Opportunity zones: vital community development tool or tax windfall for the rich?

Habitat for Humanity is planning an experiment in redevelopment without displacement. The nonprofit, known for helping low-income people achieve homeownership, aims to transform a 120-acre, 341-unit mobile home park in Charlottesville, Virginia, into city within a city, complete with single-family homes, townhouses, retail space, and more.

Habitat for Humanity bought the land in 2007 and has already spent $20 million to stabilize operations at the park, where raw sewage flowed from the ground and hot-wired trailers burst into flames. Residents of the park, who own their mobile homes but not the land beneath them, are designing the project so it meets their needs. The plan is for ownership of the new homes to eventually fall to the residents who already live there.

But a project of this scale and ambition requires an infusion of capital that’s hard to get from public funding or grants, so Habitat is one of a number of organizations hoping to take advantage of a little-noticed provision in last year’s tax bill—opportunity zones.

Spearheaded by Sean Parker of Napster and Facebook fame, the “Opportunity Zone” program gives a (potentially large) tax break to people who invest capital gains—profit they earn from the sale of assets—in distressed areas of the country. Other than exclusions on a few so-called “sin” businesses, like bars, massage parlors, and tobacco shops, the funds can then be invested in almost anything—like real estate, startups, or infrastructure.

“We think [the park] is a great opportunity for people to ... really move the needle in terms of affordable housing, and also create a national model for how to [develop] without gentrifying [a place],” said Dan Rosensweig, CEO of Habitat for Humanity of Greater Charlottesville. “[Opportunity zones are] kind of a natural fit. We would have to attract significant investment one way or another, and we think this has a lot of potential.”

The opportunity zones program seeks to direct capital to underserved areas of the country, ones in need of an influx of money to jump-start their economies. It lets investors defer their capital gains taxes—and, if requirements are met, forgo them entirely—if they invest their gains in specific areas designated by governors as opportunity zones.

Advocates for the program call it a potentially game-changing community development tool that can direct investment to areas of the country that didn’t benefit from the post-financial crisis recovery. But some policy analysts call it a loophole-riddled windfall for the ultra-rich that won’t lead to additional development but just make developments already in progress that much more profitable for investors.

“Good-faith people can look at the same fact and one can describe it as a feature and the other can describe it as a bug,” said John Lettieri, a cofounder of the Economic Innovation Group, a think tank Parker launched to advocate for the policy.

Whether opportunity zones end up being a successful community development tool likely depends on the projects investors choose, and early signs suggest the anything-goes nature of the program will likely serve as both a feature and a bug.

“You’ll see some [projects] getting a tax benefit that were already going to be developed,” said Brady Meixell, a researcher with the Urban Institute. “I think that’s to be expected. The question becomes what are the investments that were borderline or weren’t going to happen that you see being invested in as a result [of the opportunity zone program].”

How opportunity zones work

Say you invest in some sort of asset—a stock, a business, a parcel of land, a house, or even a piece of art—and then sell that asset for a profit. That profit is what’s known as a capital gain, and those gains are subject to taxation at rates relative to your ordinary income; the more money you make, the higher the capital gains tax rate.

Most people don’t make enough money or have gains large enough to end up with a huge capital gains tax bill. But if you were, say, an early investor in Facebook, served as its first president, and held the third-highest stake in the company when it filed for an IPO, you’d be subject to heavy capital gains taxes when you sold that stake. For Silicon Valley angel investors, capital gains taxes are the biggest tax they face on their investments.

Had the opportunity zones program existed at the time you sold your huge stake in Facebook, you’d have 180 days to invest the capital gains in a “Qualified Opportunity Fund,” which would in turn direct money into distressed opportunity zones.

Investing capital gains in an opportunity fund lets you defer taxes on those gains until you pull your money from the fund. You also get a tax break based on how long you keep the gains in the opportunity fund. After 5 years, the amount of your initial investment that’s taxable drops by 10 percent, so if you put $100 in capital gains in an opportunity fund for 5 years, only $90 would be subject to capital gains taxation. After 7 years, you get an additional 5 percent drop in the taxable basis.

If you keep your gains in the fund for 10 years, any gain made on whatever the opportunity fund invests in is not taxable at all. So if you invest $1 million in capital gains in an opportunity fund, and the opportunity fund uses that $1 million to invest in a real estate development that quadruples your initial investment to $4 million, the $3 million you made on the investment in the fund wouldn’t be taxable at all, and only 85 percent of your initial $1 million would be taxable.

“The whole deal about not paying taxes on gains in the fund is crazy good,” said Derek Uldricks, president of Virtua Capital Management, a real estate private equity firm that plans to launch opportunity funds to invest in hotels, apartment complexes, and single-family rental homes. “We’ve never seen anything like this before. That’s a really massive incentive for an investor to come in. It’s probably the biggest one.”

Opportunity zones are census tracts designated by the governor of each state. There are two ways for a census tract to qualify. One way is to have a poverty rate higher than 20 percent. The other is for the median family income in the tract to be less than 80 percent of the state or the surrounding metropolitan area

Of the more than 74,000 census tracts in the United States, Puerto Rico, and other U.S. territories, 56 percent qualified as potential opportunity zones. Of the eligible census tracts, state governors were allowed to designate a quarter of them opportunity zones. Five percent of that 25 percent could be areas contiguous to an eligible tract.

