The cannabis boom in Illinois has created a real estate boom in that sector, too—and just like everything in cannabis, it’s complicated. When you’re advising a cannabis company, whether it’s a leading multi-state operator or an ambitious start-up, nothing will be business as usual.
Cannabis companies have unique financial, accounting and tax issues resulting from the plant’s status as a legally available product in many states, while not yet legalized for any use at the federal level. As CPAs up to our metaphorical elbows in the cannabis business, we can tell you: real estate decisions matter—a lot—to the bottom line.
The unusual legal position of cannabis businesses has real estate implications. Of particular concern is U.S. Internal Revenue Code 280E (IRC 280E). Much derided within cannabis circles, IRC 280E is meant to block drug traffickers from deducting operational expenses on their taxes. As a result, cannabis businesses operating legally in their states cannot claim certain deductions on their federal tax returns. In effect, cannabis businesses face an effective federal tax rate that is two to three times higher than that of traditional business—a high tax burden that can undermine profitability.
Strategic business structures and other solutions can help alleviate the pressure of IRC 280E. However, attention to accounting standards and tax law is critical, as numerous recent tax court judgements have penalized cannabis operators for being in arrears.
Largely as a result of IRC 280E, and other industry complications like the prohibition of inter-state transactions, many cannabis companies have complicated structures. For multi-state operators, it is often necessary to create distinct legal entities in each state in which the company operates. In addition, it can be tax-advantageous—from an IRC 280E perspective—for a company to separate plant-touching and non-plant-touching businesses, creating both challenges and opportunities as in relation to real estate decisions.
The following are key financial and accounting issues that may affect your client’s real estate decisions.
Consider options for leveraging land as source of cash
Since cannabis is considered illegal on the federal level, cannabis companies have very limited access to traditional financial institutions as sources of funding. As a result, owned land is often a primary source of cash. Loan brokers and investment banks that specialize in the industry can connect borrowers with private lenders that will accept land occupied by a cannabis business as collateral.
Sale-leasebacks are another land-based option for securing funds. These agreements can vary widely and may be treated as either a sale or financing for tax purposes depending on the terms. A tax advisor should be consulted when entering into a sale-leaseback agreement to determine whether assets are sold or retained, and whether payments should be reported as rent expense or depreciation expense.
Segregate asset costs to optimize depreciation
A cost segregation study can reduce a company’s tax burden even though tax deductions are limited under IRC 280E. Expenses incurred to obtain or build production-related property should be capitalized rather than disallowed under 280E. This pool of expenditures can then be separated into asset types by a cost segregation study and potentially deducted as costs of production.
Despite 280E restrictions, Cannabis cultivators and processors can still deduct depreciation on production assets. Maximizing the segregation of a five-, seven- and 15-year property from a 39.5-year property and land can increase depreciation deductions significantly. Examples of shorter-life depreciable property that could potentially be extracted from the 39.5-year property pool include grow lights and specialized water delivery systems, certain security systems and specialized machinery.
Asset segregation can still be important for dispensaries (cannabis retailers) that currently cannot claim any tax depreciation at all. A report that identifies and separates real property from personal property can be utilized in real and personal property tax appeals if it meets jurisdiction standards. Should federal law change and exempt cannabis from the restrictions of 280E, an existing cost segregation report will be at the ready to maximize and substantiate the depreciation deductions that are now available.
Currently, however, cannabis businesses can only deduct the actual costs of producing cannabis, and few other expenses. This lack of deductions makes strategic real estate decisions even more important.
Explore Opportunity Zones and local tax incentive programs
Cannabis companies may want to explore a Qualified Opportunity Zone Fund as an alternate source of capital if they are willing to utilize property located in an Opportunity Zone. An investor that has realized $1 million in capital gains from a stock sale could, for example, potentially invest the gain in a Qualified Opportunity Zone Fund that funds real property occupied by a cannabis business. The investor would have the opportunity to defer capital gains taxes initially and, ultimately, could avoid the taxes altogether by holding the property for 10 years.
Opportunity Zones are quite complex from a tax perspective and benefits claimed in relation to a cannabis business have not yet been tested by the IRS or the courts. The most conservative strategy in this direction would be to seek an Opportunity Zone location for a corporate headquarters facility or a mixed-use development. Working with a tax advisor well-versed in Opportunity Zones is a must when exploring this option.
Certain state and local tax incentives may also be available to cannabis operations. Illinois city councils have recently approved allocating tax increment financing (TIF) funds to cannabis businesses, while others have allowed cannabis companies to benefit from Enterprise Zone tax benefits. For example, Mission Dispensaries benefitted from tax-free construction materials due to their location in an enterprise zone in south suburban Calumet City.
Missouri municipalities have granted property tax abatements to cannabis operators as well. It is important to note that cannabis businesses must proactively request and negotiate such benefits through the proper municipal channels just like any other business.
In any emerging industry, great risks come with great potential rewards. Whether you’re new to the industry or a seasoned veteran, a lot can be learned from the experiences of your peers in real estate, as well as from accounting and financial advisory professionals with experience in the industry.
* The above has been prepared for informational purposes only, and is not, nor is it intended to be, tax, legal or accounting advice. Please consult your tax, legal and accounting advisors before engaging in any transaction.
About the authors
Barbara Webb and Sarah McGuire co-lead the Chicago office and Midwest expansion of MGO, LLP, one of the fastest-growing CPA and Advisory Services firms in the US. As Directors of the new woman-run office, Sarah McGuire leads the practice’s accounting advisory engagements, while Barbara Webb leads the practice’s tax advisory engagements.