White Paper on Opportunity Zones

Transcription

1 White Paper on Opportunity Zones SEPTEMBER 2018 Prepared by: Aaron Deitz, PORTFOLIO MANAGER Elias Bachmann, DIRECTOR OF PRIVATE INVESTMENTS & PORTFOLIO MANAGER

2 Report Overview Here at BSW, we proactively research topics that may impact our clients. Opportunity Zones have the potential to provide a large impact for many investors. This report will provide an overview of Opportunity Zones, Qualified Opportunity Funds, the genesis behind the idea and the Tax Cuts and Jobs Act of Then we will discuss an example of a hypothetical investment along with the values and risks associated with investing in Qualified Opportunity Funds. Lastly, we will discuss potential issues, due diligence and any outstanding questions related to Opportunity Zones. There is great investment and other financial potential with Opportunity Zones and this research report intends to synthetize all the data needed to understand what they are and why they may be a consideration for investors. Opportunity Zone Definition An Opportunity Zone is generally an economically-distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment. Opportunity Zones are an economic development tool that is, they are designed to spur economic development and job creation in distressed communities. 1 Governors in each state selected Opportunity Zones from an eligible group of low-income census tracts. Selections would have been made by the end of April This differs from the New Markets Tax Credit (NMTC) Program by giving the Chief Executive in each state the ability to choose up to 25% of their census tracts to be eligible. Up to 5% of each state s Opportunity Zone census tracts may be non-qualifying tracts contiguous with qualifying tracts if the median income in those tracts is less than 125% of area median income. 2 Whereas the NMTC program allows investors to invest in Community Development Entities (CDEs) which make loans and/or investments into businesses in low-income communities

3 Qualified Opportunity Funds A Qualified Opportunity Fund is an investment vehicle that is set up as either a partnership, a corporation or a limited liability company for investing in eligible property that is located in an Opportunity Zone and that utilizes the investor s gains from a prior investment for funding the Qualified Opportunity Fund. The Fund must invest in Qualified Opportunity Zone Property. The Funds are required to invest at least 90% of their assets in designated Opportunity Zones, in real estate, local businesses and other business assets located in a Qualified Opportunity Zone, issuing stock, partnership interests or business property to their investors. The Funds themselves certify that their investments align with the law. 3 In order for the Fund to self-certify, a taxpayer will complete a form (which will be released this year) and attach it to their federal income tax return for the applicable year (IRS approval is not needed). Stock: Qualified Business Zone Stock is any stock of a domestic corporation issued solely in exchange for cash, either directly or through an underwriter. The business may be a new or existing business. If the corporation is a new corporation then it must be organized for the purpose of being a Qualified Opportunity Zone Business. If it s an existing Qualified Opportunity Zone Business, it must own or lease substantially all of its tangible property in Qualified Opportunity Zone Business Property. The business must also generate at least 50% of its total gross income from active business conduct with "a substantial portion of the intangible property of such entity used in the active conduct of any such business," and "less than 5% of the average of the aggregate unadjusted bases of the property of such entity attributable to nonqualified financial property." Lastly, the business cannot be a "private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises." 4 Partnership Interest: Similar to stock, a Qualified Business Zone Partnership Interest is any capital/profit interest of a domestic corporation acquired in exchange for cash. Same rules apply for stock and partnership interest. Business Property: Qualified Opportunity Zone Business Property is tangible property that is used in a Qualified Opportunity Zone trade or business. The property can either originate with the Fund or the Fund can substantially improve the property. Property is considered substantially improved if "during any 30-month period beginning after the date of acquisition of such property, additions to basis with respect to such property in the hands of the Qualified Opportunity Fund exceed an amount equal to the adjusted basis of such property at the beginning of such 30-month period in the hands of the Qualified Opportunity Fund." For example, if the original use of the property does not begin with the Fund and the Fund acquired the property for $75,000, then it is required to invest an additional $75,000 into the property in order for it to qualify as Qualified Opportunity Zone Business Property. Note that there is no limitation preventing the Fund from borrowing cash in order to purchase or improve the property source=kyi_

