Opportunity Zones: The Fever Sweeping the Commercial Real Estate Industry
- Jason Gordon
Title Professionals may be living under a rock if they haven’t heard the buzz about the federal opportunity zone program (The Investment in Opportunity Act). I’ve noticed that most of the numerous articles written since the inception of this new investment vehicle are often narrowly focused on the law’s mechanics involving hefty tax benefits for investors and on the lofty goals of the legislation. Let’s discuss those important elements, as well as the program’s potential defects, how it compares to past federal programs involving tax incentives, and the very unlikely but fascinating history of the legislation, originally envisioned by Sean Parker, the founder of Napster and the first president of Facebook.
Parker was a child prodigy who never attended college. As a high school student in the mid-nineties, he convinced the administration to count the time he spent coding in the computer lab as a foreign language class, thereby satisfying one of the requirements necessary for graduation. But in addition to being brilliant, Parker also had a philanthropic streak.
In 2007, while surveying the United Nation’s work on Malaria prevention in Tanzania, he was struck by the abject poverty he saw all around him. He wondered if there was any possible way to attract private investment to deliver infrastructure and progress to deeply impoverished regions. The idea remained with him when he returned to the states.
Parker surmised that if he could entice private investment to distressed American communities, it could evolve into a game changer. As he explained to Forbes in July of last year, “People were sitting on large capital gains … and huge appreciation. There was all this money on the sidelines. I started thinking how do we get investors to put money into places where they wouldn’t normally invest?” In 2013, he founded the Economic Innovation Group (EIG), a bipartisan public policy organization charged with addressing America’s economic challenges through market-based solutions. “… You’ll never solve domestic poverty by giving money to a foundation. That’s not going to achieve anything. What you need is trillions of dollars in investor capital.”
EIG began exploring the idea of using tax incentives to attract private investment to these underserved communities through opportunity funds. Eventually, it was formulated into a congressional bill, that found ardent support across the political spectrum, gaining more than 100 co-sponsors in both houses of congress. As the Forbes article observes: “For Republicans, it promised a tax cut, a market-based solution, and a way to put power in the hands of local governments. Democrats, meanwhile, liked the prospect of pouring money into areas in dire need of funding.”
It became codified in 2017 and was tucked into the administration’s Tax Cut and Jobs Act. The legislation is poised to pump major private investments into America’s low-income urban and rural communities.
How Does it Work?
As a first step, state governors designate low-income areas defined as having a poverty rate of at least 20%, or a median family income of no more than 80% of the statewide rate. When the designated area is certified by the U.S. Treasury Department as meeting either of those criteria, it is officially classified as an opportunity zone.
An investor who profits through the sale of an asset such as a stock, real estate, or a business, and invests the profit within 180 days in a new investment vehicle called an opportunity fund (which must invest at least 90% of its assets in opportunity zones), can realize substantial tax incentives. Firstly, the tax liability on that gain can be deferred or reduced.
But beyond reaping this generous tax benefit immediately upon investing in the fund, a secondary tax benefit occurs when the investor keeps his money in the fund for the long term. Those who remain invested for five years can reduce their tax liability on any capital gains by 10% after the sale of their shares. Those who retain their position for seven years can reduce their tax liability by 15%. And if the investment is held for ten years, there will be no capital gains tax on any appreciation of the opportunity fund when the shares are sold.
What Types of Investments are Opportunity Funds Permitted to Meet Government Guidelines?
The government defines a qualified opportunity fund transaction as a real estate investment in an opportunity zone, or a partnership or stock ownership interest in a business that conducts all or most of its operations in a designated zone.
In the case of real estate, there are two caveats. Firstly, the fund must demonstrate how the investment will improve the community (create jobs, attract new businesses, etc.). And secondly, when an opportunity fund purchases an existing building, it must invest more in the improvement of the building than it paid for the property. The funds can invest in constructing new buildings, as well.
