There’s a long road ahead, but this creative U.S. effort to align public and private investment incentives bears close watching.
Buried deep in the controversial 2017 tax bill lies a program with a shockingly bipartisan pedigree and the potential to transform some of America’s most troubled economic areas. There are huge hurdles ahead, but the list of cheerleaders spans from Trump Republicans to Obama Democrats and progressive policy wonks to private equity titans.
It’s as rare a story these days as the apocryphal headline about a master turning on a pet.
The program attempts to unlock the capital gains that investors are reluctant to realize. Often, they prefer to pass these assets to their heirs when the cost basis can be stepped up, and the government never gets the tax. The idea is to offer an incentive to anyone who reinvests a capital gain now into a struggling part of the country.
The basic rules are pretty simple. Investments may be in real estate or a business within a designated zone. After five years, investors pay no tax on 10% of any realized gains that are reinvested in an Opportunity Zone. After seven years, 15% is untaxed. After 10 years, the entire gain is untaxed. Eligible investments must be made through a Qualified Opportunity Fund and those gains are themselves untaxed.
By one calculation, an investor who takes advantage of the full benefits of the program over 10 years can turn a notional after-tax 2.8% annual return on the reinvested capital gain into more than twice that. More dramatic for economic development, it taps into capital that would likely otherwise sit untouched.
Since the law was passed, governors in all states and territories have nominated areas to qualify from among their poorest census tracts. The Treasury Department has certified the list of 8,700 approved Opportunity Zones and is now working with the IRS to solicit public comment and approve the more detailed rules on how to claim the tax benefits.
These are the details where the devil awaits.
The zones themselves are very troubled places indeed. They average poverty rates of nearly 29% and median family incomes of 59% compared to their broader regions; life expectancy is four years shorter; an extra 10% of the adult population is jobless and the housing stock is 10 years older than the average.
Administration officials and potential investors alike acknowledge the risk of abuse and fraud. One of the last times the government tried to create incentives for investment followed the financial crisis, and the government lost some $500 million in a solar-panel company called Solyndra.
Presumably, any losses here will be absorbed by private investors, but there is naturally scope for abuse by those who reap a large tax benefit without contributing to lasting economic development.
Among the persistent concerns is how investors will engage with fragile and depressed communities to secure local support for new projects. Will local residents really benefit from these investments? Will real estate deals, in particular, lead to gentrification that ultimately displaces current residents, rather than creating new opportunities and better jobs? Will it generate new investments that would have already been made without the tax incentives? (Eyebrows have been raised about the designation of parts of Long Island City where Amazon was going to place its second headquarters.)
For investors, one concern is that the deadlines are tight, while good projects take time to design and negotiate. To get the maximum benefit, for example, investments must be made by the end of this year. This rule was partly meant to spur quick action, but it is also due to federal budget rules. A longer commitment to the tax benefits would have required more revenues or less spending elsewhere.
Details aside, this rare piece of bipartisan policy clearly deserves close attention.
From the liberal policy camp, economist Jared Bernstein remains cautious, but still supportive. “The inequality of our era means there are trillions of dollars in idle capital sitting on the sidelines over here, and communities suffering from decades of divestment over there,” he writes.
From the unreservedly capitalist world, hedge fund manager Manny Friedman is planning a $500 million Qualified Opportunity Fund and likens the potential for change to sliced bread. “People in this room don’t understand how transformational this is,” Friedman told a session at the Milken Global Conference in Los Angeles last week. “This is transformational. It will transform America.”
That seems like a slight exaggeration. Only the brave, early souls will invest in qualifying projects and there will be plenty of kinks to work out and failures to explain. By one estimate, some 88 funds have been established with targets to raise a total of $26 billion. But if there is a critical mass of funds and deals that look on track in a year’s time, more prospective investors may start lining up and the program’s deadlines will be extended.
Opportunity Zones will hardly spark a broader outbreak of cross-party cooperation, but they just may make a small contribution to more balanced economic growth and deliver solid returns to otherwise trapped capital.