4 Investors should also be aware that there are penalties if the Fund fails to meet the 90% threshold of assets invested in Opportunity Zones. The percentage of assets is measured "on the last day of the first 6-month period of the taxable year of the Fund, and on the last day of the taxable year of the Fund." If a Fund fails to meet the 90% standard, it is subject to a penalty for each month it fails to meet the required threshold. The penalty is "(i) the amount equal to 90% of its aggregate assets, over (ii) the aggregate amount of Qualified Opportunity Zone Property held by the Fund, multiplied by the underpayment rate established under [Code] section 6621(a)(2)" for each month the Fund fails to meet the required threshold. IRC 1400Z-2(f)(1). 6 Genesis of an Idea Sean Parker, founder of Napster and an early investor in Facebook was determined to solve attracting private investments to poverty-stricken regions of the US. Working with law makers, he planted the seed to help this become part of the 2017 tax bill. The incentive needs to be powerful enough that it can unlock large amounts of capital, aggregate that capital into Funds and force the Funds to invest in distressed areas," says Sean Parker, the original Facebook president whose think tank, the Economic Innovation Group, created the policy and helped press it into law. "Instead of having government hand out pools of taxpayer dollars, you have savvy investors directing money into projects they think will succeed. 7 The goal is to unlock some of the trillions of dollars in unrealized stock market gains of U.S. investors, and make it available for investment in the real economy, where it is sorely needed for urban and rural development. 8 Opportunity Zone Tax Incentive rests on three principles; tax deferral, the potential for both discounted capital gains and tax-free capital growth. It has been noted that this is different than legislation such as the New Market Tax Credit (NMTC) which came into existence in Whereas, NMTC offers income tax credits to investors for directing capital investment towards communities in need, the Opportunity Zone legislation encourages private capital to flow to many of the same areas in exchange for tax breaks related to investment gains. Research has shown this type of tax incentive may be utilized by a much broader swath of the investing population since gains are more uniformly taxed than income. Investing in Opportunity Zones Tax Law The Tax Cuts and Jobs Act of 2017 established an Opportunity Zone tax incentive, which allows taxpayers to defer paying federal tax on capital gains from the sale of an asset if those gains are invested in Qualified Opportunity Funds. Tax Deferral: Investors who roll over capital gains (of any capital appreciated asset) into a Qualified Opportunity Fund within 180 days of sale can defer those gains until their investment in the Fund is sold or until Dec. 31, 2026, when the tax provision sunsets. (see the tax legislation, Section 1400Z Subchapter Z Opportu

5 nity Zones ). 9 There is no cap on the amount of money that can be invested in Qualified Opportunity Funds. Capital Gains Discount: The gains an investor defers may be discounted if the investor holds the Qualified Opportunity Fund investment for a minimum of five to seven years. If an investor holds the interest in a Qualified Opportunity Fund for at least five years, the cost basis of the original investment sold to invest in the Fund is stepped up by 10% of the gain deferred. This is the same as applying a 10% discount to the deferred gain. In order to earn this discount on deferred gains, the investor must invest in a Fund by December 31, 2021 (allowing for a five-year hold before the end of 2026). If an investor holds the interest in a Qualified Opportunity Fund for an additional two years (or seven years total), the cost basis of the original investment sold to make the investment in the Fund is stepped up by an additional 5% of the gain deferred. This is the same as applying a 15% discount to the deferred gain. In order to earn this discount on deferred gains, the investor must make an investment in a Fund by December 31, 2019 (allowing for a seven-year hold before the end of 2026). If investors are still holding their interest in the Qualified Opportunity Fund on Dec. 31, 2026 then, regardless of if they continue to hold the interest in the Fund, they are required to recognize and pay taxes on the deferred gain when they file taxes for that year, subject to any discounts earned. Tax-Free Capital Growth: If investors hold the interest in the Fund for at least ten years, they receive a step up in basis in the interest, so that their basis equals the fair market value of the Qualified Opportunity Fund investment when it is sold; therefore, they are not taxed on any capital appreciation related to this investment. 10 Example Opportunity Fund Investment Mary sells $250,000 of Microsoft stock on September 1, 2018 and realizes $100,000 in capital Gains. Tony Stark is a real estate developer and he creates a partnership, Stark Opportunity Fund (which self-certifies as a Qualified Opportunity Fund). On October 1, 2018 (within 180 days of the day Mary sold her stock), Mary invests the $100,000 capital gain from her sale in Microsoft into Stark Opportunity Fund. Mary may defer the capital gain on the $100,000 sale of Microsoft until the sale of the investment in Stark Opportunity Fund or December 31, 2026 when the tax provision sunsets, whichever comes first. After five years on October 2, 2023, Mary decides to sell her full investment in Stark Opportunity Fund for $400,000. Since she held the Qualified Opportunity Fund investment for over five years, she eliminates 10% in gain from her original investment. Stark Opportunity Fund sale: $400,000 Mary s capital gain on Stark Opportunity Fund: $300,000 Mary s capital gain on the sale of Microsoft: $100, source=kyi_

