What are Qualified Opportunity Zones (QOZ)?
The Tax Cuts and Jobs Act of 2017 (TCJA) added a community revitalization program to the tax code by providing incentives to taxpayers who invest capital gains in economically distressed areas. The program is designed to unlock billions of dollars in capital gains for investment in these areas, referred to as “Qualified Opportunity Zones (QOZ).” Taxpayers who realize capital gains by selling appreciated property can invest the gains in a Qualified Opportunity Fund (QOF) within 180 days of the sale to qualify.
How are the requirements to qualify as a Qualified Opportunity Fund?
There are several requirements for qualification as a QOF – most importantly, the QOF must hold at least 90% of its assets in QOZ property. If the investment is held for at least five years, it receives an increase in basis equal to 10% of the original investment. If the investment is held for seven years, it receives an increase in basis of an additional 5% – for a combined total of 15%. If the investment is disposed of by any of these benchmark years, then the rest of the deferred capital gains are recognized at the time of disposition.
Additionally, any increase in the investment (from investment in QOF to disposition) is also subject to capital gains tax at the time of sale. If the taxpayer does not dispose of the investment before 2026, then the deferred capital gain is taxed in 2026. However, any appreciation in the investment from the time of investment in the QOF is not taxed until the taxpayer disposes of his interest.
What are the tax incentives for investing in a QOF?
The best tax incentive is provided to taxpayers who invest in a QOF and hold their investments for at least ten years: an increase in basis to the fair market value at the time of sale. That is correct: they pay no capital gains tax on at least ten years of appreciation in the QOF.
There are several key requirements for the QOF to qualify for the tax advantages. Notably, the QOF must hold at least 90% of its assets in a Qualified Opportunity Zone (QOZ) Property – which can be in the form of (1) QOZ Stock, (2) QOZ partnership interest, or (3) QOZ business property.
In order to qualify under either of these three types of properties, the QOZ property must be a Qualified Opportunity Zone Business (QOZB) at the beginning, and must remain so during the QOF investment period. In order to qualify as a QOZB, substantially all of the owned or leased property of the business must be a QOZB property – which in turn is defined as:
- property acquired by the QOF by purchase after December 31, 2017;
- the original use of the property in the QOZ commences with the QOF, or the QOF substantially improves the property; and
- during substantially all of the QOF’s holding period, substantially all of the use of such property was in a QOZ.
Ambiguity Surrounding Inclusion of Cannabis Businesses as Qualified Opportunity Zone Businesses
As with many tax laws, Internal Revenue Code §1400Z-2, “Special Rules for Capital Gains Invested in Opportunity Zones,” has several gaps and ambiguities which remain unaddressed by Proposed Treasury Regulations. While ambiguities or ‘holes’ in the tax code can result in unpredictability to all taxpayers, they can pose unique hazards to investors in the Cannabis businesses. For example, the tax code specifically excludes several types of “sin” businesses from qualifying as “Qualified Opportunity Zone Business” and thus being excluded from the tax benefits. These businesses are cross referenced in I.R.C. § 144(c)(6)(B) and include:
[P]rivate or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises.
While the list of excluded businesses doesn’t include Cannabis, it is likely due to oversight on the lawmakers’ part. Otherwise, it is difficult to reconcile the treatment of Cannabis businesses by Section 280E on the one hand, and by I.R.C. §1400Z-2 on the other. Some commentators have noted that this ‘oversight’ may be remedied by the IRS by taking a position that – pursuant to a ‘reasonable’ interpretation of I.R.C. § 1400Z-2, in concert with other provisions of the tax code – Cannabis businesses are precluded from the QOF tax benefits because they are similar to, or even more ‘sinful’ than, some of specifically listed business.
The Risks for Cannabis Businesses Investing in a QOF
Under the Chevron Doctrine, an administrative law principle that compels federal courts to defer to a federal agency’s interpretation of an ambiguous or unclear statute, an agency such the IRS taking a position contrary to the unambiguous language of the statute is clearly doomed to fail as it would constitute an arbitrary and capricious interpretation contrary to clear language of the statute. However, if the statute is ambiguous because it lacks direct language on a specific point, the IRS has the delegated authority to ‘reasonably’ interpret the statute. In this case, the IRS may argue that there is an ambiguity here in that the omission of Cannabis businesses from the ‘sin’ businesses category is contrary to its treatment under another provision of the tax code: §280E.
Moreover, it is contrary to the general treatment of Cannabis businesses as illegal drug “traffickers.” Since there is an ambiguity in the statute’s language because Congress omitted direct language on the specific point – whether Cannabis business is a ‘sin’ business – the IRS may be allowed to include Cannabis business as a ‘sin’ business anyway under a reasonable interpretation of the statute.
The IRS issued proposed regulations on the subject in October 2018. While the proposed regulations provide no guidance on this point, they’re not the last word from the IRS on this topic. An agency interpretation of a statute can happen at any point if the agency is determined to challenge a tax position. Sometimes, an agency such as the IRS may wait for a challenge to its decision by a taxpayer to specify its interpretation. In any event, the hazards posed to taxpayers investing capital gains in a Cannabis business are significant. If the IRS challenges the QOF treatment of the investment, the investors may find themselves suddenly realizing all of the capital gains in the year of the sale, plus penalties and accrued interest from the time of the sale.
It is crucial for investors investing in a QOF to consult with a tax professional. Each investment may be different and may or may not qualified for tax benefits. Consequently, a tax opinion tailored to a particular investment may be necessary. A taxpayer reasonably relying on the advice of competent tax counsel may not be liable for penalties under § 1.6664-4, Income Tax Regulations.