June 26, 2018
This past December, the Tax Cuts and Jobs Act of 2017 established a variety of programs in addition to the changed tax structure for the country. Opportunity Zones, one of those programs, are causing waves around the country in development circles in the United States for their potential to promote reinvestment in the most destitute communities in the country, while also providing substantial tax savings for investors themselves.
One of the major points cited about Opportunity Zones is that, according to CityLab, they have the potential to preserve the status quo in urban and rural development or to make changes that reduce inequality in the United States. The status quo, in this case, is the tendency for development, even inside the bounds of low-income communities, to benefit the developers and new residents who move to those areas. Many of these projects see fewer economic gains for local low-income residents than may have been promised. This process, often termed "gentrification," is one of the outcomes that Opportunity Zones could possibly avoid, but which could also be a result.
Structure of Opportunity Zones
The core idea of Opportunity Zones is the chance, from the federal government, for governors to designate up to 25% of their low income census tracts with this special designator, Opportunity Zone. This designator makes them eligible for investment from Opportunity Funds, a tax-advantaged method of investment detailed below.
These census tracts are eligible based on poverty rate of at least 20% or a median family income of less than or equal to 80% of the surrounding area's median income. There are other ways that tracts can qualify, so there are many tracts to choose from.
The selection process is deeply tied to assets and programs: the goal is to add capital investment in such a way that jobs are created, existing programs get stronger purchase, and other federal programs, like low-income housing, can be built upon using private dollars to eventually promote a path out of poverty. The Economic Innovation Group, a consulting organization that has helped to design the Opportunity Zones legislation, has offered ways for Governors to choose these designations, but also left it up to the local states to figure out where this reinvestment might be best allocated.
Once the Governor's selections are evaluated and approved, they will stand for the coming decade, according to the information available about the program at this time.
Opportunity Funds: Capital for Opportunity Zones
One of the most unique parts of the program is the way that capital will be allocated to these zones, namely through the use of Opportunity Funds. The rules for these funds are still being solidified by the Treasury department, but the basic structure is clear.
The main investors will be anyone who is receiving capital gains from other investments in such a way that they would be liable for capital gains taxes. These taxes are substantial, and investors look for any way they can to avoid them.
The goal with Opportunity Funds is to specifically reinvest capital gains before they are taxed. Depending on how much time the investors leave their gains in the Opportunity Fund, they receive different tax incentives:
- As long as the investors leave their money in the Opportunity Fund to be used for development in the Opportunity Zones, they can defer their capital gains tax.
- After 5 years of leaving the gain in the fund, 10% of the initial investment is able to be excluded from capital gains tax entirely. This amounts to a "return" of 10% of whatever tax was due. This continues to increase to 15% at 7 years.
- After 10 years of investment, all returns from the 10 years of investment are able to be excluded.
Investors in Opportunity Funds are given the opportunity to defer or eliminate capital gains taxes by investing those gains into low-income or low-opportunity areas, injecting them with much-needed capital. The exact projects that will qualify for Opportunity Fund investment, and how much investment will be committed, still are questions for all who are interested in the Opportunity Zone project.
Will Opportunity Funds and Zones Change Inequality?
The method by which this money is allocated may be innovative, but the potential uses of the capital vary. As of now, it is possible for the funds to continue to promote gentrification, meaning that most of the low-income residents of these census tracts will simply move to other low-income areas if their area becomes too prosperous for them to afford to live there.
However, the fact that the investment structure makes it more appealing to develop low-income areas means that more developers will find these areas appealing, including those who are working to benefit low-income communities. By making the margins less tight for developing affordable housing, much-needed retail, and job creation, the Opportunity Zone concept promotes an exciting possible future that could make it a natural win-win-win for investors, developers, and local low-income communities.
One of the aspects that shows promise is the fact that states choose their own designated tracts for opportunity zones, rather than having them all be chosen at the federal level. States usually have a greater understanding of localities that have existing underutilized assets, such as schools, hospitals, housing stock, etc. Combining re-investment with currently existing assets will hopefully be the boost that these communities need in order to see more residents living in safe affordable housing while working jobs that promote moving into the middle class.
As the details of Opportunity Funds are hammered out and the designated tracts are revealed nationwide, investors and developers can benefit from paying close attention. When a strong economy brings substantial capital gains, Opportunity Funds promise substantial tax savings while still giving the potential for excellent rates of return. Developers who have traditionally had to focus on drawing private investment dollars can now also consider projects that could be funded through Opportunity Funds, though the exact qualifications for these projects remain to be seen.
Interested in learning more about a potential role for your business in the Opportunity Zone future? Contact us.