Misconceptions abound about the how, why and who of Opportunity Zones.
As we noted in our previous article, “How EDOs can use Opportunity Zones to Promote Economic Development”, the Tax Cuts and Jobs Act of 2017 provides substantial incentives to invest in property in low-income communities designated as Opportunity Zones (OZs). There have been a number of misconceptions about this program, how it works, who will benefit, where the deals will come from and what the projects will look like. We attempt to set the record straight here.
Myth #1: Investors can use the Opportunity Zones benefits to invest new equity into your community’s startups and small companies.
Alas, as much as we would all want this to be the case, the OZ program will only rarely work for this purpose. Yes, Qualified Opportunity Funds (QOF) can invest in Qualified Opportunity Zone Businesses (QOZB) by purchasing stock or a partnership interest in exchange for cash. However, to be deemed a QOZB, that business must meet the test that substantially all of its assets (70%) must be Qualified Opportunity Zone Business Property (QOZBP). QOZBP, critically, is defined as property that results from a new construction project or a substantial renovation of an existing building. So, an investor would only get OZ benefits if the investor’s QOF invested in a business just about to undertake a real estate project (or buy a substantial new piece of equipment that would represent 70% of its total tangible assets). This does, of course, occur, but most startups and small businesses are not necessarily looking at big real estate deals in the short term. A second barrier to investing in startups is that QOZBs must generate at least half of their gross income from within the OZ itself. Your typical high-growth startup company (think IT, Biotech, FinTech, etc.) sells nationally or globally, not just within the OZ. Those venture-type deals would be disqualified due to this gross income provision.
Myth #2: Banks will be big players in the Opportunity Zones.
To take advantage of the OZ benefits, an investor must have existing capital gains to defer via the OZ program. As noted in an article by Catalina Vielma at Boston Financial Investment Management: “The vast majority of institutional banks do not generate capital gains because they are not permitted to own equity investments.” Instead, as noted by Ms. Vielma and many others, OZ investors are much more likely to be wealthy individuals, family offices, actively managed investment funds or insurance companies, all of whom regularly realize significant capital gains.
Myth #3: Developers will use OZs to reinvest their capital gains.
This will happen, but the advantages for a developer to roll capital gains into an OZ project are less compelling than for the wealthy investors/investment funds that have capital gains from other investments, such as a gain from the sale of stocks. Developers already have a mechanism to defer capital gains from a real estate sale via a 1031 exchange for property of like-kind. Furthermore, most real estate is held by a developer for over a year and would therefore incur the long-term capital gains rate of 23.8% versus the short-term capital gains rate of 40.8% for, say, the sale of stocks held for less than 12 months. So, a hedge fund facing a 40.8% haircut on their gain would have almost double the tax value of deferral/reduction than a long-term gain realized by a developer.
Myth #4: The OZ is all about rural areas.
If you look at a map of all opportunity zones, the vast majority of acreage designated as an OZ is located in sparsely populated areas. This is largely a result of the fact that sparsely-populated census tracts are very large and therefore represent a disproportionate amount of the acreage so designated. Rather than rural areas being the main target, many commentators believe that most of the big OZ deals will happen in urban census tracts. For example, FundRise has noted its “Top Ten” Opportunity Zones based on its view of their growth potential independent of the OZ program. Not surprisingly, they are located in high growth areas of metropolitan markets that have strong fundamentals. This is not meant to discourage EDOs that serve rural areas --- the OZ program will indeed be of assistance, but your EDO will have to be highly proactive in cultivating the good real estate projects that need the sweetener of the OZ benefits to get them across the finish line. This is because investors first look for strong fundamentals before thinking about incentives, and OZ benefits will not make a bad project a good one. If you can show a strong project and can bring OZ benefits to bear, you will maximize the potential for success.
More Opportunity Zone Resources
Myth #5: The New Market Tax Credits program is a good match for Opportunity Zones.
Probably not. This is confusing because census tracts were designated using the same methodology used to designate a NMTC-eligible census tract, and both are intended to direct investment to low-income communities. However, the programs are, to some extent, mutually exclusive. This is because most (but not all) NMTC funds come in to a deal as debt, whereas debt instruments are not eligible investments for the purposes of the OZ benefits.
Myth #6: The OZ program is only about commercial and industrial property.
In fact, many of the real estate deals done through the OZ program are likely to be focused on rental housing projects, which are allowed under the program. See our companion article on this topic.
Myth #7: Amazon chose Long Island City in Queens, NY because it is in an Opportunity Zone.
Very unlikely. New York City and Washington DC have the largest pool of talent that Amazon needs outside of Seattle. Amazon probably does not have anywhere near enough realized capital gains to even use the OZ program in relation to the overall dollar value of the investment. Jeff Bezos, on the other hand, could sell some of his stock in Amazon, buy up some buildings, and get a nice tax break.
 Tangible personal property that is newly acquired could also count as QOZBP if it is used predominately in the OZ.
 Of course, there are other benefits to the OZ program beyond simply the deferral of capital gains tax.