Economic development consultant and developer Pegasus Planning and Development is always looking for new ways to revitalize communities and reduce tax liability for investors. The latest tool for investors and community developers is the community development and tax deferment program referred to as Opportunity Zones. In order to attract investors, cities will need to prepare for the potential investment infusions and will need to market their respective Zones for development. Developers, investors and businesses must be informed of where the Zones are located and how to utilize this new tool in different cities.
Opportunity Zones were developed as a response to the uneven economic recovery from the Great Recession from 2007-2009. While the United States (U.S.) national economy is celebrated for its strength and resilience today, far too many communities are still being neglected in the midst of a prolonged economic expansion.
The geographic distribution of jobs, businesses, and wage gains during the economic recovery has been highly concentrated in urban areas. As of the end of 2016, less than one-quarter of U.S. counties had re-acquired all of the businesses that were lost to the recession. This regional inequality within the United States has been recognized as one of the defining economic challenges of our era. Opportunity Zones are the first major federal effort to address this obstacle, and most pundits believe this will pay dividends for communities and investors across the U.S.
The Tax Cuts and Jobs Act of 2017 established Opportunity Zones in low- to moderate-income census tracts in urban and rural areas. Every state now has designated Opportunity Zones. The IRS just recently published the latest set of rules and regulations for Opportunity Zones (10/15/2018) and can be found here – https://www.irs.gov/pub/irs-drop/reg-115420-18.pdf
How Opportunity Zones Work
The Opportunity Zones program is designed to incentivize patient capital investments in low-income communities nationwide. All of the underlying incentives relate to the capital gains tax. These incentives are tied to the longevity of an investor’s stake in a qualified Opportunity Fund, providing the greatest return for those who hold their investment for 10 years or more. Opportunity Zones are designed to spur economic development by providing tax benefits to investors. First, investors can defer tax on any prior gains until the earlier of the date on which an investment is sold or exchanged, or December 31, 2026, so long as the gain is reinvested in a Qualified Opportunity Fund. Second, if the investor holds the investment in the Opportunity Fund for at least 10 years, he will be eligible for an increase in basis equal to the fair market value of the investment on the date that the investment is sold or exchanged.
This IRS program will allow any taxpayer to defer paying tax on capital gains from the sale of property if those gains are invested in Qualified Opportunity Funds. Further, these investors must devote 90 percent of their assets to businesses located or property used in a low-income community.
The Opportunity Zones program offers three tax benefits for investing in designated low-income census tracts through a qualified Opportunity Fund:
- A temporary deferral of inclusion in taxable income for capital gains that are reinvested in an Opportunity Fund. The deferred gain must be recognized on the earlier of the date on which the Opportunity Zone investment is disposed of or December 31, 2026.
- A step-up in basis for capital gains that are reinvested in an Opportunity Fund. The basis is increased by 10 percent if the investment in the Opportunity Fund is held by the taxpayer for at least five years and by an additional 5 percent if held for at least seven years, thereby excluding up to 15 percent of the original gain from taxation.
- A permanent exclusion from taxable income of capital gains from the sale or exchange of an investment in an Opportunity Fund if the investment is held for at least 10 years. This exclusion only applies to gains accrued after an investment in an Opportunity Fund.
An Opportunity Fund is easy to create. To become a Qualified Opportunity Fund, an eligible taxpayer self-certifies — no approval or action by the IRS is required. To self-certify, a taxpayer merely completes a form, which will be released before the end of 2018, and attaches that form to the taxpayer’s federal income tax return for the taxable year.
Opportunity Funds:
- must be certified by the U.S. Treasury Department.
- must be organized as a corporation or partnership for the purpose of investing in Qualified Opportunity Zone Property.
- must hold at least 90 percent of their assets in Qualified Opportunity Zone Property.
- Qualified Opportunity Zone property includes newly issued stock, partnership interests or business property in a Qualified Opportunity Zone business.
- Opportunity Fund investments are limited to equity investments in businesses, real estate and business assets that are located in a Qualified Opportunity Zone. Loans are not eligible for the tax incentives. Opportunity Fund investments in real estate are subject to a substantial rehabilitation requirement.
For example: Jane sells her business for a $12 million capital gain in December of 2018. She finds a limited partnership that is seeking investors in the qualified Opportunity Fund and invests all $12 million within 180 days of the sale of her business.
If Jane keeps her investment in the qualified fund until December 31, 2026, instead of paying $671,000 in federal tax by April 15, 2019, $570,000 of tax will be due by April 15, 2027.
“We anticipate that the Opportunity Zones will help with reinvestment throughout OKC, but are very excited about how this incentive can complement the Innovation District strategy we will begin implementing in 2019.”
The tax reduction is attributable to the 10 percent basis bump after holding the Qualified Opportunity Fund for five years and an additional 5 percent basis bump for holding the Qualified Opportunity Zone for seven years. Additionally, she will pay $0 tax on any profit she makes of the $12 million.
Rural vs. Urban Opportunity
A great divide in economic opportunity between rural and urban areas has been in place since the Great Depression. The Opportunity Zones legislation seeks to change this inequitable narrative. Opportunity Zones are misconceived as only providing economic benefits to rural areas. In fact, many Opportunity Zones are in urban areas.
