Sean Parker, the inventor of Napster and the first Facebook President surprisingly is the architect of the Opportunity Zone tax incentive program. His passion bore it to aggregate capital into funds and force those funds to invest in distressed areas. His focus was centered around savvy investors directing money into projects they think will succeed vs. having government hand out pools of taxpayer dollars. Sean set out to build an Economic Innovation Group that was to be independent, bipartisan and pragmatic. The think tank quickly focused on crafting a policy that uses tax incentives to move investor cash into struggling communities.
By 2016 the Opportunity Zone bill had garnered the significant support of legislators from both parties. The genius of the plan lies in that it catered to both Republicans and Democrats. For Republicans, it promised a tax cut, a market-based solution and a way to put power in the hands of state and local governments. Democrats, meanwhile, liked the prospect of pouring money into areas in dire need of funding. The bill was formally introduced at the end of the Obama administration as a standalone bill. It was later decided to wait to include it with other legislation. They got their chance when Trump was elected, and tax reform was on his main agenda.
The backbone of the law is a financial product never seen before, the opportunity fund, that offers investors three tax breaks. Here is the breakdown: Investors who sell assets have 180 days to plow their taxable capital gains into an approved opportunity fund, which must hold 90% of its assets in Opportunity Zone projects. To put money to work fast, the law requires that the funds invest all their cash within some specified time frame. (The Treasury Department is still deciding on that and other crucial details.) Tax on the original reinvested gain isn’t due until 2026, and the taxable gain is cut by 15%.
Meanwhile, the new opportunity investment grows tax-free provided it’s held for at least ten years. (If it’s sold earlier, it can be rolled into another opportunity fund and remain tax-exempt.)
How do you know what an Opportunity Zone is?
For a census tract to qualify as an Opportunity Zone, it must have a poverty rate of 20% or higher or a median household income that is less than 80% of the surrounding area. However, Governors are also allowed to designate 25% of their states’ eligible tracts as Opportunity Zones. In all, about 8,700 regions, ranging from rusty industrial towns to dusty rural hamlets, have been approved.
Different than previous development incentives such as Enterprise Zones and New Market Tax credits, which capped tax benefits and placed restrictions on the industries and regions you could invest in, the Opportunity Zone law is broad. Important to note that “vice” businesses (liquor stores, casinos, massage parlors) are barred. Moreover, while venture capitalists, private-equity shops and banks will be essential for launching opportunity funds, those firms can’t simply locate in an O-zone and grow tax-free.
For real estate developers, O-zones offer cheap real estate and unlimited, untaxed upside if the development is hit. Developers must do more than bring cash in crumbling property. To qualify for tax incentives, they must make timely and significant upgrades (at least equal to the cost of the initial purchase). The hope is activity breeds activity in these areas.
For venture capital firms, which tend to make many small, risky bets with the hope that a few will be blockbusters, backing Opportunity Zone startups can carry unbelievable gains. Under the law, VCs can divert returns into opportunity funds, deferring taxes and setting the stage for a future tax-free windfall. The promise of mega-returns could send VCs, investment banks and private equity firms to launch their opportunity funds to create incubators, scour second cities for overlooked talent or move portfolio companies into Opportunity Zones. It is highly likely that Venture Capitalists tell potential opportunities to locate their business in an Opportunity Zone to allow them to invest.
For now, it’s a waiting game. Treasury and the IRS are scheduled to hand down the final Opportunity Zone rules by the end of 2018. I would expect this to gain momentum after the rules are set and be a big deal going forward in the Commercial Real Estate business. At MCA, we have already been contacted by funds aggregating capital for these zones looking to see opportunities to invest. Initially, there have been some funds that are willing to take a less than market return on a project due to the favorable tax treatment. For more information on how you can take advantage of the best capitalization of your project that lies in an Opportunity Zone, please reach out to one of the Directors at MCA to discuss your options.