Cannabis land development is growing and gaining traction in Opportunity Zones (OZ). Not only has a large amount of stock wealth been created for cannabis entrepreneurs because of the tax advantage, but the returns of a cannabis project make the OZ vehicle a win-win. The cannabis industry is experiencing a number of trends, most notably diminishing prices and an increase in the size of the businesses. The industry is characterized by large initial capital outlays, with real estate being the primary cost component of most facilities.
This results in a trend of increasing capital investments. Let’s look at some attractive tax options that the more traditional investors can take advantage of in this emerging industry.
STATE VERSUS FEDERAL LAWS
The most important factor is the legality of the investment. Currently, federal law has taken a stance to allow states to decide their legal framework for cannabis through a budgeting amendment. But for now, the federal laws still have cannabis as a schedule 1 narcotic and prevent common business practices like banking and normal tax deductions. It is not expected that the cannabis regulation will stay in this federal grey zone and soon, larger hedge funds and corporate America will be investing. For now, individuals still have a great advantage by investing in states that are legal. Many cannabis companies add a layer of safety by dividing the land ownership and development from the management of growing cannabis or touching the leaf. The OZ opportunity exists in the land development for both deferring capital gains invested and capital gains on sale. The actual operation or management is taxed regardless on its income so separated structures works well from all perspectives.
WHICH KIND OF INVESTMENT IN CANNABIS
Cultivation can be done indoors, outdoors or in greenhouses. Let’s take a brief look at the defining characteristics of each:
Indoor was spawned from the underground starts of the industry and is typically done in industrial or warehouse buildings. Indoor is known to result in higher quality product. The model also lends itself well to year-round harvests, with increased yields. The predictability of indoors makes it well-adapted to industrial-grade operations. However, scalability is limited due to very high operating costs. Indeed, with buildings having to be erected or retrofitted, often in high-priced cities near their target markets, the initial and on-going real estate cost is often heavy, even prohibitive. Also, zoning regulations and other industry-specific restrictions greatly limit where the business can be located, resulting in additional costs for more distant facilities. Finally, and more importantly, high utility costs result from numerous lights and accompanying cooling needs, where heat and cold are in a constant fight looking for balance. As a result, costs per pound can often range between $500 and $1,000.
Outdoor quality is considered inferior for bud sales and most cost-effective for trim sales, and wholesale prices are commensurate, in the $500-$1,000 range at most, potentially lower. In addition, yields are subject to the elements, with a limited number of annual harvests (generally one per year). Finally, the low operating costs, sometimes as little as $50-100 per pound, are more than offset by all the unpredictability of growing outside, and unlike traditional farming, a range of options from sophisticated chemical pest and disease management to crop insurance are just not available to the industry.
Greenhouses can offer the best of both worlds. Using the sun, they only need supplemental artificial light, limiting electricity costs. In turn, the lesser temperatures sidestep the need for expensive air conditioning and excessive water use. The environmental footprint is thus diminished. But the positive impact on costs is also significant. As greenhouses are positioned in more extreme climates, high-tech is needed to complement the basic greenhouse layout. A best-of-breed approach uses cooling that is achieved by a combination of evaporative “wet-pads,” misting systems, and a network of horizontal and vertical fans. Multiple shade systems also provide a gradient of options. Water management and fertigation (irrigation and nutrient delivery systems) are also integrated. The entire system is automated by specialized hardware and software, configured and programmable at will, with diagnostics, data mining, and management reporting capabilities.This high-tech approach, combined with an experienced management team with solid corporate standards, focuses on modularity, scalability, and reliability, in an effort to provide a flexible model for industrial strength cannabis cultivation. Resulting costs can be lowered to $200-300 per pound.
KEY TRENDS IN THIS EMERGING MARKET
One of the key trends in the cannabis industry is that market prices have become more competitive in many of the early-adoption states as a result of increased competition. They are down to a range of $1,000 - $1,700 per pound in the Western states. This trend is likely to affect all the new states gradually entering the industry, especially with the recent pushes to relax some state border limits. As a result, indoor operations will gradually be unable to compete effectively. This basically leaves greenhouses and outdoor facilities as the most cost-effective ways to cultivate cannabis in the long run. Outdoor being limited to adequate climate zones.