Additionally, there is no limit on the amounts of capital that can be invested in the zones by the opportunity funds. Therefore, these neglected communities don’t need to decide which worthy projects get funded, and which will be left to languish.
How Does This Concept Differ from Past Federal Programs Designed to Improve Distressed Areas?
Unlike other federal programs that had the same aims, opportunity funds can self-certify without authorization from the Treasury Department. Therefore, opportunity funds are fully managed by the private market rather than a government agency. Other programs such as the New Market Tax Credit Program, and the Low-Income Housing Tax Credit Program are subject to annual government approval and operate under limits (such as the number of tax credits that can be issued yearly). This, in turn, limits the number of investors who can partake in the program, and therefore, the amount of funds that can be invested in upgrading communities.
Potential Defects of the Investment in Opportunity Act and Unintended Consequences
Many designated opportunity zone areas are in gentrifying districts, yet still fall within the guidelines outlined above. Fund managers are naturally more attracted to these neighborhoods because they are safer investment and yield quicker returns. For example, Amazon which had planned to open a new headquarters in New York’s Long Island City, before nixing the deal under pressure from local activists, is a certified opportunity zone even though it has been gentrifying for years. That new corporate resident would likely have caused that upward trajectory to escalate sharply, affording opportunity funds a highly tempting target for investment.
The same holds for numerous zones around the country from Vine City, Atlanta to SoMa, San Francisco which already boasts a Whole Foods, and houses the new headquarters of Uber, Airbnb, and Pinterest. Alternately, investing in truly impoverished areas is far more speculative.
Secondly, instead of helping residents of impoverished communities, some may be displaced, as they are unable to afford higher housing costs that are a likely outcome of improving neighborhoods. Residents, for example, could have been protected through rent subsidies, mortgage assistance, or a requirement that developers allocate a percentage of residences to those with low incomes.
Thirdly, it will be difficult to measure the loss of tax revenue to the government compared to the benefits gained by the communities. No mechanism has been set up for this important yardstick.
Beyond the potential benefits for financially challenged communities and investors, there is another cohort that stands to benefit: Property owners in the newly designated opportunity zones have suddenly seen values move up sharply the Wall Street Journal reported in October (Developers Look to Hit Tax Break jackpot). “A local [San Diego] developer shifted tactics after learning that anyone buying his property would be eligible for lucrative tax breaks.” He dramatically raised his asking price on a property he had recently put on the market. Additionally, local landlords are gleeful at the infusion of private capital pouring into their neighborhoods.
The Bottom Line
A multitude of opportunity funds have already been established. The Goldman Sachs Group began creating its opportunity funds just days after the tax law was passed. And with the final federal guidelines released just a few months ago, there has been a sharp increase of investment: “Billions of dollars have started piling into the new real estate funds targeting opportunity zones,” the same Journal article reports.
The surge of investments in these designated zones have occurred across the nation, according to Real Capital Analytics. “Sales of development sites in opportunity zones have spiked 80% in the first three quarters of 2018 compared with the same period last year.” The firm, for example, reported that investment in opportunity zones in the Bronx skyrocketed, as purchases rose to $225.7 million during the first nine months of 2018, compared to the same period in 2017, when investment in these areas of the borough was just $24 million. The trend was the same in Salt Lake City, as investment increased to $160 million, up from $21.4 million in 2017.
Will it work?
While other federal tax credit programs to promote development in distressed communities have been tried before, The Investment in Opportunity Act is more privatized, more generous in its tax benefits, and more expansive, in that there are no limits as to the number of tax credits available and therefore to the number of projects where private investment can flow. If the program can overcome some of its flaws such as redefining opportunity zones to include only truly needy communities (not those already gentrifying), then the legislation will more likely attain its goals.
At its heart, The Investment in Opportunity Act is informed by the idea that investments will flow not only where there is the likelihood of a handsome return, but also where the tax burden is considerably reduced or eliminated.
Balancing the merits and scope of the program with its flaws, and with the perspective of a couple of decades of experience in the industry, count me as, well, … cautiously optimistic.