Governors made their selections in the spring, and there are roughly 8,700 census tracts now designed as opportunity zones. The law provided no clear guidance for governors on which tracts to choose, and neither the law nor governors provided much transparency in how and why they selected the zones they did.

Governor selections are key to ensuring that investments go toward distressed areas. And because such a wide range of census tracts are eligible, there are varying levels of “distress” and need for investment among them. Two think tanks, the Urban Institute and the Brookings Institute, looked at the state-by-state results to see if the tracts selected had higher levels of distress than those that didn’t.

The Urban Institute’s study concluded that capital investments in “actual Opportunity Zone designations indicate only minimal targeting of the program toward disadvantaged communities with lesser access to capital relative to all eligible tracts.” The Brookings Institute noted that more than a quarter of selections were either “not poor, were college campuses, or were areas where no one lived,” with Mississippi, Idaho, and South Dakota being among the worst offenders, although not every state had submitted their selections at the time of the study.

“A fraternity house looks like a bunch of poor people in a neighborhood,” said Adam Looney, a senior fellow at the Brookings Institute. “A lot of states picked college campuses that really should not have been eligible but for the fact that 99 percent of the people are students. [Students] appear as poor in the data because they’re in school and they don’t have jobs and they live off campus.”

How opportunity zones will work

Arizona governor Doug Ducey took a bottom-up approach to selecting opportunity zones: He asked cities and counties to submit nominations among the tracts eligible within their boundaries, and then made selections from among those nominations.

In Avondale, Arizona, a city of 85,000 about 12 miles west of downtown Phoenix, Ducey selected three of eight eligible opportunity zones, including a northeastern portion of the city that is home to a budding medical corridor. The tract has a 27 percent poverty rate, a 43 percent child poverty rate, and is 72 percent white.

Virtua Capital owns land in this tract and plans to deploy opportunity fund investments to it for a 60-acre mixed-use development that will contain retail, residential, and hospitality. Virtua’s Uldricks told the Wall Street Journal that the firm would have pursued three of its projects in Arizona even without the opportunity zones program.

“It’s in a good, high-growth area where our health-tech corridor is being developed, so we’re already seeing some good growth there,” said Daniel Davis, economic development director for the city of Avondale. “[Virtua is] well positioned with their greenfield site to take advantage of that as well.”

Early projects that take advantage of the program will likely define how it’s used going forward. Although most financial institutions and investors are still in the exploratory phase, some early signs of what will happen are emerging.

Observers believe there will be something of a hoarding effect in how capital is invested in opportunity funds. Because investors will only see returns if their funds invest in projects that become profitable, their capital will likely go to areas where investors believe they can maximize their returns. Funds, in turn, are likely to invest in projects with a high potential for profitability.

For investors to get the best returns, they’ll have to leave their money in the fund for at least 10 years so that any gain made on the fund’s investments aren’t taxable. Such a long time frame favors projects where investors need to be patient anyway. It’s still unclear if opportunity funds will take advantage of the freedom the program affords them, but observers believe the program’s benefits favor real estate investments.

“It’s kind of the Wild West, but what’s more developed however is the real estate side,” Uldricks said. “It’s less opaque to invest in the real estate assets. I think you’re going to see a lot of investors go that way.”

If real estate is the path most opportunity funds follow, there will be a huge capital infusion into the real estate markets in a few areas where there is already growth, as growing markets ensure the underlying value of the property will rise enough to make the long-term investment worthwhile. This recipe can often lead to rising property values and rents, and ultimately the displacement of residents whose incomes don’t rise along with it.

In this worst-case scenario, the opportunity zone program will hurt the very residents the program’s advocates say they’re trying to help. Critics say the program could easily have included a few safeguards to ensure that similarly predictable negative impacts could be avoided, such as weeding out college campuses and limiting designated zones to only severely distressed areas. But it didn’t.

To be clear, there’s no doubt nonprofits and other community development organizations will attempt to wield the program for its intended purpose of pulling residents in distressed areas out of poverty, as Habitat for Humanity’s interest suggests; and some will no doubt succeed.

The challenge they’ll have is attracting capital for their opportunity funds from wealthy individuals and institutions with capital gains when the competition for those capital gains is private equity firms that have experience deploying funds into highly profitable real estate projects.

The Economic Innovation Group estimates that unrealized capital gains—or capital gains on assets that haven’t been sold yet—totaled $6.1 trillion at the end of 2017. The group believes that if even a fraction of that amount finds its way into opportunity funds, it could dramatically transform areas in need of change, but whether that potential is realized depends on who is able to wield the program and for what.

The program is being run out of the United States Department of Treasury, and those looking to launch opportunity funds or invest in them are waiting for final guidance from Treasury and the IRS, which is expected by the end of the year. After that, opportunity funds will likely launch in 2019, with projects in designated opportunity zones to follow.

For this to be truly successful, places have to do a lot more than just designate the zones,” Lettieri said. “They have to build a local strategy that addresses a broader set of challenges and issues than just equity capital alone.”