Connecting state and local government leaders
Proponents of the initiative believe it could attract billions of dollars of new investment to struggling communities.
Rules for the Opportunity Zones program issued by the U.S. Treasury Department on Friday provided substantial new insights into how the recently launched economic development initiative will work, but also leave a number of significant questions unanswered.
The proposed rules focus on two broad areas: the establishment and operation of the special funds that can make investments through the program, and the tax breaks for capital gains that individual taxpayers and companies funnel into those funds.
Proponents of the program have high hopes for the sums of money that it could attract in the years ahead to businesses and real estate projects in struggling communities across the U.S.
“We anticipate that $100 billion in private capital will be dedicated towards creating jobs and economic development in Opportunity Zones,” Secretary Steve Mnuchin said about the program, which was created as part of last year’s massive federal tax overhaul.
Senior Treasury Department officials said during a conference call with reporters on Friday that the draft guidelines should provide enough information for so-called Opportunity Funds to confidently begin operating, and for taxpayers to invest in them.
Treasury expects to issue a second round of guidance before the end of the year. One of the officials on Friday’s call said they anticipate that the draft rules issued this week could be finalized by spring, following a 60-day public comment period.
Steve Glickman, founder and CEO of Develop LLC, an advisory firm for Opportunity Zones investors, said he expects that the first round of rules will help to get more real estate investors off the program’s sidelines. “They’ve been waiting for these regs,” he noted.
But the big money that could flow toward the program, according to Glickman, is sitting with major institutional wealth managers, who generally handle investments for entities like endowments, commercial banks, pension funds, and insurance companies.
“They’re not going to invest until they feel like they've got as much regulatory clarity as is feasibly possible,” he said. “They’re going to continue to wait.”
A basic but important issue that the proposed rules clarify is that only capital gains, from the sale of assets like stock, are eligible for the tax breaks afforded under the program.
Taxpayers who qualify to make investments include individuals, corporations, partnerships, regulated investment firms, real estate investment trusts, and estates and trusts.
Investments through the program can't be issued as debt. They have to be equity investments, like stock or a partnership stake in a business.
For a business to be eligible for investment from an Opportunity Fund it needs to meet certain criteria outlined in the rules.
One is that 50 percent of the gross income of the business must come from activity in one of the zones—which are census tracts governors selected for the program, and that Treasury signed off on.
Another is that 70 percent of the business’ tangible property has to be used in the zone. This 70 percent figure sets a standard for what some observers have referred to as the “substantially all test” that is outlined in the legislative language that created the initiative.
It means a manufacturer with a facility in a zone that makes up 80 percent of its tangible property, and a warehouse elsewhere that makes up 20 percent would be an eligible business.
"It's a high threshold, but it’s one that provides a meaningful margin of error,” said John Lettieri, president and CEO of Economic Innovation Group, a think tank that has pushed for the program.
“We think this is a positive starting point,” Lettieri added.
But he also said Treasury could add flexibility for businesses if it creates carve outs to the 70 percent threshold for certain types of property, like goods and services in transit to customers, or raw materials getting transported from a supplier to the business itself.
There are other provisions in the rules that would provide a business operating in a zone with a 31-month window to put to use the capital they’ve received from an Opportunity Fund.
"That's pretty significant, in particular on the real estate side," said Jeremy Keele, an investment fund manager based in the Salt Lake City area, who is actively raising money for a $150 million Opportunity Fund that will be geared toward “impact” investing.
Keele said the 31-month time frame provides Opportunity Zone businesses with what he described as a “commercially reasonable” amount of time to put investment capital to work.
“I think as long as the IRS can take a look at it and say, ‘yeah, they’re clearly scoping out a project, working towards investing the capital,’ then that will count,” he said.
Lettieri suggested that there’s a need for Treasury to establish a similar grace period for capital at the fund level, and that for other similar programs it’s typically a year long. The concern here is a requirement for 90 percent of a fund's assets to be in Opportunity Zone property, and how it will affect how long funds can legally hang onto investors’ cash before pushing it out to businesses.
“Just because you received capital on a certain day doesn't mean you can turn around and deploy it responsibly, instantaneously," Lettieri said.
The program’s tax incentive allows a taxpayer to sell an asset and to take the gains on that asset and invest them in an Opportunity Fund without paying any tax on the gain.
Deferred gains like these, invested into the funds, are recognized as taxable on the date the investor cashes out of the fund, or Dec. 31, 2026. If the Opportunity Fund investment is held for five years, then 10 percent of the deferred original gain is tax free. That tax-free threshold rises to 15 percent if the investment is held for at least seven years.
An added benefit for taxpayers is that if an investor holds their investment in the fund for 10 years or more, then 100 percent of the gains on their investment through the fund are not taxed.
About 8,700 census tracts around the U.S. are currently designated as Opportunity Zones.
Treasury is also issuing a “revenue ruling” that deals with how land is treated under the program. For an investment in property to be eligible, it would have to essentially double the value of it. But the revenue ruling says the cost of land is not factored into that value.
So, in other words, if an Opportunity Zones deal involved property with $600,000 worth of land and a $400,000 building, $400,000 of new investment would be required.
Glickman said this provision could prove most consequential for how the program unfolds in dense urban areas where land is especially expensive, like New York and Los Angeles.
The second set of rules expected out in the months ahead could address a host of complex issues Treasury didn't tackle on Friday.
One higher profile issue Treasury has more or less punted on for now is how to treat funds if they cash out of an investment in a zone, and then reinvest the gains in another zone-based asset, all before the 10-year mark that allows for tax-free Opportunity Fund gains.
There’s uncertainty about whether this kind of activity could result in penalties, or require a longer holding period to access the program’s full tax benefits.
What Treasury decides promises to especially have implications for operating businesses seeking investment through the program.
This is because risk averse investors could choose to forego taking an equity stake in, say, a grocery store, or a bicycle shop, if they have to wait a decade before cashing out if they want the maximum tax break. Especially if the alternative is a safer bet on real estate.
Some Opportunity Funds are already up and running. But experts say that the Treasury regulations are a key step toward building the program to its full potential.
An ongoing concern is that the federal guidelines will be written in a way that skews investments toward real estate, as opposed to other types of businesses. But the senior Treasury officials on Friday's call insisted that this was not the case. “There’s nothing in here that slants these rules in favor of real estate,” one of the officials said.
“The whole goal," they added, "is to drive activity in the zone.”
Lettieri says that there are a variety of anecdotal stories emerging about the types of businesses that could access investment through the program. These, he said, range from kombucha producers, to salmon farming outfits, to indoor agriculture.
“If this thing works,” he added, “in 10 years, we’ll look back and say ‘it worked because it did a particularly good job at connecting entrepreneurs with new sources of capital.’”
PREVIOUSLY on Route Fifty:
Bill Lucia is a Senior Reporter for Government Executive's Route Fifty and is based in Washington, D.C.