Opportunity Zones: Investing for impact (and major tax savings)
Tucked into the 2017 tax bill was a bipartisan provision for Opportunity Zones, a new tax incentive designed to channel unrealized capital gains held by investors into long-term investments in parts of America struggling with high poverty and slow job growth.
Starting in 2018, investors that reinvest capital gains within 180 days of sale into an Opportunity Zone can defer payment of capital gains tax to the 2026 tax year, and they can significantly reduce their tax liability depending on how long they hold the investment up until the end of 2026. If held at least 5 years, the amount of capital gains subject to tax is reduced by 10%, and if held at least 7 years it is reduced by 15%. An extra benefit: if the opportunity fund investment is held for 10 years or longer, the investor will potentially owe no capital gains tax on the gains made on the opportunity fund’s investments in (the original capital gain is still taxed).
What are Opportunity Zones?
Opportunity Zones are economically distressed communities (or what Senator Cory Booker of New Jersey calls “domestic emerging markets”) that have been nominated by cities and states and certified by federal government. They must have an individual poverty rate of at least 20% and median family income no greater than 80% of the area median, or be “contiguous” to such an area.
There are currently around 8,700 designated Opportunity Zones across all 50 states. That includes 514 tracts in New York State and 75 municipalities within New Jersey, including many Tristate-area neighborhoods within the Bronx, Downtown and East Brooklyn, Long Island City, Newark, Jersey City and Union City.
How to invest in Opportunity Zones
For investors, it’s important to note that capital gain reinvestment can be made from the sale of any asset, not just real estate. Unlike 1031 Exchanges, which are now limited to allowing deferrals of capital gains taxes on real estate investments only (as a result of the amendments in the last tax act), Opportunity Funds allow investors to defer and reduce capital gains taxes on any type of tangible or intangible asset, such as company equity, stock or shares, bonds, and valuables such paintings or artworks.
In order to receive the tax advantages, investors (individuals and businesses) must put their investment into a Qualified Opportunity Fund (QOF), an investment vehicle (structured as a corporation or partnership) that is required to satisfy a variety of tests, including having a certain amount of its assets invested directly in qualified opportunity zone property, or an appropriate vehicle that holds a certain amount of its property within the designated Opportunity Zone.
For example, Amazon, which is opening its second headquarters in an O-Zone within Long Island City, may not necessarily benefit from this tax incentive, unless some of its holdings in Long Island City are structured to meet these tests.
The IRS and U.S. Treasury are still fleshing out regulations governing these types of funds, which are expected to be announced shortly. The first round of proposed regulations that came out in October helped to remove some of the uncertainties. In general, there is broad flexibility as to how Opportunity Funds can invest their capital, but the rules need further clarity. The funds can invest in various types of assets, such as company equity, stock or shares, business partnership interests and capital resources such as factory equipment. Real estate investments are also allowed, but are typically subject to a “substantial improvement” requirement, meaning that the business must invest make sure the cost of improvements to the building into renovations or refurbishments to satisfy the test. How these rules apply to undeveloped land is still unclear.
Business owners with existing in businesses in qualified opportunity zone businesses may be able to benefit from OZ funds if they expand their business in the right manner (to satisfy certain new investment or substantial improvement requirements) and issue interests to a QOF likely run by investment partners, given certain related party constraints. Depending upon the structure, vice businesses such as alcohol stores, massage parlors, gambling facilities and golf courses (among others) do not qualify for the designation. Additional regulations for such businesses are outlined in draft Form 8996, which the IRS expects to finalize this year.
Jonathan Schorr, an advisor to Opportunity Zone investors and occasional speaker on the topic notes, cautions potential investors not to jump in without consulting someone knowledgeable on the regulations. “Given the complexity of the rules, it’s important to work with an advisor to ensure that your investment complies with the law.”
Big picture benefits
Opportunity Zones have enormous potential for bringing much needed investment to areas of the nation where it is needed most, although some experts worry that the law’s loose rules may make it ripe for misuse or may help to speed up gentrification. Another worry is that investment dollars may end up concentrating in larger cities and states that attract disproportionate investment generally.
To ensure that Opportunity Zones effects the intended economic and social benefits, policy experts recommend that states and communities stick to several guiding principles, like setting impact objectives (including output goals like number of living wage jobs created and affordable housing units) and supporting community development intermediaries like CDFIs and community banks that can provide debt financing to support businesses and real estate that will benefit from equity investments from Opportunity Funds.