The opportunity zone incentive created by the 2017 tax law has generated a lot of interest in the business community. The tax benefits can be significant for investors who follow the process detailed in the statute, but owners who want to use the incentive to grow a manufacturing business need to understand that it takes a lot more than just renovating or opening a factory in a certain ZIP code to qualify.
Opportunity zone investments offer taxpayers the chance to defer and reduce tax on capital gains by investing those gains into a qualified opportunity fund (QOF). The gain invested in the QOF is not taxed until December 31, 2026, or the date the taxpayer withdraws the money from the fund, whichever comes first. If the taxpayer holds the QOF investment for five years, the law provides for an increase in the basis of the investment equal to 10% of the original capital gain deferred, meaning that 10% of the gain invested will not be taxed at all. At seven years, an additional 5% is added to the basis.
If a taxpayer holds the QOF investment for 10 years, they can expect to pay no capital gains tax on any appreciation from their original investment.
Below we address two questions that owners typically ask about opportunity zones:
- How can I use the incentive to reduce my taxes?
- How can I make my business attractive to investors who are using the incentive?
As you’ll see, however, there are some much bigger questions to answer about your expansion plans in order to determine if opportunity zone expansion is the right direction for your business.
Case Example: Family-Owned Rubber Manufacturer
Consider a family-owned manufacturer that processes rubber for use in tires. The owner has realized that the process the business uses could also produce high-quality shoe soles at a competitive price, but the current plant doesn’t have the capacity. When considering options for purchasing or building a new plant, how might opportunity zones affect the decision?
“How Can Opportunity Zones Reduce My Taxes?”
The primary benefit of an opportunity zone investment is deferral and reduction of tax on capital gains. In order to participate, you must have a capital gain available to invest. In our rubber plant example, the owner must have some appreciated asset like stocks or real estate that can be sold to generate a capital gain. Using retained earnings or stockpiled cash to build a factory in a designated opportunity zone does not qualify for the preferred tax treatment. (As we’ll see in the next section, there may be a benefit when it comes to attracting investment capital.)
Assuming the owner does have a capital gain available to invest, there’s still more to it than just investing that money into a new plant in an opportunity zone. The owner would have to create a QOF into which the capital gain would be deposited. The QOF would then provide the money for the new plant via an equity investment into the business. The process to create a QOF is not particularly complicated, but it does add an extra layer of administration to the process.
Assuming the fund and the plant meet the requirements in the statute and the owner holds the investment until December 31, 2026, the owner would owe tax on 85% of the original capital gain deferred when paying 2026 income tax. The owner also would owe no tax on any appreciation from their original investment when recognized.
“How Can I Position My Business to Attract Opportunity Zone Investment?”
Realistically, most owners considering the type of expansion in this example won’t have an appreciated capital asset that can cover the cost of a new plant. As a result, they will need to seek some type of financing. For manufacturers that qualify for a loan, debt is often the simplest and best solution. For companies seeking a loan, expanding into an opportunity zone wouldn’t make the project any more or less attractive.
On the other hand, if a manufacturing company is looking to expand their ownership group in the form of equity investors, locating the new factory in an opportunity zone might make it a more attractive investment. And even if the owner has decided that this expansion should be funded by additional equity investors, an opportunity zone location doesn’t make it any more advantageous unless the equity investment comes through a QOF.
Before pursuing equity investment, owners must ask themselves if they are ready to bring additional owners into the business. An expansion that will involve significant equity from outside the current ownership group, especially from an institutional QOF, will typically require more accountability to the new investors. There’s no doubt that opportunity zone investments will fund some business success stories. But be sure to consider up front how new oversight and reporting responsibilities would affect day-to-day operations.
Consider All Options
If your business is considering a significant expansion, it’s important to take into account all of the facts and circumstances related to your specific situation. Opportunity zones are only one type of incentive that might affect the after-tax profitability for you or outside investors. As always, any tax benefits need to be weighed against the non-tax effects on your current business processes.
For help evaluating and assessing all of the funding options available to your growing business, please contact your CRI advisor.