Accelerating Operating Business Investments in OZ

Published by John Sciarretti on Thursday, December 5, 2019
Journal cover thumb December 2019

The opportunity zones (OZ) incentive is a tool designed to spur economic development and job creation in distressed communities by closing the financing gap that has prevented low-income communities from achieving economic development success.

Supporters of the legislation emphasized investment in operating businesses as a primary focus of the legislation. However, it appears that nearly all OZ investments to date have been made for the acquisition, construction and/or improvement of real property.

Not many would disagree that real estate projects serve as catalysts for increased investment in low-income communities. Real estate projects create jobs through construction and business expansion and are a crucial first start for housing much-needed workforce, businesses and service providers. In addition, real estate developments change neighborhoods, from lowering vacancy rates and reducing crime to cleaning up environmentally contaminated sites.

However, in order for the OZ incentive to realize its full potential of sustained economic development, it needs to also spur investment in operating businesses.

Two primary factors are likely responsible for the early tilt toward real estate: compliance concerns and holding period. Real estate investments are less likely to present compliance problems because they are not going to move or grow out of an OZ and holding periods for real estate investments tend to be less volatile over the long term, so waiting 10 years to realize the maximum incentive is not a stretch. Operating businesses, on the other hand, can change a lot over 10 years and even though the second tranche of OZ proposed regulations removed a lot of the uncertainty of how the IRS will implement the incentive, there are a number of technical issues remaining. Furthermore, private equity and venture capital traditionally seek to generate returns within three to seven years, so waiting 10 years is likely a stretch.

Operating business investment is a primary goal of the program and it is likely that we will see investors make necessary modifications to traditional investment strategies to take advantage of the powerful tax benefits under this tool, provided that the investment otherwise makes economic sense. Addressing the following technical issues will go a long way toward accelerating the pace of that investment:

Allow for deferral and ultimate exclusion of interim gains

As mentioned, venture capital traditionally seeks to generate returns within three to seven years, which isn’t aligned with the incentive to hold investments for up to 10 years. Proposed regulations provide 12 months for a qualified opportunity fund (QOF) to reinvest ‘‘interim gains,’’ but require investors to pay tax currently on such gains or in 2026 if the gains are reinvested by the taxpayer in the same or different QOF. Allowing interim gains to be first deferred if reinvested by the QOF into replacement qualified OZ property within a reasonable period and then ultimately excluded if the QOF investment is held for 10 years is critical to attracting venture capital to operating business investments in OZ.

Extend the grace period to purchase qualified OZ property

QOFs need adequate time to build a portfolio of qualifying operating business investments and the six months provided by the second tranche of regulations is likely not adequate. IRS and Treasury should consider a safe harbor where funds invested in temporary investments are deemed invested in qualified OZ property if ultimately invested in qualified OZ property within 12 or even 18 months of receipt by QOF.

Provide for a reasonable expectation safe harbor

Operating qualified OZ business requirements are stringent and an operating business can change a lot in 10 years. Investors generally bear the risk that a qualified OZ business becomes nonqualified sometime in the future and continual monitoring can be cost prohibitive. Similar to the New Markets Tax Credit program, regulations should provide that an entity is treated as a qualified OZ business for the duration of the QOF’s investment in the entity if the QOF reasonably expects, at the time the QOF makes the investment in the entity, that the entity will satisfy the requirements to be a qualified OZ business through the entire period of the investment.

Provide more clarity around the required use of intangible property

Current regulations around the required use of intangible property tell us that a substantial portion used is 40 percent. However, more guidance regarding what it means to “use” intangible property in the qualified OZ business is needed. Intangible property may be used directly by a business to facilitate production or the provision of services or the sale or lease of tangible property to customers (direct use intangible property). A business may also sell or lease intangible property to customers (indirect use intangible property). It appears consistent with congressional intent that both direct and indirect uses be permitted as long as a substantial amount of services (say 40 percent) are conducted to use or develop the intangible in the OZ. The regulations should also establish a safe harbor to protect QOFs that are acting to comply with the standard in good faith.

Modify qualified OZ business property test for existing businesses in OZ

Much of the tangible property of existing operating businesses in an OZ is not likely to qualify as qualified OZ business property for the following reasons: (1) The majority of tangible property of an existing OZ business was likely purchased before Dec. 31, 2017; and (2) existing tangible property in use in an OZ is not likely to need improvements. To facilitate the qualification of an existing business in OZ as a qualified OZ business, regulations should provide that existing operating businesses: (1) be exempt from the rule that requires tangible property to be acquired by the QOF after Dec. 31, 2017; and (2) provide that, at the election of the taxpayer, the substantial improvement requirement can be met by a business on an aggregate basis–including property purchased before Dec. 31, 2017. Current regulations limit the substantial improvement option to an asset-by-asset approach.

Conclusion

Time will tell, but OZ constituents are optimistic that the incentive will attract a considerable amount of investment in operating businesses in OZs. Addressing the technical issues discussed above will definitely help to accelerate the pace.