.
These new regulations should make it much easier for startups to meet the 50% gross income test, which should mean that VCs start taking a serious look at the Opportunity Zone program as a method of investing in startups.
Opportunity Zones vs. the Section 1202 Small Business Stock Exclusion
A major issue that the Opportunity Zone program faces in the startup context is the Section 1202 small business stock exclusion and its tax incentives that are already utilized in the startup context. Under Section 1202 of the Internal Revenue Code, 100% of an investor’s capital gain on the sale of small business stock can be excluded from income if that stock is held for at least 5 years. Under the Opportunity Zone program, an investor would need to hold their investment for at least 10 years to see the same amount of tax benefit. Further, investments in small business stock can be rolled over to other small business stock while maintaining any previous holding time already built up. It remains unclear whether investors can roll over their investments in QOFs to other QOFs.
The Opportunity Zone program does have some advantages over Section 1202, including (1) allowing investment into hotels, restaurants, and other industries excluded from Section 1202; (2) allowing investment in stock and partnership interests; (3) allowing investors to purchase property directly and manage it themselves within a QOF; and (4) allowing investors to defer capital gains tax on already realized capital gains and reduce tax amounts paid on the original capital gains by up to 15%.
For the most part, Opportunity Zones have been primarily utilized in the real estate context. The gross income requirement, among other unknowns, had many investors waiting for further clarity before they begin to fund non-real estate projects within QOZs. The major concern was with the 50% gross income requirement and whether only sales made within the Opportunity Zone count towards the threshold. New IRS regulations have given investors clarity concerning the 50% gross income requirement, so we should begin to see utilization of Opportunity Zones outside of their current primary real estate development use.
Despite the Opportunity Zone program’s tax incentives and advantages, it seems likely that Opportunity Zones will continue to be used primarily in commercial real estate development. The shorter holding period of the small business stock exclusion makes it unlikely that investors will choose the Opportunity Zone program when they make capital contributions to startups, although the additional tax reduction on original capital gains through the Opportunity Zone program might be enough of an incentive to pull investors away from the small business stock exemption and into the Opportunity Zone exemption.
This post is provided for general information purposes and is not legal advice. As always, if you have any questions about this post or how it might impact your business, contact one of our attorneys.