Within the December 2017 Tax Reform Act was a late provision that survived the reform due to years of bipartisan effort. Led by Cory Booker (D-NJ) and Tim Scott (R-SC), the Investing in Opportunity Act was passed as a Federal IRS initiative to steer untapped pools of private capital towards underserved communities in the form of equity investments. An estimated $6 trillion dollars is eligible to participate while we are yet to see the full extent as to how big this development program will be.
In the May 17th public Senate hearing on the Promise of Opportunity Zones, John Litteri, Co-Founder and President of the Economic Innovation Group (EIG), gives us reasons to believe that this initiative is distinct from previous initiatives and holds high potential. He describes the Opportunity Zones program as a tool that is both scalable and flexible enough to be responsive to the broad community needs that also addresses the diverse range of communities across the US. In contrast, he explained how current targeted credit-based programs that narrowly prescribe incentives to specific issues lack the flexibility and scope to address the full variety of community needs and are not always inclusive of the full range of communities as needs vary (ie. Urban to rural). Litteri explains further how the prescriptive programs we have are not bad, but rather insufficient alone, and that the Opportunity Zone program is a great compliment to these programs.
Also testifying in the hearing, Maurice Jones, President and CEO of the Local Initiatives Corporation, highlights how the Opportunity Zone program is positioned well to successfully support community revitalization efforts:
“This is a focus on equity capital and that is key for the places we are trying to be of services to. We need grant capital, we need debt capital, we need equity capital. The exclusive focus on trying to get more equity in these communities is a key additional attribute.”
While the Opportunity Zones program has an exclusive focus on equity capital, Jones explains how there is a need for debt capital (ie. small business loans) and grants as well in our community revitalization efforts. Accordingly, Qualified Opportunity Zone Funds (QOFs) will serve as the vehicle to channel equity from underutilized private sources that could significantly expand the pie of capital accessible to underserved communities. This equity capital could be coordinated for a larger effort with debt and grant capital, and consequently, is positioned to catalyze a larger debt and grant effort.
What public and philanthropic stakeholders may not realize since they do not have capital gains tax liabilities is their crucial role with the OZ program for catalyzing community investment. Committing early investment positions to seed local fund strategies that intentionally respond to community issues can steer significant pools of underutilized private capital to align with the needs and priorities of communities. Often building a fully formed “complex capital stack” with a variety of capital stakeholders is necessary to get investment products off the ground, particularly, intentional strategies that respond to community needs.
Local governments and nonprofits can identify their priorities within these zones to support local strategies for intentionally steering available capital to these community goals. This would include inventorying and sharing the investable projects that align to the priorities with the funds (supporting deal flow) and advocating additional state and local policy incentives that could align (ie. state capital gains, local credit and zone based programs, ect.).
While these priorities may not necessarily always offer competitive returns, philanthropic organizations can further support the community goals by committing unfunded guarantees (ie. in the form of first loss or reduced rate positions) in order to make specific projects and/or local opportunity funds more attractive to investors. This public and philanthropic support is important for attracting this private capital seeking OZ tax advantages that will be circling around looking for investable opportunities across the 8,700 designated census tracts.
Likewise, these collaborations can be necessary to get projects and funds funded by long-term private capital that otherwise would not participate. As national funds roll out early and are competitive options for investors, local unrealized and recently realized capital gains have the likelihood to be invested into these national funds over local priorities. This is the case given that it is easier to make an allocation into an existing fund (particularly the well marketed, national brand-name funds with track records) than committing those dollars towards managing an effort through local fund formation and identifying investable deals. However, catalytic investments to launch local fund strategies for readily accepting allocations and deploying capital locally, enables communities to more effectively compete and access this newly available long-term private capital.
Overall, Qualified Opportunity Zone Funds QOFs serve as a new tool to bring long-term private capital into community revitalization efforts, enabling local partners to access more funding sources for achieving long-term community goals. Meanwhile, this newly created investment category can channel capital gains to investable options that were formerly not accessible to investors.
As of June 15th, all 50 states now have their opportunity zone designations approved by the Treasury, consisting of 8,700 tracts across the U.S. These are urban and rural low-income zones designated (see map) by state governors to encourage long-term investment in Zone assets and property for areas that are considered qualified low-income communities, as defined by Section 45D(e) of the Internal Revenue Code.
These zones were selected by governors designating up to 25% of the low-income census tracts in each state and the neighboring contiguous census tracts with median family incomes not exceeding 125% of the qualifying low-income community were also eligible. Notably, the same definition of low-income communities as used by the New Market Tax Credits was used and supports compatibility between the programs. Additionally, given the zone and federal tax composition, the incentives line up well with existing programs such as the Low Income Housing Tax Credits LIHTCs, making QOFs a flexible tool that can be used alongside current and future programs.
Governors had until March 31, 2018, to make their census tract nominations, of which all states participated and 30 utilized their 30-day extension (by April 20). On April 9, 2018, the U.S. Treasury and IRS announced its first approval of Designated Opportunity Zones (DOZ) for 15 states including California and 3 US territories.
