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Investing in Opportunity Zones: Understanding Incentives for Economic Development

Learn about the tax benefits and investment opportunities in Opportunity Zones for economic development. Explore Qualified Opportunity Funds, capital gains reinvestment, and the special capital gains treatment available. Discover how Opportunity Zones can enhance ROI rates for real estate and operating businesses.

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Investing in Opportunity Zones: Understanding Incentives for Economic Development

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  1. Investing in Opportunity ZonesUnderstanding Opportunity Zone Incentives for Economic Development Investments March 29, 2019 Frank A. Hoffman Shawn E. Peterson

  2. Opportunity Zone Investments Opportunity Zones Where Invested? What Invested? How Invested? What Invested in? Capital Gains through an equity investment in Qualified Opportunity Funds Qualified Opportunity Zone Property

  3. What Taxpayers Can Take Advantage? • Any taxpayer that recognizes capital gains for Federal income tax purposes • Individuals, C Corps, RICs, REITS, partnerships, S Corps, trusts, and estates • Capital gain must be recognizable before January 1, 2027 unless deferred through an Opportunity Zone investment • Capital gain cannot arise from related party transaction • Section 267(b) & 707(b)(1) apply but with 20% threshold • If common ownership of 20% or greater then related • Includes unrecaptured Section 1250 gain (held for investment) • Includes Section 1231 gain (used in a trade or business) • Excludes depreciation recaptured as ordinary income

  4. How is the Capital Gain Re-Invested? • Taxpayer must invest capital gains into a Qualified Opportunity Fund (QOF) within 180 days from the date that the gain would be recognized for Federal income tax purposes • Start date is often the date of the asset’s sale or exchange • An investment in a QOF must be an equity interest and cannot be a debt instrument • Cannot be invested as a debt instrument under 1275(a)(1) • May be preferred equity or have a special allocation of cash • An equity interest is not impaired if used as collateral for a loan • Taxpayer may have a non-gain investment in the QOF but will not obtain the tax benefits on the non-gain investment

  5. Partnership Investment Rules • Special rules for existing partnerships and other pass-through entities that recognize gain. • Partnership may elect to defer the gain. • If the partnership does not elect to defer the gain, the partner may defer either from: • 180 days after the partnership’s taxable year; or • If the partner chooses, 180 days from the partnership’s recognition of the gain. • Anticipated that taxpayer may be able to invest through feeder partnerships.

  6. Opportunity Zone Investment Special Capital Gains Treatment • Section 1400Z-2 offers three primary federal income tax benefits for taxpayers investing in Opportunity Zones: • TEMPORARY EXISTING GAIN DEFERRAL • PARTIAL STEP-UP IN BASIS • PERMANENT NEW GAIN EXCLUSION

  7. Temporary Period of Deferral • The period of capital gain tax deferral ends and gain is recognized upon the earlier of: • The date the investment in the QOF is sold or exchanged, or December 31, 2026 • Results in a “zero basis” attributable to “deferred gain” • Similar to Section 1031 but temporary

  8. Step-Up In Basis • Investments held at least 5 years: • Basis increased by 10% of the deferred gain • Reduces capital gains tax by 10% • Investments held at least 7 years: • Basis increased by another 5% of the deferred gain • Reduces capital gain taxed by a total of 15%

  9. Permanent Exclusion of Additional Gains • Investments held longer than 10 years: • Taxpayer still pays tax on its original capital gains less any partial step-up in basis • After recognition of the original gain, the basis equals the Fair Market Value • Results in a “step up” in basis attributable to the appreciation of original investment • Requires a special election upon sale prior to December 31, 2047

  10. Timeline for Investments into a QOF If thereafter sold, Basis step-up to Fair Market Value. Basis increased by 10% of the investment. 90% of investment taxable. Basis increased by 5% of the investment. 85% of investment taxable. Realization of Capital Gain Gain realized on initial investment. Investment into QOF NO MORE THAN 180 DAYS Held for 7 Years Held for 5 Years Held for 10 Years 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029

  11. Example 1 – 3% Annual Appreciation

  12. Example 2 – 6% Annual Appreciation

  13. Example 3 – 1% Annual Appreciation

  14. Real Estate Development without Opportunity Zone Incentive

  15. Real Estate Development withOpportunity Zone Incentive

  16. Business Expansion withoutOpportunity Zone Incentive

  17. Business Expansion with Opportunity Zone Incentive

  18. New Market Tax Credit Potential At least 95% of all Opportunity Zones are eligible for New Market Tax Credit (NMTC) Financing Using NMTC Financing may generate up to $1.25 for each $1.00 deployed within the NMTC Financing Structure NMTC Financing targets key projects to serve low-income persons or catalyze development in low-income communities

  19. New Market Tax Credit Projects

  20. Business Expansion with Opportunity Zone & New Markets Tax Credits

  21. Opportunity Zone Incentive Benefits • Improves Equity ROI Rates • Real Estate: May increase rates by approx. 3% (ex. 35% increase from 8.5% to 11.5%) • Operating Business: May increase rates by 2% (13% increase if 50% Debt / 50% Equity) • Combines with NMTC to increase yield by an additional 9.05% for a 64% total ROI increase. • Applies to location-based businesses

