The Tax Cuts and Jobs Act created a somewhat-overlooked but potentially powerful new incentive — tax-advantaged “Opportunity Zones” designed to attract private investment in economically distressed, low-income areas.
Such efforts are not new. Prior laws have created tax-advantaged Empowerment Zones (1993), Empowerment Communities (1993), and Renewal Communities (2000), as well as tax preferences for investment in specific areas affected by natural disasters and terrorist attacks. Every effort has had its own unique features, but has generally included a suite of tax benefits designed to spur capital formation and job creation by making the after-tax returns more attractive for potential investors and job creators. At best, the success of these efforts has been mixed (see GAO 2010, Congressional Research Service 2011).
Opportunity Zones are the latest, targeted effort to spur jobs and growth in low-income communities through market-based incentives.
The new law differs from prior economic development tax regimes by devolving the designation process down to the States. In the past, the regimes have involved a competitive process in which States and localities would apply to the federal government for recognition.
Governors can designate up to 25 percent of the low-income census tracts in their States as Opportunity Zones (or designate up to 25 zones, if the States has fewer than 100 qualifying tracts). Low-income census tracts are determined using the same criteria as the new markets tax credit. Interested in whether an address is located in a qualifying tract? Accounting firm CohnReznick maintains a useful mapping tool for the new markets tax credit. Note, however, that the tract still must be designated as an Opportunity Zone by the chief executive officer of a State, a process that is ongoing.
Investors in Opportunity Zones can avail themselves of two principal tax benefits: (1) the temporary deferral of capital gains reinvested in a qualified opportunity fund within 180 days of the sale that generated the gain; and (2) a full exclusion of capital gains from the sale or exchange of an investment in a qualified opportunity fund held for at least 10 years. In addition, taxpayers can also get a partial step-up in basis for gain that is reinvested in a qualified opportunity fund, if the investment is held at least 5 years (10% step-up) or 7 years (15% step-up). The temporary deferral of gain ends on December 31, 2026 — the recognition date.
The table below, from a background paper prepared by the Local Initiatives Support Coalition (LISC), summarizes the potential tax benefits based on the taxpayer’s holding period:
A qualified opportunity fund is an investment vehicle (corporation or partnership) organized to invest in qualified opportunity zone property.
Because of the 10-year holding requirement for the capital gains exclusion, investments with long time horizons are the most likely to benefit from the Opportunity Zone incentive regime. Also the tax benefits reward investment in capital assets, as opposed to operating businesses that generate significant ordinary income and little appreciation. Opportunity Zones could attract real estate development, including affordable housing (low-income housing tax credit investors, for example, have a 10-15 year time horizon). In addition to jobs in construction, property management, etc., new real estate development in Opportunity Zones — such as office buildings, restaurants, and retail space — could boost the local property tax base in these communities and attract additional investment and economic activity.
With the ink on the authorizing legislation barely dry, the debate over Opportunity Zones has already started. The top tax economist in the last Administration, Adam Looney, has expressed concern that the Opportunity Zones lack the focus on people, services, and infrastructure that was included in Empowerment Zone legislation. “There is a risk that instead of helping residents of poor neighborhoods, the tax break will end up displacing them or simply provide benefits to developers investing in already-gentrifying area,” writes Looney.” Others. like Matthew Dunne, the former director of community affairs at Google, see Opportunity Zones as the catalyst needed to unlock unrealized potential growth in rural America.
We are just at the very beginning of the roll-out of the Opportunity Zone program. The initial deadline for designation of Opportunity Zones was March 21, but States could extend the deadline for 30 days and many did. Much will depend on whether business and government leaders in individual States work proactively to promote the program and create an environment conducive to new investment.