Incentives Watch: States Partner with Feds to ‘Zone-In’ on Opportunities

Despite a strong economy and the lowest unemployment in decades, many areas of the country continue to experience poverty and joblessness. Construction and investment booms in cities as centers of economic growth and development, while small towns in rural areas struggle to attract new businesses and development. Enterprise zones are the government’s answer to this issue: incentivizing investments in designated low-income areas. Tax incentives offer a carrot to developers and investment funds that might otherwise build yet another urban high-rise. The 2017 federal tax act’s passage introduced a new federal “opportunity zone” program, partnering with states to designate areas of the country in most need of investment. Although rules governing the program are still in development, states and businesses alike have shown greater than expected interest in the program, which could become an important economic driver for struggling communities for the next decade. 

Much Ado about Something?

The new program, codified in I.R.C. §§ 1400Z-1 and 2, allows states, the District of Columbia, and U.S. possessions to designate low-income areas as opportunity zones. Population census tracts in which the poverty rate is at least 20 percent, in which the median family income does not exceed 80 percent of the statewide median family income, and certain contiguous tracts are eligible. By June 14, 8,762 census tracts had been designated, with California leading the charge by designating almost 900 areas within the state as low-income or contiguous to a low-income area. 

Investment in an opportunity zone allows the temporary or possibly permanent deferral of capital gains taxes and a step up in basis. First, an opportunity zone fund is established to receive opportunity zone investments, and must itself invest at least 90 percent of available funds in qualified opportunity zones. Gain from the sale of property which is then invested in an opportunity zone fund within 180 days is deferred for 10 years or until the fund investment is sold. A step up in basis is available for opportunity zone fund investments held for five and seven years, incentivizing stability in the amount of capital available for the fund to invest. Investors that hold an interest in an opportunity zone fund for over ten years may exclude the gain in the interest’s value but must pay the previously deferred capital gains tax no later than Dec. 31, 2026. 

Pure, Unadulterated Enthusiasm

The new program, along with the potential tax benefits, has the investment world buzzing. More than $2 trillion in capital gains are currently sitting idle to avoid the capital gains tax, and opportunity zone funds could see a significant percentage of that value, according to DRIFund, an investment manager. Sen. Tim Scott (R-S.C.), the leading force behind inclusion of the program in the tax bill, has stated he expects up to $100 billion to be funneled into low-income areas, as reported by the Daily Tax Report’s Siri Bulusu. Investors may see it as win-win: the money goes to the areas that need it most, while receiving significant tax advantages. In response to investor enthusiasm, the Joint Committee on Taxation increased the estimated revenue cost of the program from $7.7 billion to $9.4 billion, a good sign that the program will be a popular one. 

States: Been There, Done That

States are no strangers to the incentive, partnering with the federal government to provide low-income housing credits and offering their own enterprise zone credits. Since 2000, New York has offered a version of the federal low-income housing credit; the state borrowed many provisions of the federal program and worked with the federal government to develop the state incentive. Additionally, Pennsylvania currently oversees a large enterprise zone program, offering a mix of tax credits, exemptions, and deductions to spur economic growth. Although the federal program offers a mere exemption and basis step-up, states should be well positioned to know what areas need the most help and direct investor funds to achieve the greatest impact. 

Critics Harshing Investors’ Mellow

Despite the excitement surrounding the program, critics have raised concerns about how the funds will be spent and who will benefit. The broad language of the statute allows for savvy investors to skirt the rules and use tax breaks with no benefit flowing to the community. Brett Theodos, a senior researcher at the Urban institute, suggested that Amazon could turn the fund into “an investment vehicle for HQ2,” as reported by Bloomberg Businessweek’s Noah Buhayar. The key to the program’s success is in the regulations currently being drafted by the Internal Revenue Service. Regulations must thread the needle between ensuring the money goes to the right place, but also limit complexity that has doomed other low-income investment programs in the past. Regulations for the opportunity zone program are expected to be released by the end of October.  

Only with the benefit of hindsight can policy makers and communities evaluate the success or failure of the program. Enthusiasm for previous low-income investment programs petered out when incentives were not strong enough or qualifications were too complex. Close supervision of the operation of the program and communication with its participants will be necessary for the result its creators envisioned.