Financial planners have approached us repeatedly to address the competition between Opportunity Zone (OZ) investments and contributions to community foundations (CFs). In theory, funds that may have otherwise gone to the CF to make charitable gifts of appreciated stock might now be directed to funds that are being set up to support OZs across the country. While there are clear tax benefits to either a charitable gift as well as an OZ investment, the tax tail shouldn’t necessarily wag the tail of the investment dog, and some individuals should highly consider making both.
The federal OZ tax incentive was enacted in December 2017 as part of the Tax Cuts and Jobs Act. The OZ incentive was designed to spur economic development and job creation in underserved communities across the United States by attracting investment to these communities through the use of significant tax benefits to investors. The incentive is centered around investors harvesting a capital gain and then investing any portion of that capital gain into a qualifying project through an investment vehicle called, a “qualified opportunity fund” (QOF). Once invested in a QOF, investors receive the following three tax benefits:
- Investors’ original capital gains invested into a QOF are deferred until the QOF is sold or until Dec. 31, 2026, whichever occurs first.
- Investors receive a step-up in basis of 10% to 15% of the original capital gain depending on if investors fund their QOF investments by 2021 or 2019, respectively. As a result, investors who fund by 2019 receive a 15% reduction in the taxes due in 2026; investors who fund by 2021 receive a 10% reduction in the taxes due in 2026.
- If the QOF is held for longer than 10 years, then investors do not pay capital gain taxes upon exit from their QOF.
By investing in a QOF, an investor is able to defer capital gains tax on an appreciated asset, decrease the amount of that gain that’s eligible for taxation (depending on how long the QOF is held) and potentially pay no capital gains taxes at all on the growth that is realized while invested in the QOF.
Interplay With Philanthropic Goals
These benefits are attractive to investors with large capital gains due to an asset sale or liquidation, but they're also attractive to individuals with concentrated positions reluctant to diversify and realize a taxable gain by triggering the sale of their appreciated positions. Often, individuals in this position look, at least in part, as to if or how this sequence of events plays into their philanthropic goals. As the number of OZ investors continues to uptick and gain momentum, there will be further discussion on how investors can roll their gains into a QOF eligible for the tax benefits afforded through the OZ program. However, we also expect to see collaboration with CFs, which are uniquely positioned to identify these individuals and help them direct their capital to communities in need.
CFs are an expected partner to the conversation as to how to uplift a community and how investing in a given community can encourage economic growth and social betterment. CFs are integral and established in these areas and have engaged boards and connections with local government, and work with existing and potential donors with unrealized capital gains who may be interested in investing in these revitalization zones. CFs have knowledge of the community and frequent contact with socially engaged donors who may have unrealized capital gains property. That said, there are challenges.
Internal Revenue Code Section 501(c)(3) prohibits nonprofit organizations, including CFs, from engaging in “private inurement,” meaning that the organization may not distribute its earnings and profits to a private party. As such, this prevents CFs from having “investors” and would prevent a CF from qualifying as a QOF itself or holding QOF assets within the charity. Additionally, IRC Section 501(c)(3) requires nonprofit organizations to operate primarily for charitable purposes, meaning they must engage primarily in activities that directly benefit the organization’s charitable class to a substantial degree. Activities that benefit private parties (that is, investors in a QOF) should be indirect and insubstantial. These legal requirements don’t, however, prevent CFs from establishing QOFs in a separate entity that the CF manages and can help attract capital. CFs can benefit from the OZ program by furthering the CF’s mission. This can be done by the CF by:
- Managing a QOF;
- Advising a QOF;
- Co-investing in a QOF; or
- Fundraising for a QOF.
One major scrutiny and hesitation that some investors express is that the OZ incentive needs more clarifications through the regulatory process, and regulators and administrators are still finalizing details of the OZ incentive. However, philanthropy, CFs in particular, are in a position to be able to help shape the OZ landscape so that benefits of the legislation also accrue to longtime community members and businesses. The U.S. Department of Treasury anticipates that OZs will unlock over $100 billion in private investment in low-wealth communities across the United States. As addressed above, the tax incentive aims to encourage capital investments in more than 8,700 designated census tracts across the country by permitting investors to reinvest capital gains in designated census tracts in exchange for tax benefits.
How CFs Can Help
CFs can help enable the OZ initiative by furthering their own community missions in several ways, including:
- Bring together stakeholders by helping cities and communities organize for success by coordinating efforts within government and across key institutions and sectors. While each of the designated census tracts is unique, there are common challenges and patterns across designated zones. CFs can help accelerate results and improve the allocation resources by supporting coordination and communication across markets. One way this can be done is through the collection of market data and the conduct of market research.
- Encourage accountability to incentivize long-term results by influencing Internal Revenue Service regulations for OZs (and potentially follow-on legislation) using data-driven insights to ensure that the incentive reflects the interests of communities and the intent of the incentive.
- Influence investor behavior by encouraging investment with significant impact returns. Clearly, capital will follow the path of highest return and lowest risk. Standardized impact reporting will be helpful to show how deployed capital in OZs will yield community and financial returns.
- Help create investable opportunities by communicating a pipeline of transactions that meet both the needs of communities and the return expectations of investors. One way to do this is assisting city, county and state leaders with marketing their investable projects in an institutional manner. Accordingly, this can create public private partnership opportunities.
Bottom line is that CFs and the OZ initiative present an opportunity for individuals with gains who want to commit some of those gains to charity to propel the program to make substantial social and financial returns.
Meg E. Dodge is a principal and co-founder of Indigo 8 Advisors, which works with clients to develop and manage a customized Opportunity Zone investment strategy aligned to their financial and values-based objectives.