What Are Opportunity Zones?
Opportunity zones are economically distressed areas where investors can take advantage of a federal tax incentive program created in 2017. By placing unrealized capital gains into qualified opportunity funds, investors can finance real estate and other business initiatives within opportunity zones and receive deferrals and even reductions on their capital gains taxes.
- Opportunity zones were created by the Tax Cuts and Jobs Act of 2017. They were envisioned as a way to spur development in low-income areas that have been overlooked by investors and business owners.
- Investors who hold their stake in an opportunity fund for seven years can shelter up to 15% of their investment from capital gains taxes — and defer taxes on the entire investment.
- Opportunity zones have come under scrutiny from lawmakers who have raised concerns that opportunity zones do not always coincide with economically distressed areas, and that the program itself represents a one-time tax break for the enormously wealthy.
How do opportunity zones work?
Opportunity zones are census tracts that have been designated by each state’s governor and certified by the U.S. Secretary of the Treasury for certain tax benefits under the Tax Cuts and Jobs Act of 2017.
Anyone who has an asset with a capital gain — for example, appreciated stock or real estate — can sell that asset and place the proceeds into a qualified opportunity fund, or QOF, without incurring capital gains taxes. Those QOFs can then invest in real estate projects or other business ventures within an opportunity zone.
QOFs are required to deploy at least 90% of their capital within an opportunity zone in order to receive preferential tax treatment, and must “substantially improve” the properties in which they invest.
Opportunity zone investors are able to defer capital gains taxes on the capital that they invest, but are also able to shelter some of their gains taxes entirely based on how long they hold their stake in the opportunity fund.
After holding their stake for five years, investors can exclude 10% of their gain from capital gains taxes. After seven years, investors can receive an additional 5% step-up in basis, resulting in a 15% shelter of the gain.
Finally, if they hold their stake for 10 years, investors will not owe federal income taxes on the appreciation of the fund itself. If the investment has performed well in the intervening decade, those savings could be significant.
The opportunity zone program has a strict end date of Dec. 31, 2026. That means that investors who form a QOF in 2020 will not be eligible for the extra 5% step-up in basis that can be achieved after a seven-year hold, but still can receive the initial 10% abatement after five years. However, that does set up an impending deadline for Dec. 31, 2021.
Where are opportunity zones?
States were allowed to set aside 20% of their census tracts as opportunity zones. The zones had to meet a few basic requirements about local poverty rates and income levels, but which census tracts were chosen was left largely open to governors.
There are over 8,700 opportunity zones across the U.S.
What sorts of projects can QOFs invest in?
QOFs have largely been used to fund real estate ventures, including new housing, office, retail or industrial projects. The emphasis is on development — QOFs are required to invest as much capital toward the venture’s development as they originally paid for the property, within 30 months. If a QOF purchases a plot of land for $500K, it has 30 months to deploy at least an additional $500K to improve that property.
QOFs are barred from funding the development of certain kinds of businesses, including liquor stores, massage parlors, hot tub stores, golf courses and tanning facilities.
Though opportunity funds are often thought of as purely a real estate play, they can fund other business ventures as well. Qualified Opportunity Zone Businesses — which must earn at least 50% of their gross income from business activities within an opportunity zone — offer a higher-risk, higher-reward kind of OZ investing, similar to venture capitalism. QOZBs can also meet the criteria if their tangible property is “owned or leased” within opportunity zones or if at least 50% of its employee hours or its services are performed in opportunity zones.
How did this all start?
The idea for a federal opportunity zone program is typically credited to the Economic Innovation Group, a D.C.-based think tank, and a paper it put out in 2015, “Unlocking Private Capital to Facilitate Economic Growth in Distressed Areas.”
Tax incentives for investing in underdeveloped areas — including federal programs like New Markets Tax Credits and state programs like Pennsylvania’s Keystone Opportunity Zones — have been around for decades.
However, these programs typically reduce the taxes assessed on new developments. By offering an abatement on capital gains taxes, the OZ program takes a different approach. Its goal is to unlock the unrealized capital gains that are sitting relatively inactive in stocks and mutual funds, putting them to work instead in underdeveloped areas.
A bipartisan congressional effort, led by Republican Sen. Tim Scott and Democratic Sen. Cory Booker and Reps. Pat Tiberi and Ron Kind, drafted the Investing in Opportunity Act, which was later passed as part of the larger Tax Cuts and Jobs Act of 2017, which overhauled much of America’s tax code.
The new OZ legislation quickly created a storm of hype in real estate circles as investors scrambled to learn more, and investors and public officials like Anthony Scaramucci and Chris Christie worked to raise massive blind-pool funds for investing in OZs.
However, enthusiasm has been tempered somewhat as tax experts and money managers have had to wait for successive rounds of guidance from the IRS to get the final details on the program. And deal flow has been slower than many experts predicted, since the pool of OZ investors is surprisingly different from the pool of real estate investors.
Criticism of opportunity zones
As more of the program has come to light, opportunity zones have come under fire.
Activists and lawmakers have decried a lack of transparency in how opportunity zones were chosen and certified, pointing out that many opportunity zones fall within or border areas that have been rapidly growing and gentrifying, such as Oakland, California, and Portland, Oregon. They argue that in these areas, the OZ program hasn’t actually drawn in new development, but is simply offering a huge tax break for projects that were already going to happen. Concerned states including California and Massachusetts have pledged not to abide by the program’s specifications.
Some higher-income census tracts that are contiguous with OZs are also eligible for the same tax benefits. This allowance has prompted concern that developers will simply cherry-pick the most desirable sites along the edges of these contiguous zones rather than investing in OZs themselves. There have even been allegations of corruption in how census tracts were chosen.
Even the investment community has leveled a few criticisms, arguing that the program is only geared toward the ultra-wealthy, who may have unrealized capital gains in the tens of millions, rather than smaller investors who may still want the same benefits.
“It started out as quiet. Now you can’t pick up a trade rag without an opportunity zone article every day.” — Brad Molotsky, partner at Duane Morris LLP
“Historically when we were investing in these areas, we went out to raise capital from our institutional investors, there was a sales job that we had to do to convince them. What has changed with this program is we have people calling us on a daily basis saying, 'We want to invest in these communities, find us deals.’ That has the potential to be revolutionary for these areas.” — RXR Realty Executive Vice President Seth Pinsky
“It’s not just another community development program; it’s a new industry.” — Steve Glickman, founder and CEO of Develop LLC, an architect of the opportunity zone program
"The Opportunity Zones initiative is the most ambitious federal attempt to boost private investment in low-income areas in a generation, one with the potential to drive billions of dollars in new private investment to struggling communities over the coming decade," Economic Innovation Group President John Lettieri, congressional testimony, May 2018
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