6 Mary s basis discount: $10,000 ($100,000 x 10%) Mary s capital gain recognized: $390,000 Mary instead continues to hold her interest in Stark Opportunity Fund until October 2, 2025 and sells her full investment for $400,000. She eliminates another 5% in gain from her original investment. This would total an elimination of 15% of the gain from her original investment due to holding the interest in the Fund for at least seven years. Investment sale: $400,000 Mary s capital gain on Stark Opportunity Fund: $300,000 Mary s capital gain on the sale of Microsoft: $100,000 Mary s basis discount: $15,000 ($100,000 x 15%) Mary s capital gain recognized: $385,000 If Mary instead continues to hold her interest in Stark Opportunity Fund until October 2, 2028, a few important things happen. First, the provision sunsets on December 31, For the 2026 tax year, Mary will owe capital gains on $85,000 for the sale of Microsoft instead of the original $100,000 due to holding the investment for over seven years. Second, assume Mary sells her interest in Stark Opportunity Fund for $500,000. The cost basis of the investment in Stark Opportunity Fund steps up to the fair market value at the time of sale, effectively eliminating any cost basis for Mary. Mary would not have to pay capital gains on $415,000 of investment gains. Investment sale: $500,000 Mary s capital gain on Stark Opportunity Fund: $0 Mary s capital gain on the sale of Microsoft: $100,000 Mary s basis discount: $15,000 ($100,000 x 15%) Mary s capital gain recognized: $85,000 If Mary fails to hold her original investment for the minimum five years, the only advantage she would receive is the deferral of capital gains she owes on the sale of Microsoft. She will have to pay the gain on the $100,000 sale of Microsoft plus any other potential gains from the sale of Stark Opportunity Fund for that tax year. Value Proposition Opportunity Zones have the potential to unleash significant capital into distressed communities. There are compelling tax incentives related to the ability to defer the payment of capital gain taxes and the possibility for a discount on these deferred gains. There are an estimated $6Trillion of unrealized gains in taxable accounts, which underscores the availability of capital to flow into Opportunity Zone investments. It is envisioned that these investments will create jobs and advance prosperity in these zones. A key point of the law requires that the Qualified Opportunity Fund make additional investments into an asset greater than

