Introducing Opportunity Zones

8 min read

Capital gains deferrals to support community development  

Amidst the ongoing debate about who benefits most and who least from the passage of the tax  reform act in December 2017, one provision embedded in the new law appears to offer significant benefits for investment designed to improve low-income and underserved communities. Specifically, investors will be able to defer capital gains taxes on the sale of stock, real or personal property or business assets if they are invested in an Opportunity Fund directed to one or more specially-designated Opportunity Zones. The idea is to draw private capital into geographical areas of distress and make it easier for investors to pool their resources into larger blocks that can have the greatest economic impact on those communities where economic development has been lacking.

Each Opportunity Fund can invest in any kind of business, real estate or housing development within an Opportunity Zone or specifically-defined “contiguous area,” which gives the program the potential to be a powerful additional and complementary tool in the community development, affordable housing and minority business promotion spaces. According to the latest IRS Revenue Procedure clarification, in addition to the capital gains tax deferral, an Opportunity Fund can also benefit from Low Income Housing Tax Credits (LIHTC), New Markets Tax Credits and Historic Preservation Tax Credits.

Politico calls the provision “one of the Easter eggs hidden in the new Senate tax bill.”

The concept was introduced into the bill by Senators Tim Scott (R-SC) and Cory Booker (D-NJ) and Representatives Pat Tiberi (R-OH) and Ron Kind (D-WI). “I came out of one of these communities,” Scott told The New York Times, “so I believe that there’s untapped potential in every state in the nation.”

Original backing for the idea came from several sources long interested in improving economic development in distressed areas and attempting to find a practical way to even out some of the great disparity in the dividends of American prosperity. One of those sources was Sean Parker, Napster creator and an early member of the Facebook brain trust, whose progressive Washington think tank, Economic Innovation Group (EIG), introduced the idea to Senator Scott and secured the support of President Trump’s Council of Economic Advisors.

EIG’s statement explains, “The fund model will enable a broad array of investors to pool their resources in Opportunity Zones, increasing the scale of investments going to underserved areas.” Parker says he will personally invest in an Opportunity Fund.

“I love the idea of public policy that drives private sector capital formation and this approach has the potential to be a big deal,” says Ira Weinstein, managing principal of the Baltimore office of CohnReznick accounting and consulting firm. “There has been tremendous momentum for impact investing and this program enhances the framework to drive more patient capital into community development.”

The Essentials
The basic concept of the new provision is straightforward. The specifics remain something of a moving target: “left vague enough to let the market drive it,” Weinstein observes. Important details are still to be worked out, including where these zones will be located and the exact criteria by which they will be chosen. But the essentials are these:

To qualify for the tax benefits, the individual, partnership or company must invest capital gains from a given sale or exchange – there is no upper limit to the amount — into an Opportunity Fund within 180 days. One need not put all the gain into the fund, but only the amount that is invested will be subject to deferral. Any additional capital that was not the subject of a recent capital gain could be part of the capitalization of an Opportunity Fund but would be treated distinctly and not subject to deferral on any appreciation. Each Opportunity Fund must invest at least 90 percent of its total assets in Opportunity Zone businesses. There is no limit to how many individuals or business entities can go into the same fund.

The Opportunity Fund invests in “qualified opportunity zone business property” (QOZ) in the form of stock, partnership interests or direct tangible property. There are a few exception businesses that don’t qualify, including, not surprisingly, golf or country clubs, racetracks and gambling facilities, massage parlors and liquor stores.

“I’m encouraged by how much positive attention the QOZ program has gotten so far,” says Weinstein. “There is so much pent-up supply of capital that could come in the form of deferred gains. We will have a very strong complement to the existing arsenal of community development tools and coming from sources likely to be different from the typical institutional tax credit investment.  We’re going to see a totally new asset class as a variety of financial services participants collaborate to execute on these funds.”

The tax implications of the new legislation are complex and still being interpreted by experts, as are how compliance will be monitored and certified. “Some provisions will have to get clarified,” says Weinstein. Therefore, the following is simply a rough guide, which each individual’s tax advisor will want to study and weigh in on. Basically, though, if an O Fund investment is held for five years, ten percent of the deferred capital gains that went into the investment is excluded from eventual taxation by being added to the original basis, and 15 percent if it is held for seven years.

At this point, the provision is scheduled to end on December 31, 2026, on which date the deferred gains will be treated as income, whether or not the Opportunity Fund investment is sold, which could create significant “phantom income” for the 2026 tax year. Once that tax is levied, the basis for the Opportunity Fund investment then shifts from zero to the total amount on which taxes were paid. So, any gain from that date until the O Fund investment is actually sold starts from that basis.

An investment held for ten years, which would necessarily go beyond the 2026 day of reckoning, will be taxed on the market value on that date, but any further appreciation on the investment beyond the deferred capital gain is eliminated by an automatic step-up in the basis to the amount of the final sale. At least, that is the idea. This part remains somewhat theoretical, though. Several experts who have studied the tax act’s provisions are hoping the 2026 date will eventually be extended and the program made permanent.

Writing for the Tax Management Real Estate Journal, attorney Steven Mount of Squire Patton Boggs states, “The 2017 Tax Act has potentially created a valuable program to drive capital to and benefit low-income communities. Its ultimate success will depend on how quickly the certifying agency can organize the program and begin certifying O Funds, the limitations that the certifying agency may impose on O Funds and its permissible investments, and most importantly, whether Congress extends the current date of December 31, 2026, on which all deferred gains are automatically taxable.”

In his article, Mount further speculates, “If the December 31, 2026 ‘phantom income’ date were extended by Congress, it is possible that an O Fund investor that held its interest for at least ten years could have all gains – deferred and resulting from future appreciation – forgiven, which would be a very strong incentive for taxpayers to invest in an Opportunity Fund and would likely drive large amounts of capital to deserving low-income communities.”

“We don’t yet know what class of assets the opportunity zone business property will take,” states Weinstein. “But the flexibility is there, just like with the New Markets programs.”

Who Chooses?
Responsibility for designating Opportunity Zones lies with the governor of each state and the mayor of the District of Columbia, and is supposed to be accomplished by March 21, 2018, with a 30-day extension, if necessary. Each governor can designate up to 25 percent of qualified census tracts, or a total of 25 if the state has fewer than 100 qualified tracts. Qualification means that the tract has at least a 20 percent poverty rate or higher than 80 percent of Area Median Income (AMI) or statewide median income. There is no recourse if the governor fails to designate Opportunity Zones by the deadline. Once the governor designates the Opportunity Zone tracts, the Secretary of the Treasury has 30 days to certify them, again with a 30-day extension, if needed.

Exactly what criteria will be used to certify an Opportunity Fund are not spelled out in the tax law, but the consensus seems to be that qualifications similar to New Market Tax Credit guidelines will be applied.

An important consideration is that while the program offers the potential for yield enhancement from the deferral of capital gains, the Opportunity Fund program is still an investment, so the main emphasis will be on which designated zones are likely to offer the best prospect of business success. It remains to be seen whether affordable housing will be a significant component of O Funds, based on what level of return investors seek. As with traditional New Markets and Historic Tax Credit programs, much of the investment will likely be triggered to areas where there is strong municipal and community stakeholder support. It is expected there will be numerous advocates for specific areas in each state.

“Private sector market participants are interacting with public sector administrations to create awareness,” Weinstein comments. “There are organic processes already taking place within the states to collect information and make well-informed decisions.” He concedes, though, “There will be geography left behind.

“But the newly created funds will have a multiplier effect as they drive opportunity in distressed tracts, and that will be a great outcome.”

Story Contact:
Ira Weinstein