To illustrate this point, it is important to understand how three cities are preparing for investments as part of the Opportunity Zone legislation. Bruce Katz and Jeremy Nowak have been instrumental in the creation of Opportunity Zones legislation. Both individuals have been working with Accelerate for America to help three U.S. cities develop an urban investment prospectus tailored for use in the Opportunity Zones. Mr. Nowak passed away this year, but Mr. Katz continues to work with Accelerate for America in bringing investments to Oklahoma City, Oklahoma; Louisville, Kentucky; and South Bend, Indiana. Oklahoma City is focused on overall revitalization and economic development, while Louisville is targeting social impact. South Bend is concentrating on improving the town-gown relationship with University of Notre Dame.
Spotlight: Oklahoma City’s Opportunity Zone and Innovation District
Through its work with Oklahoma City, a current client, Pegasus has afforded the opportunity (no pun intended) to learn firsthand how Oklahoma City is preparing for the Opportunity Zones. Pegasus is part of a team led by Perkins & Will, working for the Alliance of Oklahoma City, to create a land use and strategic development plan for creating an Innovation District adjacent to downtown Oklahoma City. The Innovation District is a 1.5-square-mile area (roughly 1,400 acres) where the Oklahoma Health Sciences Center, OU Medical School, and other health-related institutions are located, along with private companies working on research and development. Much of this land was acquired through years of urban renewal, where neighborhoods adjacent to the Innovation District are now impoverished.
The majority of the OKC Innovation District also happens to be within an Opportunity Zone. The OKC Urban Renewal Authority (OKURA) also owns a significant amount of land within the Innovation District. The Innovation District is poised to attract significant private investment for research and development, office, retail and residential development. Pairing the OKURA properties with a TIF District (tax increment finance zone), the Opportunity Zones’ incentives create a uniquely attractive investment opportunity, which OKC is capable of implementing.
"The Accelerate for America program is working with Oklahoma City to create an investor prospectus to spur economic development," says Alliance Executive Director Cathy O’Connor. "OKC is in the vanguard of the next new investment tool for community reinvestment. We are very excited to be chosen for this program, as it complements the many other projects OKC has seen in and around downtown over the last 10 years. We anticipate that the Opportunity Zones will help with reinvestment throughout OKC, but are very excited about how this incentive can complement the Innovation District strategy we will begin implementing in 2019."
1031 Exchange or Opportunity Zone?
Some investors call the Opportunity Zones a "1031 exchange on steroids." The ability to reduce tax liability and not incur taxes on sale proceeds in the future is a massive benefit. Additionally, the tax deferral is available for any capital gain, not just "like kind" real estate. The "catch" is that these investments must be through a qualified Opportunity Fund as designated by the Treasury.
Most experts agree that this tax incentive will not only provide communities with an infusion of capital investment, but it will also offer investors a tremendous tax deferral incentive. The final regulations should be released before the end of 2018, after which many cities (in addition to Oklahoma City, Louisville and South Bend) are expected to capitalize on these incentives. Investors can participate today in Opportunity Zone funds and begin realizing the long-term economic gains of their investments.
The Intersection of Community Development and Economic Development
There has long been a debate in national politics over whether federal policies focused on capital investment will have better returns to the public versus policies focused on improving the conditions for the poor and that are more community development-oriented. Opportunity Zones are seen as one of few programs that could very well benefit those with capital means and those who need better jobs and overall community improvement.
Communities across the U.S. should pay close attention to how South Bend, Louisville and Oklahoma City are preparing to capture the interests of Opportunity Fund investors. In the meantime, a community should be do the following:
- Map out all of the Opportunity Zones in your community. The CDFI Fund provides an online mapping tool: https://www.cims.cdfifund.gov/preparation/?config=config_nmtc.xml
- Hold a forum for local developers and investors. Bring in an outside expert on Opportunity Zones. Discuss local opportunity areas and resources. Share the census tract maps of Opportunity Zones in your Area.
- Network with local, regional or national funds that have been created for Opportunity Zones in your region.
- Network and educate residents and business owners within your Opportunity Zones about what could occur with potential investments. Work with local organizations on capacity building to help them engage on some of the developments to incorporate community benefits into these investments. Encourage these residents and businesses to participate at local Opportunity Zone workshops.
As an investor or developer, begin a fund or find a fund that is looking to invest for bottom-line reasons but who also see an opportunity for simultaneous social improvements. Knowing many of the communities that are engaged in Opportunity Zones right now, it will not be difficult finding a local partner to help identify business or properties within their zones and how to connect capital with ideas for overall benefit. Speak with local community groups and identify local needs and interests with making money.
It will be the patient investors who hold their money in for the long-term that benefit from zero taxes on profit made from an investment. Using what normally would be 1031 funds to delay capital gains, but this time do it through at least 2026, can now generate tremendous tax advantages to businesses, investors and developers, but it can also help to revitalize communities across the U.S. that may not have gained as much as the rest of the U.S. urban areas over the last five years.
Sean Garretson, AICP, is President at Austin, Texas-based Pegasus Planning and Development, specializing in economic development analysis and policy, land development and plan implementation. For more information, visit www.pegasusplanninganddevelopment.com.