7 or equal to its original purchase basis. This means for real estate that either a heavy value-add or ground up development would be required to satisfy this condition. Such development is expected to create far more economic activity than simply buying an asset with little additional capital requirements. If an investor holds a qualifying investment in the Opportunity Zone for more than ten years, they may be eligible for a step-up in basis to the fair market value at the time of sale, effectively eliminating any realized gains. The enticement of this tax-free growth should positively impact the communities where these investments are located. This long horizon should align investors with the community for a significant hold period. For investors, the value of this tax-free growth in addition to the deferral and the discounts of original realized gains used to fund the investment can add multiple points of IRR to the annualized after-tax return of an investment. Risks of Investing Our research has shown there are risks with investing in Qualified Opportunity Funds, just as with other private investments. We have come up with a non-exhaustive list of risks that need to be considered before investing in Qualified Opportunity Funds: 1 Investors should be wary of the risk profile of Opportunity Zone deals, which could be much higher in certain targeted census tracts than the investment which was sold. Investors should take extra care to monitor the changing risk of their overall portfolio as they add potentially illiquid, private, high-risk investments in Opportunity Zones. 2 The Opportunity Zone Program is newly created, and final regulations have yet to be issued, which, when issued, may impact the Fund in unanticipated ways. 3 The Manager s intent and ability to comply with the requirements of Section 1400Z of the Code may adversely affect the timing or structure of exit from investments, the integrity of the tax benefits or the success of those investments The Fund s business is subject to all the risks associated with investing in the equity ownership of real estate and private companies. 5 The Fund may make investments which promote gentrification, which may price existing residents and workers out of these areas. For example, in Atlanta, Vine City, just adjacent to the new Falcon s Stadium, is eligible to be designated as an Opportunity Zone. However, much of the available real estate there has already been snapped up by developers waiting for Atlanta s wave of gentrification to sweep through The tax benefits associated with this legislation are compelling and may encourage too much capital to chase too few economically viable deals, thus reducing expected returns. 7 Investors may sacrifice on due diligence in order to deploy capital in compliance with the legislation s time constraints

8 Potential Issues Historically, there are people-based vs. place-based approaches to poverty reduction. People-based is focused on giving direct subsidies to individuals through government programs. Place-based investing programs define a geographic area to receive incentives, grants and other subsidies in an effort to spur economic growth which should lift many of the residents out of poverty. Qualified Opportunity Funds fall in the later, under place-based investing. Research shows, the challenge with place-based approach to poverty reduction is that as economic conditions improve, some residents may no longer be able to afford to live in the area. A flood of value-added real estate investing has raised concerns about rising housing costs, displacement of local residents and other downsides of gentrification. Current ambiguity around what qualifies as an Opportunity Zone investment has increased those concerns. 13 A consortium of investors believes there should be more transparency on the impact of Opportunity Zone investments. To help fight the potential displacement, impact investors and non-profits may choose to offer low-cost renovation loans and subsidized mortgages, so locals can benefit from rising property values instead of getting priced out. 14 So far, initiatives like this are complimentary and voluntary to the requirements of the law. In many cities, the lag in data availability means that some census tracts may have experienced substantial market renewal even though they still qualify for Opportunity Zone selection, raising the concern that Qualified Opportunity Funds could displace even more residents through further gentrification. Many social impact advocates have implored governors and local officials to consider the current market conditions when designating Zones to reduce the risk of subsidizing investment which would have been made in the absence of this new incentive. It is unlikely any of these zones will be rolled back at this point, since the treasury has already approved these zones as nominated by their respective state governors. Research has shown the effectiveness of the incentive will depend on three factors over and above smart zone selection: 1) local capital investment capacity; 2) the quality of human capital programs; and 3) the sophistication of local institutions that play various matching and development functions. Every area has a threshold of capacity to accept new investment. In some cases, local agencies are taking an active role in mapping out the economic landscape and providing line-of-sight into emerging opportunities for investment. Investors need to be especially aware of the amount of capital flowing into an area relative to the supply of viable investments. The existence and quality of human capital programs relate to training of vocational skills, basic business skills, improvements at all levels of education and other empowering life skills, which may serve as a positive backdrop for private investment. Like most investments, the long-term success has much to do with the quality of the people. Areas with consistently good investment outcomes would likely have made significant investment into the infrastructure that supports the development of good human capital