With the final certification of the nominated census tracts by the U.S. Treasury, for the next 10 years, private investors are incentivized to make equity investments into the approved opportunity zones (see map). Notably, this excludes incentives for debt (ie. Fixed Income, loans to small business) and includes equity investments for small businesses (private equity ie. VC), real estate investments, and infrastructure investments of only the equity portion. However, debt will have a vital role alongside the capital that flows into these zones (ie. CDFIs).
These tax incentives apply to investors with unrealized capital gains that are either short or long-term gains from (ie. stocks, real estate, investments, ect.) and are gains realized within the past 6 months (180 days). According to the IRS, investors can self-certify to establish an Opportunity Fund, meaning they do not need to register or hear back with formal approval and can fill out a form to begin investing and receiving capital.
The realized capital gains invested in a Qualified Opportunity Fund, if held long term, are eligible to receive 5 and 7-year step-ups in basis. After 5 years, 10% of the original gain invested is forgiven and only 90% is taxed. After 7 years, an additional 5% or 15% total is forgiven of the original gain and only 85% is taxed. Investments in QOFs are exempt from further federal capital gains for the next 10 years if held for the full duration, wherein tax on any appreciation of the investment is forgiven after 10 years. Importantly, there is a limited window of opportunity this year to take full advantage of the incentives of this program because in 2019 the 7-year incentive runs out due to a recognition event happening on December 31, 2026.
QOFs vs. 1031 Exchanges:
What makes this type of deferral through QOFs particularly distinct from a traditional deferral mechanism known as the 1031 exchange is the wider investment options this vehicle enables in its scope of equity investments. For example, with the 1031 exchange, after a sale of a property, reinvesting the proceeds (deal closes) in a like-kind asset within 6 months for a qualified exchange (identified within 45 days) offers the opportunity to defer capital gains. Equity investments with QOFs, although limited by geography, are not limited to a like-kind property or even the same asset class that a traditional like-kind exchange would require.
For example, a real estate sale could now defer into stock or partnership interests in a business and any property regardless of whether qualified as a like-kind exchange within 45 days. An additional example, a portion of a large commercial property could have its gains realized and rolled over into private equity investments for forming a VC fund that invests in small businesses. What is particularly notable, is that this deferment opportunity applies to public equities (stocks) of which the 1031 exchange does not apply to, now offering a flexible opportunity for stocks to be rolled into private equity, real estate, or infrastructure for deferrals.
However, a 1031 exchange essentially offers an indefinite deferral opportunity wherein continual like-kind exchanges can be made sale after sale. On the other hand, deferrals through QOFs appear to run out with the recognition event triggering on December 31, 2026. Losing the ability to continually defer had you been in a real estate investment, appears to be a limitation.
Despite voiding the indefinite deferral opportunity, the wider aperture of investment options through the flexible boundaries of an equity investment offers quite an attractive deferral option with no long-term obligation. Also significantly attractive, the QOF deferral option offers a 10-year exemption on further capital gains alongside this increased flexibility. For investors, this opportunity to be forgiven from further federal capital gains tax on any appreciation by electing the basis to be assessed after 10 years at fair-market value is a key incentive.
Alongside these federal capital gains deferral opportunities, an important consideration is also in regards to how state capital gains line up with these incentives. To date, there are 34 states that are conforming to these federal incentives, of which NY recently aligned their state capital gains to conform and California is yet to with their tax rate of up to 13.3%.
Key requirements for Qualified Opportunity Funds:
There are a number of requirements for a qualified opportunity fund and at a high level, the key requirements are that 1). The fund must maintain at least 90% of its assets in Zone assets or property (stock, partnership interests, business property). 2.) Qualified Opportunity Zone Business (QOZB) must have substantially all of its property based within the zone as well as 50% of its revenue generating operations. 3). When investing in existing real estate, there are requirements to make “substantial improvements”, meaning, a 100% increase over the original cost basis within 30 months.
Notably, an additional requirement for QOZB is that they cannot operate as a golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack, gambling facility, or business with the sale of alcohol for consumption off premise (ie. liquor store).
These incentives come at a time where underserved communities across the US are in need of capital while residents of these communities voice fears of displacement and concerns relating to gentrification. In this context, there are both concerns and opportunities relating to the substantial improvement requirements that prevent investors from merely buying up real estate without the community seeing much benefit. Ideally, these substantial improvements requirements would provide opportunities to include the community in sharing the wealth and new jobs from these investments.
At the same time, the larger investments that require substantial improvements may have unintended consequences of evictions that come naturally with larger housing projects. However, there are successful examples of civic revival and inclusive prosperity as communities champion their own inclusive revitalization efforts. Also related to this issue, redeveloping brownfields, vacant property, or empty parcels of land holds a much stronger case to defend a sincere intent to not displace residents.