In 2017 the Republican Party successfully pushed the largest tax overhaul in over 30 years through Congress. A few provisions in particular received considerable attention, including the permanent reduction in the corporate tax rate and the temporary tax cuts for individuals.
However, tucked away in the legislation is a little-known provision that offers tax incentives to investors seeking to fund projects in economically distressed areas. Senators Tim Scott (R-SC) and Cory Booker (D-NJ) introduced the framework for these “Opportunity Zones” in an earlier stand-alone bill. It received significant bipartisan support in Congress; Democrats saw it as helping low-income communities while Republicans viewed it as transferring power back to state and local governments. Members of both parties considered it to be a novel solution to curb the growing economic inequality between thriving cities and areas still struggling to recover from the Great Recession.
In the United States, there’s roughly $6.1 trillion in paper profits from unrealized capital gains resting on balance sheets. The Opportunity Zone program offers households and businesses an alternative to sitting on these profits or paying large amounts in taxes. Through this new tax incentive program, individuals can move this capital into Opportunity Funds to invest in economically distressed areas designated as Opportunity Zones. If they do so, they can defer paying taxes on the original investment until 2026. After maintaining their investment for five years, they receive a 10% reduction in the capital gains taxes owed, and after seven, they receive 15%. If they maintain an Opportunity Fund for ten years, their capital gains will not be taxed at all.
This is not the first program of its kind. Introduced by Reagan in the 1980s and passed into law by Clinton in 1993, enterprise-zone programs offered tax breaks for small businesses willing to relocate to struggling neighborhoods. But studies found mixed results of these enterprise-zone programs. Unlike the regulations guiding enterprise-zones, however, the 2017 law places few restrictions on who can participate and does not cap tax benefits, making it one of the most generous programs of its kind. Pursuant to the tax law, governors had until April 2018 to nominate up to 25% of all Low-Income Census tracts in their states to be considered for qualification as Opportunity Zones. In order to qualify, areas had to meet certain thresholds, including a 20% poverty rate and an average median family income of no more than 80% of the statewide median income. The Treasury Department analyzed the submissions and announced a final list of roughly 8,700 Opportunity Zones across the country.
Although the goal of this program is to drive economic growth in depressed communities, some economists and policy experts worry that investments will go towards areas in early stages of gentrification or, worse, areas that are already well off. In a recent Brookings Institution report, researchers noted that some Opportunity Zones were located in college towns with artificially high poverty rates due to the inclusion of large student populations in the calculations. Other qualifying areas contained many beachfront properties where the owners live part-time, meaning their incomes were not included in the estimates used to determine neediness.
Other critics say Opportunity Zones could give substantial tax breaks to investors who were already planning to invest in those areas. Although approximately 11% of Opportunity Zones have poverty rates lower than the national average, around 200 of the 8,700 zones are considered low-poverty and rapidly developing. Investors may avoid investing in the neediest neighborhoods, and direct capital instead to developing areas that provide less risky investments. This policy could also encourage disproportionate investment in real estate, and in particular, high-end real estate, driving housing prices up and gentrifying neighborhoods more rapidly.
In October, the Treasury Department released its proposed rules for Opportunity Zones. To the relief of many investors, the regulations do not impose excessive restrictions on the kinds of projects that qualify. They state that at least 70% of an Opportunity Fund’s property portfolio must be located in an Opportunity Zone in order to receive preferential tax treatment. The Treasury will also grant businesses 30 months to hold capital in an Opportunity Fund as long as its owners have plans for investment and can be audited by the IRS.
At this stage, it’s unclear how many investors will take advantage of the Opportunity Zones, or how those investments will be distributed across the country. A clearer framework will emerge in early 2019 when the Treasury Department publishes its final regulations. In the end, it will take several years to determine whether the Opportunity Zone experiment can live up to its potential, or whether it will simply hasten the course of gentrification.
For more information on Opportunity Zones, download this deck.