The economic divide in large cities continues to expand. Despite a financial resurgence following the 2007-2009 recession, the system wasn’t fixing itself. Enter Qualified Opportunity Zones (QOZ), a program included in the Tax Cuts and Jobs Act of 2017 designed to boost development in economically distressed communities. In exchange for new investments in these communities, investors receive preferential tax treatment.
As traditional as it sounds, the QOZ program is far from a typical community development tool. It’s a way to tap into investment capital from within. Historically, community development efforts have relied on massive, externally driven government programs. With QOZs, communities can tap into investors who are willing to rebuild the connective tissue of their own cities.
What’s the incentive for these investors? Investors can place existing capital gains into vehicles called opportunity funds, which push investment dollars into the distressed areas. By investing in QOZs, several benefits can be realized, including:
- Deferral of gain recognition until the earlier of Dec. 31, 2026, or sale of investment
- Exclusion of 10% or 15% of the gain if the investment is held for five or seven years, respectively
- One hundred percent gain exclusion for investments held at least 10 years
While the advantages of investing in QOZs are clear, there is also a clear catch. To qualify for participation, investors and corporations must have capital gain. Further, because recognition of capital gain can be deferred until 2026, investors are subject to an uncertain – and potentially fluctuating – tax rate. For example, the top capital gain tax rate is currently 20%. If that changes to 30% in the year of recognition, that is the rate investors will pay.
Currently, fund managers are the primary drivers of the initiative. QOZ fund managers must raise capital from high-net-worth investors, execute real estate and development and investment – and do so in second-tier markets, some of which are economically distressed – manage the investments like a private equity fund, and adhere to the strict rules of the program. Investors and developers are also very active in the market.
The implementation of QOZs is leading to the formation of a new industry asset class that focuses on a place-based value of investing. Investors are able to make long-term bets on locations most people aren’t recognizing as growth opportunities. Yet, when growth occurs, the gains can be tax free.
One of the key challenges to the program is identifying viable projects to undertake within an Opportunity Zone. The identification process needs to be very intentional and focused on the right partnerships; it needs to ensure investors get what they want out of the program while also benefiting the targeted communities.
Investors must also be willing to accept a certain level of risk. Because initial – and even subsequent – IRS regulations weren’t completely clear, deals are structured based on where statutes are expected to go. But for high-net-worth investors with capital gains looking to capitalize on the new legislation while simultaneously improving communities, the program has substantial upside.