  22. Opportunity Zone Investments Opportunity Zones Where Invested? What Invested? How Invested? What Invested in? Capital Gains through an equity investment in Qualified Opportunity Funds Qualified Opportunity Zone Property

  23. Qualified Opportunity Fund • Any investment vehicle organized as a corporation or a partnershipin 50 states, D.C. or U.S. Possession • May be an LLC if taxed as a corporation or partnership • An entity taxed as an S corporation should qualify but proposed regulations are silent • No related party test for the investment • May be a newly created or a pre-existing entity • Organized for the purpose of investing in Qualified Opportunity Zone Property (other than another QOF) (QOZP) • U.S. Possession QOF must be organized for the purpose of investing in QOZP that relates to a trade or business operated in U.S. possession in which it is organized. • Entity self-certifies as a QOF by filing Form 8996 • Requires organizing documents to state that QOF’s purpose of investing by end of QOF’s first year • Must hold at least 90% of its assets in QOZP

  24. Qualified Opportunity Fund Investment Models Direct Ownership Qualified Opportunity Zone Business Property Investors QOF Indirect Ownership Qualified Opportunity Zone Business Property QOZ Business Investors QOF

  25. Opportunity Zone Investments Opportunity Zones Capital Gains through an equity investment in Qualified Opportunity Funds Qualified Opportunity Zone Property Where Invested? What Invested? How Invested? What Invested in?

  26. Qualified Opportunity Zone Property Qualified Opportunity Zone Stock Qualified Opportunity Zone PartnershipInterest Qualified Opportunity Zone Business Property

  27. Qualified Opportunity Zone Business Property • Tangible property used in a trade or business of the QOF (direct) or QOZB (indirect) • Acquired by purchase after December 31, 2017 from an unrelated party (20% standard) • Either its • Original Use of such property in the Opportunity Zone commences with the QOF (direct) or QOZB (indirect); or • QOF (direct) or QOZB (indirect) must “substantially improve” the property • During substantially all of the QOF (direct) or QOZB (indirect) holding period of such property substantially allof the use of such property was in a qualified opportunity zone • “substantially all” guidance remains outstanding

  28. Trade or Business Requirement There is no definition of what constitutes a "Trade or Business" under Section 1400Z-2 or the Proposed Regulations. Recent Proposed Regulations for Section 199A the IRS and Treasury generally define "trade or business" for section 199A purposes consistent with the meaning of that phrase under Section 162(a). Under prior "trade or business" IRS guidance and case law it is likely that real estate rental activity (including triple net lease structures) would constitute a "trade or business" under Section 1400Z.

  29. Original Use Requirement • Original Use of Land • Rev. Rul. 2018-29: Provides guidance that the Original Use Requirement is not applicable to the land on which a building is located and being substantially improved • Does Original Use Requirement ever apply to land? • Land must still meet the other requirements (used in a trade or business, purchased after 12/31/2017) • Original Use of a Building • Rev. Rul. 2018-29: Provides guidance that an existing building rehabilitated from an industrial to a residential did not satisfy the Original Use Requirement • Treasury seeking comments on an abandonment, vacancy or under-utilization “eraser” of prior “original” use • Completely Separate Treatment for Purchase Requirement, Asset Compliance Tests, or Safe Harbors?

  30. Substantially Improved Requirement • Tangible property is substantially improved if, during any 30-month periodafter acquisition, additions to the basis of the property exceed an amount equal to the adjusted basis of the property at the beginning of the period. • Substantial improvement to a building located on land wholly within the QOZ is measured by the additions to the adjusted basis of the building. • Land on which an existing building is located does not also have to be substantially improved. • Timing: seeking guidance as to whether substantial improvement must be to be achieved to qualify as QOZBP. • Proposed Working Capital Safe Harbor for QOZBs (indirect only) allows tangible property not to fail during the expenditure period merely because planned expenditures are not yet made. • QOZB may need sufficient designated working capital on hand to meet QOZBP test.

  31. Qualified Opportunity Zone Property Qualified Opportunity Zone Stock Qualified Opportunity Zone PartnershipInterest Qualified Opportunity Zone Business Property

  32. Qualified Opportunity Zone Stock or Partnership Interest • Can be any stock in a domestic corporation or any capital or profits interest in a domestic partnership (special rules for a U.S. Possession) • Must be acquired by QOF from the entity at its original issue after December 31, 2017 • No related party test • Solely in exchange for cash • The entity must be a "Qualified Opportunity Zone Business" at the time of investment(or was being organized for the purpose of being a Qualified Opportunity Zone Business) • Must continue to be a Qualified Opportunity Zone Business during "substantially all" of the QOF’s holding period • “substantially all” guidance remains outstanding

