Part of the tax overhaul enacted in 2017 is a special provision called the Investing in Opportunity Act, which focuses on drawing private investments into distressed communities. By investing in Opportunity Zones, investors with unrealized gains will be able to defer, reduce or eliminate capital gains taxes. According to the Economic Innovation Group, there is at least $6 trillion in unrealized capital gains in the economy, creating a significant opportunity for investors to exit locked investment positions.
Types of Investments
More than 8,700 census tracts in the U.S. have been approved as Qualified Opportunity Zones (QOZs), low-income areas that lawmakers see benefiting from an inflow of private capital. Many individual investors have the capital, but not the ability to invest directly in these areas, but they can take advantage of an Opportunity Fund, a partnership or corporation that invests at least 90% of its assets in Opportunity Zone property. Capital gains tax on the initial investment is deferred until 2026 or the time at which the investor exits the QOF.
The program will also enable sophisticated investors to invest in property directly, in a manner similar to a 1031 exchange, with the additional incentives of a reduced deferred tax bill and a requirement that only capital gains be reinvested. Such QOZ property may consist of real assets or companies where a significant portion of property and revenue lies in, or derives from, a QOZ. Additionally, if the deferred gain is held in the fund for five years, the capital gains tax on this initial investment is reduced by 10%, a discount that increases to 15% after year 7. If the deferred gain is held in the fund for at least 10 years, any additional gain on this initial investment is tax-free, further incentivizing QOFs.
To ensure compliance, an asset test will be conducted twice a year to confirm that 90% of a fund’s assets are invested in Opportunity Zone property. This fact has led some to believe that funds must deploy new capital into Opportunity Zone property within 180 days, although further clarification is needed. Thus, the Investing in Opportunity Act creates the potential for investors to reap tax gains while positively impacting impoverished areas that stand to benefit from an influx of capital.
Impact and Outcome
In the past, programs such as the New Markets Tax Credit (NMTC) were successful in leveraging billions of private dollars to create more than a thousand projects ranging from schools to health care facilities. Despite this success, there is some concern that instead of helping residents of poor neighborhoods, the new tax break will end up displacing them or simply provide benefits to developers investing in already-gentrifying areas. States and the District of Columbia were required to select qualified neighborhoods and submit for Treasury’s approval by late March 2018. Since only one in four low-income areas in any state could be designated as an Opportunity Zone, one hopes that there was a rigorous comparison process among zones to help ensure that the objectives could be achieved for the zones’ residents and not simply for the investors.
While final guidance from the Treasury surrounding QOFs is pending, it appears that there will be no federal regulatory process to measure the impact of capital deployments in Opportunity Zones. Without such “guard rails,” investments may in fact yield adverse social and environmental results such as gentrification. Skepticism about whether QOZs will positively impact the lives of a substantial number of local residents is a recurrent theme surrounding federal programs, as similar assertions have been made about Empowerment Zones and the NMTC. Without strong federal monitoring of impact, potential investors wishing to abide by the spirit of the law in helping low-income communities will need to identify QOFs whose missions reflect such a commitment.
Investing for True Benefits
Rebecca Lester, assistant professor of accounting at Stanford Business School, has undertaken a research study to determine whether the Opportunity Zones will lift neighborhoods out of poverty. While the study is still underway, Lester’s perspective is that the extent to which the projects actually help low-income residents is, to some extent, a function of how local governments participate in directing the investments.
For advisors working with impact-investing clients who could realize tax benefits from QOZ investments, it is important to conduct adequate due diligence to ensure that the clients achieve their impact objectives. The goal in evaluating the merit and strategies of QOFs is, ultimately, to determine whether distressed communities actually experience meaningful change.
David Aaron is Co-CEO and Chief Investment Officer for EMM Wealth (www.emmwealth.com), a 50 year-old firm in New York City that offers comprehensive wealth management for high-net-worth families and provides outsourced services to single-family offices.