How Attractive are Opportunity Zone Investments?
The Tax Cuts and Job Acts of 2017 (“TCJA”) introduced a new type of alternative investment called the opportunity zone investment. The IRS defines opportunity zones as “an economically-distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment.” (IRS) In total, more than 8,700 opportunity zones have been designated in the United States, and the law was set to economically develop these communities. While the Government is encouraging this investment by adding tax benefits for the investors, there is low attraction because of reasons that include corrupted usage of opportunity zones and uncertainties this investment faces.
The tax benefits come in three ways. The first benefit is the deferral of capital gains taxes. If an investor liquidates an asset with capital gains, the capital gains taxes does not have to be paid until the end of 2026 or when the opportunity zone investment is disposed. The second benefit is the increase in investors’ basis on the original investment. If an investor holds opportunity zone investment for more than 5 years, then the basis will increase by 10 percent. For capital gains placed in opportunity zone funds for more than 7 years, the investors’ basis increases by 15 percent. In other words, there will be less capital gains realized after these periods, and investors’ taxes decrease according to how long they held the investments. The third, and last, benefit is the permanent exclusion of taxable income on gains from opportunity zone funds. If an investment is held for more than 10 years, investors don’t have to pay any capital gain tax. To simplify what I just explained in a diagram, the tax benefits works as shown in the title image:
Following the creation of the tax incentives, Treasury Secretary Mnuchin predicted that opportunity zones would attract more than $100 billion in private capital; investors, in fact, don’t seem to be highly interested, considering that most funds have only raised less than 15% of their initial fundraising goals on average (Simon and Grant). Bearing in mind that investors get the full tax benefit if they invest before the end of 2019, the fact that funds, on average, raised less than 15% of their goals is signaling that this project could be a complete failure.
There are many reasons why investors are reluctant to invest in opportunity zones, and one of the biggest reasons is the uncertainty over the time of a long-term investment. Investors can receive the most benefit when opportunity zones are held for more than 10 years.
Moreover, while taking a lot of risk by investing in distressed communities, the investment only provides minimal return to the investors. The typical promised rate of return of this investment is 6 percent to 10 percent for funds with diversified portfolio (Ermey). However, investors, generally, are looking for 15% according to Gill Holland, a developer seeking $50 million for projects in a distressed Louisville neighborhood (Simon and Grant). Considering the amount of risk this investment is exposed to, 6% to 10% return isn’t good enough.
Loophole is another headwind that this investment faces, hindering the impact this investment gives. The designation of opportunity zones have been ineffective as some qualified opportunity zones turned out not to be low-median household income areas. For example, West Virginia Gov. Jim Justice included the area near The Greenbrier, which is a huge luxury resort that Gov. Justice owns (Soergel). Although this law was legislated initially to help poor households, the flaws in regulating opportunity zones are making solely the landowners winners.
Considering that there are many other ways to influence the society in a better way, opportunity zone investments don’t seem that attractive to investors. Although the Government initially had good heart when legislating tax benefits for opportunity zone investments, there needs to be more work done by the Government to regulate the designation of opportunity zones and educating the investors on the impact that they can give to the distressed communities. Yet, opportunity zone investments look too uncertain as of now to attract investors.
