Opportunity Zones 101
By Keith Beverly, CFA, CFP®, MBA
In 2017, Congress signed into law the Economic Tax Cuts and Job Act, which also ushered in the Opportunity Zone Program. The program provides powerful tax incentives for investors to deploy an estimated $6 trillion in unrealized capital gains to predominantly low-income rural and urban neighborhoods throughout the country. By some projections, over $1 trillion will flow to Opportunity Zone investments over the next ten years offering the potential to be the largest community development undertaking in the last 30 years. Those who ignore or are not abreast of the legislation and associated investment opportunities risk missing out on substantial tax savings that could bolster investment returns substantially.
State Governors designated over 8,700 census tracts as Opportunity Zones. These tracts are home to more than 30 million Americans, 56% of whom are demographic minorities. Though the legislation was passed under the current administration, it’s conception began under President Obama with billionaire Sean Parker (Napster co-founder and Facebook’s founding president) playing a pivotal role in developing the framework of the legislation that ultimately passed. The premise - to unleash trillions of dollars on distressed communities across the country - found both Republican and Democrat supporters.
There are 3 forms of tax benefit which become progressively more attractive with an investment’s duration.
A 5% step-up in basis for investments held 5 years
A 15% step-up in basis for investments held 7 years
The above 15% step-up in basis on investments held 10 years plus permanent tax exclusion on gains in OZ funds
For an investment to qualify for favorable tax treatment, the capital gains must be made in a qualified Opportunity Fund or “O Fund.” An O Fund is an investment vehicle structured as a business or partnership that invests in one or more opportunity zones with at least 90% of the fund’s assets being held in opportunity zone property.
Here are 3 examples to illustrate the economic benefit of O Fund investments - assuming 7% annual return, a 23.8% capital gains tax rate on $100 of 2018 capital gains being invested:
An investor would earn an additional $9 over a 5 year period, increasing annual returns by 1.7%.
An investor would earn an additional $15 over a 7 year period, increasing annual returns from 1.5% to 3.4% or by 123%.
An investor would earn an additional $44 over a 10 year period, increasing annual returns from 2.8% to 5.8% or by 107% .
While Opportunity Zone investments offer undeniable tax benefits that can magnify after-tax returns, investors should not be lulled into making hasty investment decisions. After all, there is no capital gains tax exclusion to speak of if there are no capital gains. Investors should undertake the standard due diligence as they would any investment. With the heightened publicity and awareness Opportunity Zones have generated of late, it could be enticing to abandon or relax your typical investment process. We highly discourage against doing so.
Investing with Impact
For those who consider impact criteria when making investment decisions, you should apply the same impact criterion to Opportunity Zone investments as you would traditionally. While the spirit of the legislation is to bring increased economic development to low-income communities, there are no guidelines or metrics to measure progress. For example, an investor with a holistic orientation regarding housing development should not assume a real estate project in an Opportunity Zone is considering ways to address displacement or gentrification. Similarly, an investor considering a QOF focused on equity investments in middle market companies, should not presume additional job creation will accrue to minority employees despite being in a census tract where people of color make up the majority of the population. To this end, the U.S. Impact Investing Alliance offered a framework for prospective Opportunity Zone investments worth considering.
The Investing in Opportunity Act undoubtedly offers a generational opportunity to transform communities while buttressing investment returns. We expect further amendments and guidance from Congress as capital is deployed and activity ramps up. At some point, we envision reporting guidelines that may resemble the framework offered by the U.S. Impact Investing Alliance. While investors continue to digest the implications of the legislation, we advise against sacrificing your typical investment disciplines when making QOF investments.