  33. Qualified Opportunity Zone Businesses • A trade or business in which at least 70% of allof the tangible property owned or leasedby the taxpayer is qualified opportunity zone business property (QOZBP) • “Sin” Business Prohibition • Private or commercial golf course • Massage parlor • Hot tub facilities • Suntan facilities • Racetrack or Casinos • Liquor stores • Additional business operation requirements • 5% Limit on “Nonqualified Financial Property” (cash and securities) • 50% “Active” Trade or Business Gross Income Test • Use of “Substantial Portion” of the Intangible Assets in the “Active” Portion of the Trade or Business Test

  34. Qualified Opportunity Zone Business Safe Harbors Proposed Working Capital Safe Harbor Working capital assets must be: Designate in writing the amounts to be held for acquisition, construction, or substantial improvement of property; With a written schedule consistent with the ordinary start-up of a trade or business for the working capital assets to be used within 31 months of receipt of the assets; Actually used the working capital assets substantially consistent with the written designation and written schedule; and 70% QOZBP Test: Tangible property being substantially improved must be expected to satisfy the requirements of QOZBP as a result of the planned expenditures of those working capital assets. Statutory Safe Harbor Tangible property that ceases to be QOZBP shall continue to be treated as QOZBP for the lesser of (i) 5 years after the date on which shall it ceases to be QOZBP or (ii) the date on which it is no longer held by the business

  35. Qualified Opportunity Zone Business50% “Active” Gross Income Test Recent IRS guidance for what constitutes an "Active" Trade or Business for purposes of Section 355 would limit "Active" Trade or Business for rental real estate to scenarios where the management of the real estate is performed by employees of the entity or employees of controlled affiliates of the entity. Entities with unaffiliated management would not be classified as "active." Recent 199A Proposed Regulations permit a passively held triple net leased property to be considered as an active business activity to the extent that the property is leased to another active trade or business that taxpayer has direct or indirect ownership, if the taxpayer and/or parties related by family attribution or common ownership of the business tenant own more than 50 percent of the business tenant. If the income comes from multiple tenants, one being a related party and the other an unrelated party, then only the portion attributable to the related party will automatically be considered an active trade or business, and the landlord will have to do more than just collect rent from the unrelated party in order for that portion to be considered an active trade or business. Industry is suggesting an objective standard that QOF reasonably expects that the entity will generate revenue within 36 months from at least 50% of its tangible assets but no clear statutory authority and minimal precedent to lower threshold.

  36. Opportunity Fund Purpose Direct Ownership Qualified Opportunity Zone Business Property Investors QOF Indirect Ownership Qualified Opportunity Zone Business Property QOZ Business Investors QOF

  37. Direct & Indirect Comparison(Commonalities)

  38. Direct & Indirect Comparison(Differences)

  39. Qualified Opportunity Zone Business Property Direct Method Advantages: • Up to 10% of assets may be held in cash without qualifying as reasonable working capital • Rev. Rul. 2018-29 applies to QOF’s redevelopment of an industrial site for “residential rental property” • No Additional Operational Tests: • No "Active" Trade or Business Test • No 5% Nonqualified Financial Property Test • Potentially No Operating "Sin Business" Limitations Notes • Must purchase QOZBP from an unrelated party • Must carefully structure QOF, its election and property purchases • Requires managing all other non-QOZBP after QOF election

  40. Qualified Opportunity Zone Business Property Indirect Method Advantages: • Only a 70% tangible asset threshold (a 63% total threshold) • 5-year Statutory Safe Harbor for QZOBP classifications • 31-month Proposed Working Capital Safe Harbor • Additional timing and structuring flexibility Notes • Allows QOZB stock or purchase from a related entity • Requires additional structuring for operational requirements

  41. Important Outstanding Issues • QOF Reinvestment of QOZP Proceeds • Non-recognition of gain within QOF would be transformational • Active Trade or Business Standard • An objective revenue or a reduced standard would expand usage • Development Previously Owned Land • Application of Leases and Leasehold Improvements • Grace Periods for QOF Improvements and for QOZB • QOF Compliance and Decertification Standard • 50% Gross Income Test Sources

  42. How to Leverage Your Opportunity Zones • Understand Your Opportunity Zones • Available Land & Buildings • Market Opportunities and Barriers • Community Needs • Create a Development Plan for Your Opportunity Zones • Assemble Your Available Tools (TIF, State, NMTCs, etc.) • Attract Business Expansions & Developers

  43. Assemble Your Toolbox What if we combine: • OZ Investment Benefit ($25 Per $100 Gain Invested) + NMTC Benefit ($23+ per $100 Project Cost) • OZ Investment Benefit ($25 Per $100 Gain Invested) + IRTC/CRED Benefit ($20+ per $100 Project Cost) • OZ Investment Benefit ($25 Per $100 Gain Invested) + TIF/EID Benefit ($32+ per $100 Assessed Value)

  44. Potential Opportunity Zone Incentive

  45. Next Steps This PowerPoint presentation is for educational and general informational purposes only. It is not specific legal advice. You should seek legal advice from your counsel in an attorney-client relationship Attorney Advertising Material • Any Questions? • Contact Frank A. Hoffman at Frank.Hoffman@icemiller.com or (317) 236-2340 or • Contact Shawn E. Peterson at Shawn.Peterson@strategusllc.com or (317) 236-2185

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