9 Different sources of capital investments can flow into new businesses, expanding businesses, commercial and residential development projects, brownfield refurbishment, some infrastructure assets, and more. Research has shown communities that thrive have competitive and collaborative capital sources. While, Opportunity Zones only address the need for equity capital, there are many other organizations both for and not-for-profit who can fill in other layers of the capital stack. Local agencies and governments can play an active role in cultivating this network of capital. The ultimate effectiveness of Opportunity Zones will rely on the ability of communities to align public capital sources (grants and government programs) with social and physical infrastructure improvements that can enhance the investment backdrop for private capital deployment, as well as financing solutions that can help local residence participate in the ensuing economic growth. Otherwise, the value of the incentive in terms of deal generation and low-income labor market success will be short-lived and impact diminished. 15 Due Diligence While there are many benefits discussed in this research report on investing in Qualified Opportunity Funds, it is extremely important for investors interested in these investments to do their due diligence, including consulting their personal tax advisor. Regulatory: Investors should have confidence that the sponsor of the investment has the experience and expertise to preserve the compliance of this investment with the regulations and that the investment time horizon matches the expected tax benefit. Investment: Investors should apply the same rigor of due diligence as they do to other private investments in their portfolios. This would include an assessment of the people and strategy required to translate an investment of capital into a return of and on capital. Impact: Investors should ask about how the investment strategies will benefit the area in the short-term/ long-term and if and how these benefits will be measured. Additionally, an article called Guiding Principles for Opportunity Zones written by Bruce Katz and Jeremy Nowak suggests useful criteria that Qualified Opportunity Funds can apply when vetting investments into Opportunity Zones. 1 Employment Clustering: Job growth is increasingly clustered in relatively small geographies. The advanced economy increasingly favors places where talent, research, quality amenities and startup Innovations co-locate. 2 Training and Access: Communities with strong training programs linked to industry and quality transportation hold an advantage. 15

10 3 New Forms of Capital Intermediation: There is an abundance of global capital, but it is place agnostic and not always suitable for every stage of business growth or project development. Qualified Opportunity Funds create the potential for expanding the quality of intermediaries that have two essential qualities: local knowledge and capital markets credibility. 4 Technological Disruption: Qualified Opportunity Funds should take advantage of or experiment with technologies to boost resident engagement, strengthen employment linkages, accelerate product and process innovation and enhance quality place making. 16 Questions Outstanding Our research has provided us with conviction on the principles of Opportunity Zone investing. However, more guidance is needed from the Treasury and IRS. A coalition of more than 40 impact investing groups, including Temkin s Detroit Opportunity Fund and the Economic Innovation Group, which helped design the legislation that created Qualified Opportunity Funds, has written a 21-page letter to the acting commissioner of the IRS requesting guidance on a number of issues regarding implementation of Qualified Opportunity Funds. These include the timing for deployment and investment of capital, valuation method to meet the 90% asset test and the definition of a Qualified Opportunity Zone Business Property. 17 Many leading investors in this space believe there isn t a great fundraising opportunity until the first quarter of There are still many outstanding questions which need to be answered before moving forward. Below are a few additional questions that need to be addressed: 1 The tax benefits of Qualified Opportunity Funds are due to expire at the end of December 2026 unless they are extended with new legislation. Are you able to get grandfathered in to the ten-year tax benefit if invested any time before December 31, 2026? 2 Does a Fund have the ability to reinvest refinance proceeds into additional Opportunity Zone Properties to preserve the protected status of the investment? After the ten-year period, will Funds holding real estate assets that have exposure to dividend recapture be able to step up the cost basis to fair market value at the time of sale? 3 If a Fund invests in a stock of a company in an Opportunity Zone and they move locations outside the Opportunity Zone, what is considered a substantial duration of the Fund s holding period? 4 It is unclear how the legislation will treat multi-asset Funds where exits may happen at different times. Can these proceeds be reinvested and tax benefits preserved? source=kyi_19

11 References hr1enr.pdf new_localism_ pdf Pearl Street Boulder, CO Inverness Parkway, Suite 405 Englewood, CO