Opportunity Zone Program turns blight sites into tax havens for asset-rich investors
The rich are getting richer in America but that prosperity is not trickling down the economic food chain, with investment capital pooling up in thriving portions of big cities.
One reason for this, experts believe, is the amount of wealth tied up in assets—real estate holdings and stock portfolios, primarily—that can’t be accessed without being subjected to hefty capital gains taxes.
Facing the prospect of losing close to a quarter of their profits to the taxman, or potentially more if depreciation is involved, the investor class has chosen to hold its assets and allow them to continue adding value.
However, a little-heralded component of the Tax Cut and Jobs Act aims to address this issue by lowering taxes on capital gains that are funneled in investments in economically depressed areas.
“If you’re a real estate investor, it looks like the greatest government program you’ve ever seen,” Frank Giantomasi, a lawyer with the law firm Chiesa, Shahinian & Giantomasi, said. “And if you’re a troubled area, you now have pools of private equity that you can go after to address your community’s needs.”
Within this program, investors will have 180 days to flip a capital gain into a Qualified Opportunity Fund. These funds must keep 90 percent of their assets in designated Opportunity Zones, areas with a poverty rate of at least 20 percent or a median income of no more than 80 percent of the area average.
Each state can nominate a quarter of its eligible low-income communities to be Opportunity Zones within the new program. Qualified areas have been identified by the U.S. Census Bureau. New York, for example, has 2,055 recognized low-income tracts so it can nominate 514 to be Opportunity Zones.
Opportunity Fund investors get the benefit of immediate deferral. If a property owner sees $200,000 profit on the sale of a building, he pays no taxes as long as the money stays in the fund. The longer he stays in the fund, the greater the potential benefit.
After five years, he sees a 10 percent basis reduction, meaning if he pulls out of the fund, he’d pay a 20 percent capital gain tax and a 3.8 percent net investment income tax on $180,000 plus the same rate on whatever the fund earns. Assuming seven percent growth either way, he leaves the opportunity fund with $218,509 instead of $213,748 if he were to have held onto the building for five more years.
Meanwhile, if a stock trader sells a portfolio for the same amount but keeps her earnings in an opportunity fund for seven years, she sees a 15 percent drop in basis. Assuming the same seven percent interest, she pockets $251,861 from the fund instead of $244,721 from the market. If either stays in an opportunity fund for 10 years, they get the 15 percent basis reduction and pay no tax on the money earned by the fund. They’d net $352,970 compared to $299,793.
“It’s an excellent government policy to redirect capital toward census tracts that have historically not had a lot of investment in them,” Sean Aylward, vice chair of Chiesa, Shahinian & Giantomasi’s corporate and securities group. “It comes at a time when the stock market is at all-time highs, when real estate is booming but also when parts of the country are hurting economically.”
Last year alone, the U.S. added $8.5 trillion worth of wealth, according to the Credit Suisse Research Institute’s Global Wealth Report 2017. The average net worth was $388,585 but the median was a mere $55,876. The pie got bigger, but the slices didn’t grow proportionately.
The Opportunity Zone Program is the brainchild of Senators Tim Scott, a South Carolina Republican, and Cory Booker, the junior Democrat from New Jersey.
Yet, while the concept is fully-self funded and appeals to the agendas of both parties — offering (geographic) wealth redistribution along with tax relief for the rich — it has received little publicity, even from conservative circles that held up the reform package as the crowning achievement of the Trump Administration’s first year.
Despite the promise of the program’s broad strokes, Stuart Saft, a partner at the law firm Holland & Knight, said the lack of finer details has suppressed enthusiasm. The IRS and Treasury Department are charged with monitoring the program and those agencies have yet to establish regulatory policies.
“The question is one of enforcement and it comes down to what impact the enforcement has on the investors,” Saft said.
“If you sold something and you’re sitting there with a large capital gain and you’re told that an investment qualifies you for tax relief and then you find out it doesn’t, what happens? If something goes wrong with the Opportunity Zone, in which you have no control, could you be hit with all your taxes right away? That’s the sticking point.”
There’s also the question of where these Opportunity Zones will be located. The deadline for nominations was March 21, but New York State was granted a 30-day extension. New Jersey, on the other hand, submitted its 169 nominees last month and it awaits confirmation.
Garden State officials selected a mix of urban and rural communities and New York is expected to follow suit, although it has significantly more eligible tracts and a wider range of issues.
“We have very different problems here than [New Jersey does], primarily because New York State is so large,” Saft said.
“You have huge areas of the Upstate area that are absolutely poverty-stricken; ever since mills and clothing manufacturing moved out of New York, they’ve never recovered. But there are also parts of New York City that could benefit from further development and even areas that are considered wealthy like Westchester, Nassau and Suffolk County.”
Although there hasn’t been much outward lobbying for these designations, Saft believes horse trading is taking place “quietly and behind the scenes.”
Also, unlike a government mandate, this program provides no guarantees to the areas selected as Opportunity Zones. That, too, is up to the free market.
If no Opportunity Fund sees a path to profitability in Flemington, a rural community in central New Jersey, then it will receive no investment.
Meanwhile, if a fund sees opportunity in a designated part of Jersey City, it could use its capital to address that community’s every need and all but guarantee a positive return.
Also, there’s no requirement for investors to keep their money local and this, too, cuts both ways.
A Manhattan mogul could flip her gains into a fund that specializes in Grand Forks, North Dakota just as easily as a Detroit prospector could funnel his earnings into South Florida.
Similar programs have been tried in the past and exist today, but none offers the same flexibility as the Opportunity Zone Program.
The Clinton Administration, for example, saw the creation of Empowerment Zones, which offered tax breaks and loan assistance in economically depressed areas, and enterprise zones have been a staple of western governments for decades.
In the U.S., though, Saft said these programs have often failed because they’ve been subject to Congress renewal, which the Opportunity Zone Program is not.
Aylward said the closest equivalent, at least in real estate, is the 1031 Exchange, which allows property sellers to avoid capital gains if they put their earnings into another real estate investment. Unlike the 1031 Exchange, however, this program includes a path to liquidity.
“It’s a cousin to a 1031, but there are some pretty significant differences and benefits that come with the Opportunity Zones Program,” Aylward said. “You have the initial deferral, the basis step and, if you hold for the full 10 years, you get to exclude any gain. So if a million-dollar investment turns into two million dollars, you get to keep the full second million.”
Giantomasi, whose firm is already working on programs to help guide investors through the Opportunity Zone Program, said there’s already a buzz among potential investors, particularly among those interested in estate planning.
Once the zones are set and funds are in place, Giantomasi predicts a rush of sales activity among investors looking to have liquid assets by December 31, 2019, when all Opportunity Fund investments must be in place to qualify for the 15 percent basis reduction. He envisions this having compounding benefits for the U.S. economy.
“It’s going to keep investment dollars in the United States because you have to invest here not somewhere in Asia,” he said.
“People will begin to liquidate assets that they would heretofore consider un-liquidatable and the incentive will not be to buy and hold but to invest and develop.”