The Tax Cuts and Jobs Act of 2017 created over 8,700 Opportunity Zones (OZs), representing some 12% of the U.S. land mass, a huge new playing field for impact investors who want to stimulate economic growth and bolster affordable housing in disadvantaged areas.
The rules are complicated and still under review, but essentially work like this: Investors with a taxable gain can sell an investment and pour the proceeds into a project in a designated OZ, where their gains will be sheltered from taxes for up to 10 years. Better yet, if the project appreciates in value and the investors hold it for more than a decade, those gains will be sheltered from taxes.
The combination creates a powerful incentive to make long-term investments in low-income neighborhoods. But unlike the low-income housing tax credit (LIHTC) program, OZ legislation doesn’t require investors to construct low-income housing. They can build luxury apartment towers or shiny office buildings—Amazon’s New York headquarters will be in an OZ—raising the risk of tension with residents, nonprofits, and authorities as their projects threaten to displace low-income residents instead of enhancing their lives.
Done right, an OZ investment can provide a return edge of 2.5% to 3% a year from the tax incentives alone. Done wrong, it might deliver unwanted criticism or subpar returns. To help spot the difference among the more than 150 opportunity funds that have been announced since the Tax Act was signed, investors should remember the central idea behind OZs: to benefit the residents of areas that struggle to attract capital while rewarding investors who deliver that capital.
The opportunity
The law defines a Qualified Opportunity Zone (QOZ) as a census tract with a poverty rate greater than 20% and median household income that is 80% or less of the statewide or metropolitan median. States could designate up to 25% of their census tracts as QOZs, and 8,751 have been established so far; they are in all 50 states, Puerto Rico, and the territories.
Since OZs are designated according to the income of their residents, some can be found in urban areas that are ripe for development. Large parts of Boston, including areas near Somerville and the Boston Medical Center in the South End, are eligible for investment even though they contain relatively few residents.
Investments must be in business property or in an enterprise that derives substantially all its revenue from within the OZ. Given this restriction, most investments will be in real estate.
Investors can roll a capital gain into an OZ investment within 180 days and shelter the entire gain until the project is sold. To obtain tax shelter treatment, they must invest at least 100% of the initial cost of the project (exclusive of land value) within 30 months. That means investors can’t land-bank and collect rent waiting for the neighborhood to turn around; they must be active participants in the area’s recovery.
Capital gains from any investments are eligible for shelter, whether it’s the sale of publicly traded stock or a private business. If investors hold the property for five years, the tax basis of the gain is stepped up 10%. If they hold it seven years, the tax basis steps up an additional 5%. If they hold it 10 years the basis of the OZ project steps up to fair market value, meaning investors only pay the deferred taxes on their capital gains and nothing from appreciation of the project they invested in.
Potential pitfalls
The statute authorizing OZ investments is scheduled to expire in 2026, so investors who want to obtain the full seven-year basis step-up must identify and fund projects this year or lose some of the tax benefit. That places a premium on projects that are ready to go, especially in cities like New York or San Francisco where developers can expect long delays thanks to tight zoning rules and regulatory red tape.
Even if investors act in 2019, they must plan to pay the deferred taxes on their capital gains no later than 2026. And they only reap tax benefits on the appreciation of an OZ project if they hold it a decade or more, which is a longer horizon than many taxable investors may feel comfortable with.
Projects in OZs also may be riskier than development in affluent areas, so investors should concentrate on projects that make economic sense regardless of the tax benefits. Unlike LIHTC projects, which produce tax benefits every year, OZ projects will perform the best if the underlying property appreciates over several years.
This will likely steer capital to areas close to affluent urban districts. Since a union electrician costs the same in a neighborhood with $400 rents as one with $1,000 rents, many developers will probably focus on the higher end despite the intent of the legislation.
That increases the risk of anti-gentrification protests if investors back projects with rents that are out of reach of ordinary residents. If the community perceives a threat to the neighborhood because of displacement, they’ll find ways to slow down or obstruct a project. The best tactic is to invest in projects that offer at least some housing that is affordable for middle-income or working-class residents.
Doing well by doing good
Gentrification isn’t an entirely bad thing, of course. Increased development in disadvantaged neighborhoods has several positive side effects, including more jobs, retail options, and essential services like ambulatory care centers. As neighborhoods gain educational institutions, hospitals, and transportation nodes, they create opportunities for developers who understand urban markets and, with OZs, have new sources of motivated capital, especially from impact investors.
The best outcome for residents and investors alike is a project that appreciates with the surrounding neighborhood, delivering solid, tax-advantaged returns over a long-term holding period. That will motivate investors to seek out the next Park Slope or Fort Green. But the only reason to give a tax break to someone who is already wealthy is to encourage them to help people who are less fortunate. Properly conceived OZ projects can achieve that goal, producing solid returns and a positive social outcome.
