Last Friday, the IRS published its first set of proposed regulations for Opportunity Zones, a provision of the Tax Cuts and Jobs Act (TCJA), that created an attractive set of tax incentives intended to encourage investments in economically-distressed communities.
Earlier this year, Treasury approved roughly 8700 economically-diverse Zones, covering 12 percent of all census tracts in the US. Now IRS has expanded the tax advantages for Opportunity Zones even more, potentially magnifying their cost. The guidance is favorable to investors, giving them flexibility and certainty without requiring them to document or demonstrate the value of their tax-subsidized deals. But the jury is still out on the social benefits of these investments.
The tax incentive works like this: Suppose you just made a $500,000 profit in the stock market. You invest these capital gains in an opportunity fund which, in turn, invests in property in a Zone. The statute permits you to delay the capital gains tax on your $500,000 until the end of 2026. You could also exclude 15 percent of that gain from any tax if you hold the fund investment for 7 years. And you can completely exclude the gain on any further appreciation of your investment if you hold the fund for 10 years.
The IRS now offers much more flexibility. The IRS would allow the funds to take up to 31 months to invest in Zones. But investors could defer the tax on the gains they invested in these funds immediately—and could start the clock running to receive further tax benefits. The IRS would also permit investors to continue to claim tax benefits from the program until 2048, even though the TCJA sunsets the Opportunity Zone designations in 2028.
The IRS also said that Opportunity Funds could make qualifying investments in a business where a minimum of 70 percent of its assets (“tangible property”) is in the Zone—meaning that 30 percent could be held elsewhere. This flexibility would make it easier to invest in operating businesses. But it would also mean that more dollars will leak to more affluent communities and residents where a share of the business’s assets may be located.
And, significantly, the IRS guidance would also expand a TCJA provision that required investors to spend at least as much to improve property as they paid for it. The proposed regulation only applies this requirement to buildings and not to underlying land value. This would considerably expand opportunities for real estate investors.
As a result, the proposed regulations would further open the door to both meaningful and marginal investments. A fund, for example, could use your money to rehab a block of abandoned homes into sound, affordable housing. If so, the fund won’t need to include the land costs to determine whether its investment meets the percentage requirements for property improvements. And the community could benefit significantly.
Or the fund could use your money to buy a parking lot. Merely repairing the parking attendant’s shed, under the regulations as currently proposed, would meet the test for substantially improving the property. You and your fellow investors get a sizable tax break from the federal government. But what has the local community or its residents gained from the federal largesse?
What would the proposed regulations mean for the designated communities? We expect that many —though not all—would see greater levels of investment thanks to these favorable terms. Yet neither the statute nor the guidance ensure that the investments will benefit low- and moderate-income residents of these communities.
The investment flexibility makes it very difficult to evaluate the success of Opportunity Zones? Congress and the IRS did little to curb the program’s cost. Congress projected it would cost a net $1.6 billion over 10 years, largely because it assumed the gains that were deferred in the early years of the program would be recognized by 2026 (as required by the law). Maybe lawmakers expected the program’s costs to end by 2028—or perhaps they were playing games with the 10-year budget window. Either way, the generous rules in the proposed regulations would likely add substantially to the incentive’s long-run cost.
And what of the targeted communities? We’ll never know without proper recordkeeping. The next round of IRS regulations and tax forms is expected to detail those reporting requirements. It will be vital that this disclosure provide the public with the answers to a series of basic questions: Who is investing in Opportunity Zones? How much is being invested? How is the money being used?
The IRS’ proposed guidance would give investors broad flexibility in how they use their tax-subsidized dollars. But there is a serious risk that Opportunity Zones will foster a lot of investor interest, without substantially benefiting the communities. Only robust reporting will tell us whether this increasingly generous tax program is achieving its stated ends of drawing new capital into economically struggling communities and improving the lives of their residents.
The author would like to thank his colleagues, Brett Theodos and Brady Meixell, for their substantial contributions to this blog.
