June 21, 2018 - Article
For a wide range of underserved and emerging neighborhoods across the United States, one of the least debated provisions of the Tax Cuts and Jobs Act of 2017 may just prove amongst the most transformative. With a goal of encouraging private capital investment in low-income communities, the Opportunity Zone program included in last winter’s tax reform package confers highly preferential tax treatment on investments in neighborhoods nominated by the States and then designated by the Treasury Department. These census tract-level neighborhoods are the program’s eponymous Opportunity Zones (or O-Zones) and the prospective beneficiaries of billions of dollars of growth-oriented investment.
The favorable tax treatment of O-Zone investments1 does not apply to all capital deployed in these designated neighborhoods, nor does it come without its own stipulations. While a number of salient features of the program await clarification, the scale of the program is nonetheless unambiguous: through Qualified Opportunity Funds, a broad range of capital gains can be carried forward and deployed in real estate or businesses located within Opportunity Zones. With approximately $2.3 trillion of unrealized capital gains in the United States, the Joint Committee on Taxation expects the program will generate $7.7 billion in deferred taxes over the next five years.
In its first round of O-Zone designations, the Treasury Department approved nominations by 18 states, including Arizona, California, Georgia, and Michigan. The diverse makeup of the O-Zones—both in terms of geography and underlying economics—is critical to the evaluation of the investment opportunity. According to analysis by the Brookings Institution, more than 20 percent of these neighborhoods have relatively low poverty rates; nearly 20 percent are classified as already-gentrifying. In California, for example, the median home value in designated neighborhoods is over $250,000. The potential for a diversified portfolio of O-Zone investments crossing a range of neighborhoods at different stages of development mitigates risks associated with a speculative investment strategy focused exclusively on distressed neighborhoods.
As described by the Joint Committee on Taxation in the Estimates of Federal Tax Expenditures, “the inclusion in gross income of capital gains reinvested in a qualified opportunity fund may be temporarily deferred and 15 percent of capital gains reinvested may be excluded if the investment is held for seven years. Capital gains from the sale or exchange of an investment in the qualified opportunity fund held for at least 10 years are excluded from gross income.” While a detailed review of the tax treatment of investments in opportunity zones is outside the scope of this brief, the Internal Revenue Service has developed answers to some common questions.