Qualified Opportunity Zones – an Executive Summary

Mark Sloan, Director, CFO Consulting Partners

There has been much discussion regarding Qualified Opportunity Zones (“QOZ”), the tax benefits of investing in a QOZ and how it should fit into a strategy of minimizing taxes on long term capital gains. This newsletter will provide an overview as to the rules governing QOZ and some practical considerations regarding investing in QOZ.

BACKGROUND:

As a result of the Tax Cut and Jobs Act (“TCJA”) passed in late 2017, a taxpayer may elect to recognize certain tax deferrals and exclusions on the gain realized from the sale or exchange of property to an unrelated party if the gain is reinvested in a qualified opportunity zone fund within 180 days from the date of the sale or exchange and the gain remains invested for a defined period of time.

Opportunity zones are eligible low-income census tracts that had either poverty rates of at least 20 percent or median family incomes no greater than 80 percent of their surrounding area’s, according to the U.S. Census Bureau’s 2011-2015 American Community Survey. Such tracts have been nominated by governors and certified by the U.S. Department of Treasury for designation as an Opportunity Zone. There are over 8,700 such tracts located throughout the United States.

A qualified opportunity fund (“QOF”) is the vehicle to which gains must be invested in order to qualify for the tax benefits of the program. In order to achieve the tax benefits, the taxpayer must invest in a QOF and not directly into qualified opportunity zone property. A QOF is a corporation or partnership organized with the specific purpose of investing in opportunity zone assets. The entity must invest at least 90% of its assets in qualified opportunity zone property.

Qualified opportunity zone property can be in the form of direct ownership of business property, or into opportunity zone portfolio companies through either stock ownership or partnership interest. Certain businesses are precluded for consideration as property to be held by opportunity zone portfolio companies and these include golf courses, country clubs, massage parlors, tanning salons, hot tub facilities, racetracks, casinos or any other gambling establishment and liquor stores. These limitations do not apply when a QOF is investing into the Qualified Opportunity Zone directly.

Upon the investment of qualified gains, the basis in the capital gains will be zero. The gain will then be recognized into income on the earliest of the disposition of the opportunity zone property or December 31, 2026. If the QOF is held five years, then the taxpayer’s basis is increased by 10% of the original gain and then it is increased another 5% if held for another two years. If the QOF is held at least ten years, then all gains attributable to the appreciation on the original gain will be excluded from income.

BENEFITS:
There are numerous tax benefits attributable to the timely investment of capital gains into a QOF.

• Deferral of tax on invested capital gains until December 31, 2026, at the latest;
• Permanent exclusion of tax on capital gains of up to 15% if held for seven years, and;
• Permanent exclusion of tax on any subsequent appreciation on the invested capital gains if held for more than ten years.

OTHER CONSIDERATIONS:

There are other advantages to investing in a QOF that make it a more flexible option to Section 1031 as a means to shelter capital gains:

• As opposed to Section 1031, which requires the investment of the full proceeds in order to qualify for temporary tax deferral on gains, only the gain portion of the proceeds needs to be invested, freeing up cash at the time of the original sale of capital assets.
• Investment in a QOF can provide permanent exclusion of tax on a portion of capital gains; Section 1031 transactions will only provide for deferral of tax on capital gains.
• As opposed to Section 1031, which requires the investment of proceeds into like kind assets, the only requirement for a QOF is that the gains are invested into opportunity zone assets. For example, if a work of art is sold at a gain, then the gain can be invested in a different class of asset such as real estate.
• It should be noted that as a result of the TCJA, the use of Section 1031 is now limited to real estate assets and no longer other types of capital assets.

While there are significant benefits to investing in opportunity zone funds, there are certain caveats that need to be considered:

• If the investment has not been disposed of sooner, the invested gain will be recognized in income at December 31, 2026. This means that the taxpayer will need to provide liquidity for this event while the gain is still locked up in the investment.
• To achieve the 15% permanent exclusion on the original gain, there must be a rollover of the gain no later than December 31, 2019 in order to achieve the 7 year holding period for this exclusion.
• To maximize the tax benefits attributable to this program, the strategy is to lock up the invested gains for a period of ten years. This could result in a lower IRR over the life of the project.
• Although the census data used to designate tracts as opportunity zones is dated and there may be some areas that have gone through improvement, there can still be a higher risk attributable to investing in areas that are opportunity zones.
• An investor may not contribute appreciated property directly into the QOF. Such property must be first sold (and begin the clock running for the recognition of a portion of the gain) and the amount attributable to the gain invested into the fund.
• The regulations impose limitations on the amount of cash and intangible assets that can be held at any time by an opportunity zone fund. This limitation can be mitigated through a structure where the QOF invests into an opportunity zone portfolio company (either through stock ownership or partnership interest). Under this structure, the portfolio company can hold intangible assets that are used in an active trade or business and cash in an amount for reasonable working capital needs.
• The investment in opportunity zone funds should be evaluated on the overall economics of the fund and its strategy, and there should not be disproportional weight given to the tax deferral/exclusion feature of the program as the basis for investing in the opportunity zone.

