Opportunity Zones Investments in Operating Businesses PANELISTS Michael Kressig Novogradac & Company LLP Chris Schultz Launch Pad Rick Holliday Factory OS Jonathan Goldstein Advantage Capital
Operating Businesses For purposes of this discussion, how are we defining Operating Businesses? Businesses whose principal source of revenue is other than rental income.
Operating Businesses Why important to a low-income community? Permanent job creators Tax base Catalytic Creates psychological sense of vitality Observation: It is likely what Congress intended was not a tax benefit targeted principally at real estate.
Qualified Opportunity Zone Businesses (QOZB) A trade or business in which substantially all of the tangible property owned or leased by the taxpayer is qualified opportunity zone business property (QOZBP) and: At least 50% of income derived from Active Conduct Substantial portion of intangible property used in active conduct of business < 5 percent unadjusted basis of property is nonqualified financial property
QOZB: Excluded Businesses Can t be a Sin Business A private 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.
Qualified Opportunity Zone Stock and Partnership Interests The investment must be acquired after December 31, 2017 solely in exchange for cash; Must be a qualified opportunity zone business, or is being organized for the purpose of being a qualified opportunity zone business; Must remain a qualified opportunity zone business for substantially all of the qualified opportunity fund s holding period
Qualified Opportunity Zone Business Property (QOZBP) Tangible property used in a trade or business Acquired by purchase from an unrelated party (20% standard) after December 31, 2017 During substantially all of holding period, substantially all the use is in a QOZ Original use in the QOZ commences with the taxpayer OR Taxpayer substantially improves the property during any 30-month period after acquisition, additions to basis exceed an amount equal to the adjusted basis of such property at the beginning of such period
Operating Businesses - Non-qualifiers What types of operating businesses are NOT likely to qualify as either a Qualified Opportunity Fund (QOF) or a Qualified Opportunity Zone Business (QOZB)? Businesses such as financial institutions - hold large amounts of NQFP Businesses holding intangible property not actively used in the TOB Sin businesses cannot be QOZBs
Operating Businesses - Non-qualifiers Businesses that may qualify with clearer guidance and/or structuring finesse: Businesses which use a substantial amount of their tangible property outside of OZs: Multi-location businesses Businesses with substantial in-house distribution (trucks and other vehicles used outside the OZ) Existing Businesses existing in an OZ as of December 31, 2017 (unless a large expansion is planned) existing outside an OZ if it owns substantial tangible assets Companies that lease a substantial amount of the property used in their business pursuant to operating leases? (Need guidance)
Guidance Priorities for Operating Businesses Ability to defer interim gains reinvested in QOZP If permitted, timing requirements for reinvestment Ability for investors to invest in QOFs through feeder partnerships Treatment of Operating leases for Substantially all QOZBP requirement. Can we substantially improve an existing operating business? Treatment of construction cash reserves (e.g. financing a business expansion)
VC Fund OZ Investing Model Chris Schultz
Applying the Venture Model to Opportunity Funds Thesis: Traditional tax credit incentive programs bias towards investments in real estate and hard assets which present a different risk/return profile than traditional VC. Successful early stage VC investing requires a portfolio approach that presents additional constraints to the OZ program. Assumption 1: The goal of the OZ program is to drive investment dollars towards underserved markets and communities. Assumption 2: The most impactful businesses on a community in terms of job creation and wealth creation are high-growth technology businesses which are asset and real estate light businesses.
