Unique Opportunity for Investors in the New Jersey Cannabis Industry
by Raymond V. Owens, CPA, Citrin Cooperman & Company LLP –
May 15, 2019
When President Trump signed the Tax Cuts and Jobs Act into law on Dec. 22, 2017, the country experienced a dynamic shift in tax policy, the likes of which had not been seen since the Reagan administration. Amongst the changes were lower corporate and individual tax rates, provisions for the repatriation of income and provisions to bolster economic growth in areas in need of a boost. One such provision is IRC §1400Z-1, which provides for Qualified Opportunity Zones (QOZ). QOZs are generally economically depressed areas where the federal government is attempting to spur investment. Eligible areas have a calculated poverty rate of 20 percent or a median family income not exceeding 80 percent of the statewide or metropolitan-wide median family income. Investors can potentially defer or reduce taxable capital gains by reinvesting them into such zones, subject to certain requirements. At present, New Jersey has 169 designated zones, and three of these jurisdictions have openly expressed their desire to host cannabis businesses. This could provide a potentially exciting investment opportunity to the right group of investors.
How It Works
The mechanism by which investment is encouraged is relatively straightforward. In exchange for their investment, investors in QOZs are allowed to temporarily defer capital gain recognition on investments sold in the current year. After initially realizing the gain, investors have 180 days to reinvest their gains into a qualifying zone via a Qualified Opportunity Fund (QOF). Per IRC §1400Z-2(d), a QOF can be organized as either a corporation or a flow-through entity, but it must hold at least 90 percent of all of its assets within the QOZ and make an election to be treated as an eligible entity.
If the investment is held for five years, the investor will benefit from a 10-percent step up in basis to use against the gain. If the investment is held for seven years, the investor will benefit from another 5-percent step-up on top of that. If the investment continues to be held at Dec. 31, 2026, the investor will be forced to recognize the remaining 85 percent of the gain invested. This becomes limited to the lower of the original investment or 85 percent, should the investment fail to appreciate in value. Investments held in excess of 10 years will benefit from a full exclusion of gain recognition. The regulations have no maximum on how much can be contributed to an investment vehicle, and an investor may be permitted, under current law, to hold the investment while it appreciates up until Dec. 31, 2047.
Now, it is important to note that not every business can be eligible for this treatment. When Congress wrote the law, they specifically exempted certain businesses from the program. These so-called “sin businesses” include casinos, liquor stores, racetracks and country clubs, to name a few (see IRC §144(c)(6)(B) for the full list). Luckily for those eyeing the cannabis industry as their next possible venture, cannabis enterprises are not listed and should therefore qualify.
Why It’s Exciting
At present, cannabis is still federally illegal to buy or sell under the Controlled Substances Act of 1970. As a Schedule I narcotic, any business engaged in trafficking cannabis is subject to IRC §280E, meaning none of their ordinary business expenses (e.g., rent, repairs) will be deductible against taxable receipts. This generally deters investors and operating companies alike from wanting to operate in the cannabis industry. By forming a QOF and investing in real estate, which may be leased to an operating cannabis company depending on the jurisdiction, investors may be able to participate in the growth of the industry. This strategy could potentially offer investors the ability to defer recognition on their current taxable capital gains while also making available capital for them to invest in the “secondary cannabis market.”
New Jersey may be a perfect market to employ this strategy. On Feb. 5, 2019, New Jersey released guidance indicating their conformity with the federal opportunity zone provisions. The cities of Jersey City, Asbury Park and Trenton have all expressed interest in allowing “alternative treatment centers” (New Jersey’s name for medical dispensaries) in their cities. Each of these three municipalities contain QOZs within their borders which could host cannabis enterprises.
A 2016 report published by the New Jersey Policy Perspective estimates that if cannabis were to be legalized for adult use in New Jersey, it would likely grow into a $1 billion-a-year industry. There is potential for approximately 343,000 consumers; possibly more from a spike in tourism from nearby states where cannabis may remain illegal. Given the industry growth that has already taken place in states like California and Colorado, the populous state of New Jersey appears to be the site for the next industry boom, and QOZs may be the ideal strategy to share in the prosperity.
Raymond V. Owens
Raymond Owens is a tax manager at Citrin Cooperman, and has expertise in providing corporate and individual tax compliance services for closely held businesses and flow-through entities including partnerships, S corporations and high net-worth individuals. He is a member of the NJCPA's Cannabis Interest Group, Cannabis Advisory Group, Emerging Leaders Interest Group and the State Taxation Interest Group.
This article appeared in the May/June 2019 issue of New Jersey CPA magazine. Read the full issue.