This newsletter is meant as a broad overview on Qualified Opportunity Zones. There are many other details concerning the structure of funds, limitations on the type of assets that can be held by a QOF, determination of original use and subsequent improvements, etc. CFO Consulting Partners has been following developments in this area and we stand ready to provide you with guidance in navigating through this new and challenging area. In addition to helping you understand the details and advising you if this program can fit into your investment strategy, we also have relationships with various sponsors and service providers who can offer you opportunities with various funds that they have established. We also have relationships with law firms who can evaluate that the funds are structured in accordance with Treasury regulations.

CFO Consulting Partners is a proud sponsor of the Exit Planning Exchange (XPX). XPX is a multi-disciplinary community of professional advisors who work collaboratively to help owners build a valuable business and assist them in preparing and executing a successful transition.

CFO Consulting Partners XPX Advisors:

Oliver Brooks

Steven Crowley

David DeMuth

John Kovacs

Mark Sloan

Allan Tepper

Joseph VonEhr

Implementations of the New Lease Standards Under the ASC 842

Mark Sloan, CPA, CFO Consulting Partners

On February 25, 2016, the FASB issued new guidelines under ASC Section 842 regarding the recognition and financial reporting of leases. The new standard will impact both lessees and lessors, with the most significant impact falling upon lessees. The standard is effective for years beginning after December 15, 2018 for public firms and December 15, 2019 for nonpublic firms.

This is one of the most comprehensive changes to accounting principles in many years, almost 250 pages long, and it will require major effort of firms to understand and implement its impact.

Due to the complexity of this pronouncement, this update will focus on the impact the new standard will have on lessees; a future update will focus on the impact on lessors.

In summary, the significant effect of this standard on lessees is as follows:

1. Transactions which had been previously reflected as rent expense on the income statement will now require a right-of-use asset and a related lease liability being reflected on the balance sheet;
2. Service arrangements for the use of assets over a period of years need to be evaluated and, if certain criteria is met, there needs to be a segregation of elements that are considered either lease components or non-lease components;
3. Lease liabilities must be continually evaluated for the occurrence of significant events and revised accordingly, and;
4. Criteria under previous guidance for determining a lease to be either an operating lease or a financing lease has been changed for the following:
   1. eliminating specific guidance regarding thresholds for determining economic life and fair value of leased assets;
   2. replacing such guidance with transaction specific judgement, and;
   3. adding a criteria that the leased asset has no alternative use to the lessor at the end of the lease term.

As a result of the new standard, it is expected that balance sheets will increase with over $1.5 trillion of additional assets and liabilities.

As a starting point, contracts for services must be reviewed, and both the lease and non-lease components must be identified and segregated. In its simplest terms, the standard states that if a contract conveys the right to control the use of identified property, plant or equipment (an identified asset) for a period of time in exchange for consideration, without significant control or substitution rights by the lessor, then a lease exists.

This will be among the most challenging aspect of the new standard. There must also be an analysis to determine whether there are multiple lease components which need to be accounted for separately and whether there are multiple non-lease components which should be accounted for under other appropriate GAAP. Also, there needs to be an ongoing evaluation of contracts to determine when an event occurs that may change the recognition or measurement of the lease, and that the entity distinguish whether there is a modification of an existing lease or the recognition of a new lease arrangement requiring separate accounting.

In addition to arrangements which clearly demonstrate a lessee/lessor relationship (such as the lease of office space), other arrangements must be carefully evaluated to determine if a lease exists. Such arrangements may include:

• Advertising agreements
• Service agreements
• Transportation agreements
• Construction agreements
• Related party arrangements

It is important to identify lease and non-lease component of a service arrangement. The arrangement must be carefully evaluated for any asset that could be construed to be a lease in nature. One example is a data storage arrangement with a service provider. If the service contract includes the installation of a server on the location of the lessee, the lessor has no substantive substitution rights and the lessee derives most of the benefit of the asset over the lease term, then the server represents a lease component. An allocation of the rent payments need to be made between the server (the lease component) and the data storage (the non-lease component). The lease component must then be evaluated for either an operating lease or a finance lease and treated accordingly. The major difference between the two types will be that the income statement effect of the operating lease will be through rent expense while the income statement effect of the financing lease will be through interest expense and amortization expense.

