How Opportunity Zones May Help Affordable Housing Development
The Tax Cut and Jobs Act of 2017 passed late last year includes a provision to allow states to designate “Opportunity Zones” in low-income areas. Investors who develop real estate or fund businesses in these zones are eligible for tax breaks. Governors have been working with mayors, county officials, and local leaders over the past few months to submit proposed zones to the U.S. Treasury Department.
April 20 was the final deadline for submitting nominations. Thus far, Treasury has approved Opportunity Zones in 20 states and four territories, and is still reviewing nominations submitted closer to the April 20 deadline. If a governor didn’t submit Opportunity Zone nominations by April 20, the communities in that state won’t be eligible to receive investment with these tax benefits over the coming decade. Treasury has 30 days to approve the remaining nominations, unless it requests an additional 30 days.
The first step of implementing the legislation was for governors to designate which census tracts will be classified as Opportunity Zones until the expiration of the tax payment deferment at the end of 2026. According to the legislation, the governor of each state and territory can designate up to 25 percent of qualifying low-income community census tracts as Opportunity Zones (or up to 25 census tracts if the state or territory has fewer than 100 census tracts). The legislation’s definition of “low-income census tract” is the same as the definition used for the CDFI Fund’s New Markets Tax Credit (NMTC) program:
- Poverty rate greater than or equal to 20 percent; and
- Median family income no greater than 80 percent of the area median income.
Additionally, the legislation allows governors to include non-low-income census tracts (up to 20 percent of Opportunity Zone census tracts) if they meet the following criteria:
- Census tract is adjacent to a low-income census tract; and
- Median family income is not greater than 125 percent of the area median income.
Incentives for Investment
The provision’s backers hope the tax breaks will create jobs, boost local economies, and develop affordable housing in parts of the country that badly need it. One of the provisions of the program is to allow investors to defer paying capital gains taxes if they sell appreciated investments and roll the money into funds that target distressed communities. This would entice Americans to put some of their roughly $6 trillion in unrealized investment gains toward areas that need it.
Another incentive, in addition to the tax deferral, deals with capital gains on any appreciation. If people keep an investment in an Opportunity Fund for at least a decade, they pay no capital gains on any appreciation. There are smaller breaks if investors sell after five or seven years. The goal is to attract long-term capital and prevent investors from using this as a quick way to avoid paying taxes.
Which types of investors end up using the benefit will depend on guidelines the Treasury Department will issue in the coming months. The law defines “Opportunity Funds” as “a corporation or a partnership” that keeps at least 90 percent of its assets in investments in Opportunity Zones. Funds are permitted to hold everything from company stock to real estate, as long as it’s “substantially” improved.
Opportunity Zones and Federal Tax Incentive Programs
While there are existing federal incentives and programs meant to attract private investment in low-income communities through the tax code, Opportunity Zones differ from these programs because they aren’t limited by annual Congressional approval or tax credit allocation authority.
New Market Tax Credits. The NMTC program within the U.S. Department of the Treasury’s Community Development Financial Institutions (CDFI) Fund uses federal tax credits to attract investment in low-income communities. The NMTC program attracts private sector investment capital to underserved markets by permitting individual and corporate investors to receive a credit against their federal income taxes in exchange for equity investments in specialized financial institutions called Community Development Entities (CDEs). These CDEs, in turn, make flexible debt or equity investments in for-profit or non-profit operating businesses and real estate projects in low-income communities.
Although both NMTCs and Opportunity Funds lower the tax bills of participating investors, the potential for diverse and large-scale investor participation in Opportunity Zones is much greater because there’s no need for annual Congressional approval or allocation of limited tax credits. The NMTC program requires annual Congressional appropriation of tax credit authority, and is run by CDFI Fund staff who approve allocation of tax credits to applicant CDEs through a competitive annual award process. The CDEs that receive NMTC allocations then distribute these to investors in exchange for equity investments in CDEs, and the investors claim a tax credit worth 39 percent of the equity investment over seven years.
Low Income Housing Tax Credits. Rather than a federal agency, as with NMTCs, state housing credit agencies in each state distribute an allocation of federal LIHTCs (which is based on the state’s population) to developers of affordable housing. These developers can then claim tax credits over a 10-year period.
In contrast, the Opportunity Zone legislation doesn’t set up a new program run by the U.S. Treasury or another agency, although Opportunity Funds must be certified by the U.S. Treasury. The Opportunity Zone program is described as a new IRS rule, which changes the tax treatment of capital gains invested in Opportunity Funds.
However, because the U.S. Treasury hasn’t published the corresponding rules mandated by the Tax Cuts and Jobs Act, it’s unclear how much oversight investments in Opportunity Zones will have from specific federal agencies. Since the legislation allows for any taxable capital gains to be invested in qualifying Opportunity Funds and receive the tax benefits, the Opportunity Zones could result in anywhere from none or all of the current estimated $2 to $3 trillion dollars in capital gains currently in the U.S. market invested in these designated low-income communities. This is in contrast to the fixed and limited amount of investment allowed by NMTCs or LIHTCs each year.
Benefits for LIHTC Investments
All rental real estate, including residential real estate, located in Opportunity Zones appears to be eligible to be a qualified Opportunity Zone property as long as the real estate is newly constructed, or acquired after Dec. 31, 2017, and substantially improved, and meets the active conduct standard provided in the law. Qualified Opportunity Zone businesses must meet the following requirements:
- Substantially all of their tangible property owned or leased must be qualified Opportunity Zone business property, which is defined as: (1) property acquired by purchase (not exchanged) after Dec. 31, 2017; (2) property whose original use in the Opportunity Zone commences with the qualified Opportunity Zone business or is substantially improved over a 30-month period; and (3) property that’s substantially used (e.g., available to be leased) during substantially all of the qualified Opportunity Zone business’ holding period in the Opportunity Zone;
- Fifty percent of their income must be derived from active conduct, and a substantial portion of their intangible property must be used in such active conduct;
- Less than 5 percent of their unadjusted basis of property is nonqualified financial property; and
- They are not “sin” businesses as defined by the private activity bond (and NMTC) statute.
Many groups are beginning to study how the Opportunity Zone program might be used by developers, especially in conjunction with the LIHTC program. Depending on the final rules published by the U.S. Treasury, Opportunity Funds could potentially attract equity investments by leveraging the qualified Opportunity Fund investment with other debt, including from other government-guaranteed or subsidized lending programs.
According to some industry estimates, for new LIHTC investments located in Opportunity Zones, the program is likely to significantly increase yields for equity investors. This extra yield should have a significant effect on the prices that investors in opportunity funds are willing to pay for LIHTCs. However, these tax benefits are not expected to totally offset the damage that the LIHTC program has suffered over the last year as Congress considered and passed its comprehensive reform of the U.S. tax code. Lower taxes for corporations have lessened the need for tax benefits like LIHTCs, and prices have fallen as a result.