Qualified Opportunity Zones (QOZ or OZ) were created as part of the 2017 Tax Cuts and
Jobs Act to promote economic development in low-income neighborhoods through tax advantaged, private equity investments. Opportunity Zones work by allowing investors to reinvest their capital gains into authorized O Funds, providing significant tax deferral. The greatest benefits go to investors who invest for 10 or more years. For impact investors, the intent is to keep the focus on learning and development and high impact community building projects in these underserved communities.
Should investments be guided solely by tax benefits? Will investing in opportunity zones help
elevate the distressed communities they were created to support? Opportunity Zone parameters, still in their early genesis, need to be evaluated closely, identifying the cracks that create vulnerabilities and leave the programs exposed to fraudulent activity and high risk. In many cases, the inherent loopholes in early legislation, subvert the philanthropic goal to help these communities, while inheriting tax advantage and deferral.
In the spring of 2019, invitations for public comments to revise the legislation around
opportunity zones, triggered a variety of responses from the impact investing community,
focused in large part on how to avoid potential misuses of the program. Though many
foundations are using this program as an opportunity to build local ecosystems and
networks focused on impact, there are many using these programs, not only for capital gains
deferral, but also as general tax shelters.
The ambiguous language of the legislation brings into question who and what truly qualifies and how these metrics can be responsibly tracked. For instance, what does it mean to “derive” half their income from an “active business” in the opportunity zone—one of the qualifying factors? It gives license to define “derive” and “active business” at random, but in fact, no reporting is required to produce evidence of ways in which the community or businesses in these zones have been improved.
The core goals of these programs like rural development, infrastructure projects, affordable
housing, environmental remediation and small business development, need not be illustrated in tangible form. Conversely, the incentives reward investments whose values rise the fastest,
supporting the temptation to build a hotel or casino, versus an affordable place to live.
Currently, the U.S. Treasury is the only oversight committee on opportunity zones. Unlike the
U.S. Securities and Exchange Committee, the U.S. Treasury is not equipped to exert sufficient
oversight.
Ironically, some of these early opportunity zones have been selected in places where income was already rising before they became opportunity zones, thus moving the needle toward
gentrification, displacing the local residents, having a deleterious effect on their socioeconomic status, the opposite of the purported aim of these opportunity zones. So not only is lack of impact an issue, but the incentives themselves may be misaligned, as some of these areas didn't need the incentive in the first place.
Even for investors, though, the risks are high and it is questionable whether the benefits will be realized. An estimated $100 - $400 billion is projected to be invested in 2019, and similar
amounts in 2020, which could create an overabundance of capital deployed in a small window of time, leaving only a limited number of attractive investment opportunities. This overabundance may bid up prices and compress potential returns.
The Basis Adjustments have inherent issues in both market timing and tax laws, because the vast majority of fund managers are not focused on providing intentional, tangible, benefits to low income communities. Where fund managers are capable of and willing to make meaningful contributions, building from the ground up and redevelopment is outside of their purview, yet would be a necessary investment strategy to attract capital. The real estate cycle and other market conditions are not taken into account within the provisions, causing acquisition and disposal of assets to be driven by tax considerations, rather than optimal investment.
The highest of the tax benefits for these QOZs will be achieved at 10 years retention, but the tax laws will more than likely have changed by then. In addition, although tax rates are relatively lower now than in the past, there is a risk that they may increase in the future.
So, what is the true story behind opportunity zones? Will they benefit investors who act in good faith and promote economic development in the impoverished communities they seek to elevate? Will lawmakers reshape the language to clarify, rather than obfuscate, the requirements? Will the U.S. Securities and Exchange Committee join forces with the U.S. Treasury in enforcing thoughtful oversight that will prohibit gaming of the system as it stands?
The U.S. Impact Investing Alliance and the Beeck Center of Social Impact + Innovation at
Georgetown University released a set of core principles and an impact measurement framework to help guide the OZ market, in February. Moving toward principles of community engagement, equity, transparency, measurement and outcomes of both a quantitative and qualitative value is a step toward genuine transformation. There’s no doubt that low-income communities need support to manifest jobs, training and development, the question is will these tax breaks create the kind of social justice, impact investors envision?
It’s important to remember that while tax benefits provide some value, the investment team,
circumstance, investment strategy and opportunity itself ultimately drive returns. While
opportunity zones and their investment opportunities are still in the early stages of program
implementation, we’ll continue to track development in regulations and progress, following their evolution and seeking to uncover, the true story behind opportunity zones.