Similar to previous guidance, leases meeting certain criteria will be considered a finance lease and there will need to be a right-of-use asset with a corresponding lease liability reflected on the balance sheet. The two amounts will be initially set up as the present value of the lease payments discounted at an appropriate interest rate (e.g., the lessee’s incremental borrowing rate).

A lease meeting any of the five following criteria will need to be classified as a finance lease:

1. Ownership of the leased asset transfers at the end of the lease term;
2. A bargain purchase option (i.e., one that is reasonably certain to be exercised) for the leased asset exists;
3. The lease term, which does not commence near the end of the economic life of the leased asset, is primarily the remaining economic life of the leased asset;
4. The sum of the present value of the lease payments and the residual value guarantees is equal to, or more than, substantially all of the fair value of the leased asset, and;
5. The leased asset has no alternative use to the lessor at the end of the lease term because of its specialized nature.

What is important to bear in mind is the new pronouncement removes the 75% (for criteria #3) and 90% (for criteria #4) that former GAAP had provided as guidance and, instead, the lessee will need to take positions as to determining the remaining economic life or substantially all of the fair value of the leased asset. Also new is criteria #5 which needs to be taken into account in the determination of the character of the lease. The right-of-use asset will be amortized on a straight line basis (or any more systemic approach) over the term of the lease and the lease liability will be extinguished using the effective interest method. The income statement will reflect amortization expense for the reduction of the right-of -use asset and interest expense for the interest component of the lease payments.

If a lease arrangement is identified and considered not meeting the above criteria for a finance lease, then such operating lease will reflect, on the balance sheet, a right-of-use asset and a corresponding liability recorded at the present value of the rent payments, using an appropriate interest rate such as the lessee’s incremental borrowing rate. Both the amortization of right-of-use asset and the accreted interest on the lease liability will be reflected in rent expense on the income statement.
If an entity has both finance leases and operating leases, then the right-of-use asset and the lease liabilities must be presented separately for each type of lease.

If there are elements in the lease arrangement for step-up in rent payments, initial direct costs, payments of residual values, etc., such elements must be taken into account in calculating the right-of -use asset and corresponding liability.

Leases with terms of 12 months or less will be exempt from the standard as it relates to reflecting a balance sheet impact. Such leases will continue to be accounted for as under previous guidance, i.e., off balance sheet and footnote disclosure only.

As part of the transition process for the standard, there are practical expedients that an entity may elect, as a package and applied consistently, to all of its leases which commenced prior to the effective date of the standard:

1. An entity need not reassess whether any expired or existing contracts are or contain leases;
2. An entity need not reassess the lease classification (i.e., operating versus finance lease) made under previous GAAP for any expired or existing leases, and;
3. An entity need not reassess initial direct costs for any existing leases.

If an entity foregoes these practical expedients, then it must apply the standard to all previous periods presented for which there are leases or contracts which contain lease and non-lease components.

On January 5, 2018, the FASB issued an Exposure Draft revising some of the provisions of ASC 842. The Board is requesting comments to this Exposure Draft no later than February 5, 2018.

The two issues on which the Board is seeking comments are as follows:

1. Comparative reporting for initial adoption, and;
2. Separating and allocating lease and non-lease components in a contract.

As it relates to comparative reporting for initial adoption, the Board has proposed recognizing a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption. As it relates to separating and allocating lease and non-lease components in a contract, this proposed amendment would be applicable to lessors only. The amendment would provide lessors with a practical expedient that is currently available to lessees, which is to not separate non-lease components from related lease components for identified classes of underlying assets. This practical expedient would be available only upon meeting certain requirements, i.e., (i) the timing and pattern of revenue recognition for the non-lease component(s) and related lease components are the same, and (ii), the combined single lease component would be classified as an operating lease.

A subsequent newsletter will provide an update to the standard once the comment period has expired and the Board has finalized any revisions to ASC 842 regarding the aforementioned issues.

As can be seen from this brief summary, the new pronouncement on lease accounting will have a deep and profound effect on most entities. While the implementation date is still some time off, it would be prudent to begin to assess the effect this pronouncement will have on your financial statements. We here at CFO Consulting Partners have an extensive understanding of the new standard and stand ready to assist in evaluating and implementing this standard.

Physician Practices: The Future is Changing

John DeLorenzo, MBA, CFO Consulting Partners LLC