The benefits of investing in Opportunity Zones (OZs) are many. Investors benefit by having capital gains tax obligations deferred, taxes reduced, and competitive investment returns, while stakeholders in distressed communities benefit from investments of capital which create jobs, improved access to services and affordable housing.
The Tax Cuts and Jobs Act of 2017 created a new federal incentive for OZs meant to spur investment in undercapitalized communities. Any corporation or individual with capital gains can qualify. Taxpayers defer payment of capital gains tax until December 2026. If the investment is held for five years at that time, then the investor gets a tax break by a 10 percent step up in basis. If the investment had been held for 7 years by that time, then a 15 percent step up in basis applies. Recent proposed legislation (The Opportunity Zone Extension Act of 2021) would extend the federal incentive until the end of 2028, which would allow taxpayers to defer taxes for two additional years than the current legislation permits. In addition, it would allow more investors to benefit from the 7-year step up in basis amount. However, regardless of whether legislation like this passes, the chief tax incentive for OZs is the elimination of capital gains tax on the gain associated with the investment if it’s held for 10 years.
While the tax incentive is a critical element in the minds of investors, many are also motivated by the opportunity to invest in a way that has a positive social impact. The OZ initiative was created to help close the gap that has been growing between communities across our country since the great recession. This may be the most important challenge facing our nation and the effects of the ongoing pandemic have made it even worse. The pandemic has increased awareness of these issues and investors are coming to realize that whether invested for the full 10 years, or five years, contributions to a Qualified Opportunity Zone (QOZ) Fund benefit one of the distressed 8,700-plus zones across the United States.
The impact on the market is significant
Opportunity Zones have attracted $75 billion in capital investments and are on track to decrease the poverty rate in the impacted areas by 11 percent, according to a progress report by the White House Council of Economic Advisers (CEA) delivered on Aug. 24, 2020. Reducing the poverty rate in OZs could lift one million people out of poverty.
Investments to date have also created at least 500,000 new jobs in designated Opportunity Zone tracts. Of the $75 billion in capital investments, approximately $52 billion would not have entered Opportunity Zones without the incentive, according to the CEA. To compile the report, the CEA examined Opportunity Zone investments and activities through the end of 2019.
The importance of compliance and reporting
The results to date are promising evidence that the OZ initiative is working. However, it is still early considering that final IRS guidance wasn’t available until late 2019. It’s encouraging to see new legislation proposed to extend the initiative because the types of social improvements that are possible will take many years to reach their full potential. That’s why it is so important for fund managers to ensure that compliance and reporting is a top priority.
Opportunity Zone funds have some unique reporting requirements that can appear to be complex. As an example, on a biannual basis (June 30 and December 31), the fund has to certify that 90 percent of the assets invested have been deployed into Opportunity Zone property. In addition, once the money is invested at the property level, the fund needs to satisfy either the “original use” test or the “substantial improvement” test, and once the fund has deployed capital down to the project level, the project has 31 months to actually use that capital. Moreover, because of the pandemic, the IRS has been adjusting guidance in order to provide specific deadline extensions and working capital suspensions due to COVID-19-related interruptions that may have delayed project financing, planning, approval, and construction activities. With all of this complexity and dynamic adjustments associated with Opportunity Zone compliance, fund managers are wise to work with experienced industry professionals.
At the end of the day, however, the success or failure of the OZ initiative will be determined based on the impact it has made in distressed communities. At the moment, there is no requirement for fund managers to provide this type of reporting information and without it there is significant debate about the positive or negative effects of the OZ initiative. Fortunately, there are solutions that have been developed for the market that can provide impact reporting for funds without it being overly burdensome or costly. The majority of fund managers are interested in having a positive impact on the community that they are investing in and some have already adopted such solutions. Those that have will likely have a competitive advantage in the near term because under the new administration, it is anticipated that these types of reporting requirements will become law and proposed legislation such as Senator Tim Scott’s IMPACT Act reporting plan are gaining support.
Investors don’t want “impact washing”
Recent economic and social turmoil has accelerated the growth of “impact investing” broadly. One of the great things about Opportunity Zones is that it can provide a “double bottom line impact” by making a positive on social and community impact alongside a strong return on investment.
It is important for investors to know the real impact of their investment, dollar by dollar. They don’t want to invest in something that is “impact washing,” where the true impact of the investment has been overstated, or there is no transparency or accountability measures. To meet this demand, fund managers should include impact measurement from the outset as part of their ongoing reporting to investors and the community. In this way, everybody wins.
Reid Thomas serves as chief revenue officer and managing director at NES Financial | JTC, the US division of JTC Group, a multi-jurisdictional provider of fund, corporate and private client services.