Opportunity Zones Offer Investors the Chance to Do Well and to Do Good
Although the 2017 Tax Cuts and Jobs Act did not receive bipartisan support, there is at least one provision in the legislation that has appeal to members of Congress and constituents on both sides. This provision offers what could potentially be a generous tax break to investors who reinvest their capital gains from other investments into economically distressed areas that have been designated as “Opportunity Zones”.
Throughout the country more than 8,700 census tracts have been designated as Opportunity Zones. The Zones were certified in every state, Washington, DC, and five US territories, including all of Puerto Rico, and are a mix of urban, rural, and, to a lesser extent, suburban areas. Local governments nominated the census tracts, and the US Treasury made the final determination.
The average poverty rate in the Opportunity Zones is about 30% and the median household income is just under 60% of the average in the wider geographic area. The unemployment rate is about 10 percentage points higher than the national average and more than one-third of prime age adults are not working. In addition to need, the Zones were selected for their potential for revitalization, as evidenced by some employment and business growth in recent years.
Investors with large unrealized capital gains can benefit in the following way:
- The investor sells an existing asset that has appreciated in value.
- The capital gain (all or a portion) is reinvested in an Opportunity Zone within 180 days.
- The capital gains tax on that reinvested amount is deferred for at least five years, after which time 10% of the gain is excluded from taxation. If the investment is held for another two years, another five percent of the gain is also excluded. These deferred gains would be recognized on December 31, 2026, or on the date sold, whichever comes earlier.
- If the investment in the Opportunity Zone is held for at least ten years, any gains on the Opportunity Zone investment itself are tax-free. This benefit has led to the coining of the term “Roth IRA for the rich”.
These investments are called Qualified Opportunity Funds (QOFs) by the IRS, which has gradually been releasing guidance. Although there has been some movement towards establishing such funds by several institutions, any actual investments are awaiting further information from the IRS in early 2019.
Theoretically, a QOF can be created by anyone, but the need to properly follow the regulations, conduct due diligence in the selection of appropriate projects for investment, cover the legal costs, and perform annual compliance and tax reporting suggest that the funds will be set up by experienced businesses and institutions and possibly by family offices (private wealth management firms that serve ultra-high-net-worth investors). Once QOFs are set up, individuals may be able to invest in them, with minimum investments probably starting at $25,000 or higher.
There is a wide range of projects in which QOFs can invest. The projects can include new real estate developments, substantial property upgrades that exceed a defined level and are made within 31 months of purchase, new business ventures, and other types of projects. Major players are expected to include real estate developers, private equity funds, venture capital companies, investment banks, and mutual funds. At least 90% of the fund must be invested in Opportunity Zones and the business investment itself must derive at least 50% of its gross income within the Zone. There are some types of businesses that do not qualify for the investments, including liquor stores, casinos, massage parlors, and golf courses. Also, financial services firms cannot simply locate in an Opportunity Zone and grow tax-free.
The provision is not without its critics. Results from past efforts that offered tax breaks to encourage private investment in low-income areas have not been as successful as hoped in achieving desired social ends. However, unlike past efforts, the tax benefits are not capped, fewer restrictions are placed on eligible businesses, and investors must stay in the investment for a longer period of time to reap the full tax benefit. Other critics feel that the benefits may not be worth the loss in tax revenue and that investments in the most attractive projects would have been made even without the tax break. And there is also concern that many of the projects will involve gentrification that will displace low-income residents.
The pool of money eligible for investment in Opportunity Zones is estimated to be around $6 trillion in unrealized capital gains, so there is tremendous potential, but it remains to be seen what portion of that money finds its way to Qualified Opportunity Funds, particularly at a time when tax rates are at historically low levels. Some investors may view investments in distressed areas as too risky for the potential tax savings. Even if the program attracts a lot of investment, the funds may not be distributed broadly or located where they are most needed, because participants may be motivated more by the tax benefits than by the benefits to society. In time, we will find out.
About The Author
Anne Christopulos
Anne is a Managing Director and Financial Planner with over twenty years of experience in the financial services industry. After holding corporate management positions in finance and strategic planning in New York City, she moved to Boston to become the Product Manager for the IRA business at Fidelity Investments. Following that, she was Vice President, Retirement Investments, at Fleet Financial Services. A native of Cape Cod, she returned to the Cape in 2001 and made the transition to personal financial planning with Secure Future Financial Services in Dennis and Davis Financial Services in Orleans before joining West Branch Capital. Anne holds a B.A. in music and economics from Wellesley College and an MBA from Harvard Business School.
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