Feeder Partnership
Example Investments Lucid - a market research technology firm Started at Launch Pad w 1 employee, today has more than 250 employees, raised 60mm LidCore - a music licensing watermarking firm DigDates - a dating app for dog lovers
Example Investments Types of businesses: Software / technology companies w. knowledge workers and high growth potential Asset light businesses that meet QOZB Keys to success: Nationally diversified deal flow across OZ s
A Case Study Factory OS Rick Holliday
Factory_OS Facility Mare Island Building 680 Occupancy: July 1, 2017 256,700 SF More than 100k SF larger than the other facilities we considered Extra SF allows for increased productivity and a greater focus on R&D / Innovation Located near a good pool of labor and in close proximity to the Northern California Carpenter s Union training facility
Factory_OS Facility Mare Island Building 680 (today)
Factory OZ Substantially All Analysis TANGIBLE PROPERTY Phase I QOZBP NQ Total Incurred through 12/31/2017-3,800,000 3,800,000 Est. cost to complete 7,400,000-7,400,000 Est. Ph I total 7,400,000 3,800,000 11,200,000 66% Phase 2 QOZBP NQ Total Budget with assumption of leased existing building 15,000,000-15,000,000 Est. Ph I + II total 22,400,000 3,800,000 26,200,000 85% Est. purchase price of Ph II existing building* 10,000,000-10,000,000 Est. Ph I + II with bldg. purchase 32,400,000 3,800,000 36,200,000 90% *Building would be substantially improved with $15 million of Phase II improvements.
Options If Substantially All = 70% 1. The targeted amount of QOZBP is approximately $8.9 million so one option would be to spend an additional $1.5 million in Phase I on QOZBP. 2. Spend an at least $1.5 million of Ph. II QOZBP during the grace period.
Options If Substantially All = 85% 1. The targeted amount of QOZBP is approximately $21.6 million so it would be necessary to complete Phases I and II within the grace period in order to qualify all. 2. If, for other business reasons, it isn't feasible to complete both phases within the prescribed timeframe, the timing of the QOF investment into the QOZB could be delayed such that Phase II qualifies on its own. In this scenario, Ph II would be owned by a separate entity (QOZB).
Options If Substantially All = 90% 1. Purchase the Phase II land + building and substantially improve it. 2. Qualify Ph II separately. Ph II would be owned by a separate legal entity (QOZB).
Uncertainties What is "Substantially All" %? Treatment of operating lease of Phase I (and possibly Phase II) real estate for substantially All purposes. Grace period to qualify as QOZB
Real estate and Equipment financing models for OZ Based Operating Businesses Jonathan Goldstein
Providing Real Estate Finance to Support Operating Businesses Focus on scalable, repeatable structures for small business investment capital Challenges to direct operating business finance: Absence of debt alternatives Requirements that favor new and/or asset-lite businesses No clear application (yet) of substantial improvement clause Wider latitude in real estate development finance: Direct ownership option Substantial improvement alternative 10 year horizon more easily accommodated
Providing Real Estate Finance to Support Operating Businesses (cont d) What might a real estate purchase/lease look like? OZ Funds could offer highly flexible capital solutions: OZ Fund might purchase desired real estate Ownership of real estate would qualify, assuming sufficient improvements made within 30 month statutory window OZ Fund can operate real estate under lease to operating business No prohibition on giving business purchase option, e.g. after 10 year hold
Providing Real Estate Finance to Support Operating Businesses (cont d) Potential benefits: QOZBP should be easy to qualify Direct investing eliminates active conduct requirement In pass-through funds, qualifying leverage should provide basis to OZ fund to permit some losses to be recognized during hold period Cash flow during initial years can offset investors phantom income event on 12/31/26 After 10 years and sale, all capital gains (including interim depreciation) should be forgiven
OZ Funds for Equipment Finance What might equipment finance look like? Long-lived assets (e.g. heavy equipment), like real estate, might be suitable for direct OZ Fund ownership New equipment purchases, used first in OZ, should qualify No active conduct requirement in direct ownership Similar ability to use qualifying leverage to generate basis Depreciating asset might limit or eliminate benefit of 10 year step up in fund basis
Opportunity Zones Investments in Operating Businesses PANELISTS Michael Kressig Novogradac & Company LLP Chris Schultz Launch Pad Rick Holliday Factory OS Jonathan Goldstein Advantage Capital