Another industry trend has been an increase in size. This can happen either organically or more commonly through consolidation. As the Canadian public companies have clearly shown, size has been a key driver to achieve critical mass. Incentives for spending raised money quickly, which resulted in mega grows that will continue to drive prices lower as capacity comes online. This has not remained unnoticed: they have successfully attracted U.S. big tobacco, alcohol, pharma and retail corporations to take significant equity stakes. Given the current valuations, high based on present revenues and profits, this race to expand and realize the promised economies of scale is now in full force in the U.S.
The key cannabis industry trends of lower prices and larger players seems to favor a greenhouse cultivation method, ideally high-tech, in the context of a more sophisticated corporate approach.
Similarly, the refinement of the financial and capital structure aspects of the industry will have to increase in step. Agriculture has long been a capital-intensive industry. Cannabis in particular is heavy in real estate. Typically, investors have to purchase real estate on a state-by-state basis, often starting with raw land that needs to be custom-built for the specialized use in question. Then, investors have to find local license-holder partners that they can trust. This is a time-consuming process that is quite error-prone in this industry, often referred to as the Wild West. Once the land and license are acquired, the real estate needs to be built or an existing building outfitted. This is also a lengthy process, easily taking more than 2 years, with tough local building code hurdles. Once the real estate is ready, operations take 6 months from seed to first harvest, with another 6 months needed to tune operations and narrow down the strains and phenotypes desired.
WAYS TO INVEST IN THE CANNABIS INDUSTRY
Fortunately, investors have a number of tax incentives they can use, some long-standing, and others quite recently enacted, including full expensing, like-kind exchange (1031), Qualified Small Business Stock (QSBS/1202), QSBS Rollover (1045), and Qualified Opportunity Zones (QOZ).
• Full expensing: Recently enacted and starting with the 2018 tax year, a firm can now fully expense business equipment in the year put in service. This contrasts with depreciation over a number of years. It is particularly applicable to greenhouses because the cost of the main greenhouse structure is relatively small compared to the cost of the equipment and systems within. Since most of the greenhouse contents are not considered part of the structure, they can be fully expensed, without having to worry about prior limits such as those of Section 179 (although that option is still available and in fact with an increased $1million limit.)
• 1031 Exchange: This has been a long-standing fixture of real estate investments, basically enabling to defer paying tax on capital gains as long as the entire proceeds are reinvested into more real estate (that is identified within 45 days and closed within 180 days). Like-kind exchanges were previously applicable to a number of assets, but have recently been limited to real assets. This preserves the benefit for reinvestment into cannabis real estate, notably greenhouses and their related operational buildings. This also applies to production and distribution facilities, or dispensaries and similar retail locations. In fact, vertical integration is a desirable feature of larger players, especially in terms of maximizing valuations for acquisitions. The final capital gain can then be rolled further into more real estate, cannabis-related or otherwise.
• QSBS/1202: This has also been a long-standing option for small businesses, particularly in the tech world. Under Section 1202, an investor that acquired original stock in a “qualified small business” (QSBS) that meets a number of criteria, can exempt from capital gains the first $10 million at sale of this stock after a 5-year holding period. This applies to each shareholder, so if investors invest through multiple entities, they could conceivably multiply their $10 million exemption by the number of entities used. 1202 unfortunately does not apply to farming. However, it applies to the non-farming components of an integrated cannabis business, such as production, distribution, and retail. Depending on the allocation of proceeds at the sale of a business, the non-cultivation components may or may not be a significant portion of the proceeds.
• 1045 Rollover: Another rule in force for a long time, it gives investors 60 days to roll over capital gain from the sale of QSBS into another QSBS without having to pay any capital gains tax. This is similar to a 1031 for corporate stock.
• QOZ: This very recent regulation only took effect in 2019, with follow-on specifics still being worked out. This investment is only applicable to businesses requiring real estate investments in “Qualified Opportunity Zones,” economically disadvantaged areas that have been defined by each state government. This actually fits the unskilled labor needs of cultivation. Notably, an investor can roll capital gains proceeds from the sale of another investment and thus defer paying tax on those capital gains for up to 7 years.
After a 10-year holding period, the investor is exempt from all tax from the capital gains. Basically, this means that if an investor invests a prior $1 million capital gain in a cannabis business, that $1 million is not subject to taxation for another 5 to 7 years, with only $900,000 taxable after 5 years and only $850,000 taxable after 7 years. And finally, if that $1 million grows to $10 million after 10 years, that entire $10 million is tax exempt after the 10-year holding period. The competitive advantage of cannabis is the high annual returns possible in the industry. Since QOZ offers a 10-year window, the incentive is to grow as fast as possible to exempt the maximum capital gain at exit.