Highway to the Opportunity Zone

As part of the recent tax legislation, the Department of the Treasury and the Internal Revenue Service have designated Opportunity Zones in 18 states in order to spur investment in distressed communities. In these Opportunity Zones, new investments may be eligible for preferential tax treatment.

During the economic recovery of the early 2010s, larger metropolitan areas accounted for almost three-quarters of net job creation in the country, while the areas that will be targeted by the Opportunity Zone program (including rural, suburban, and urban areas) lagged behind. The new program is a means of helping those areas catch up in terms of economic growth.

The program works by allowing capital gains relief for investors. These investors can put their money into real estate or businesses located in a qualified zone, and if they hold the investment for ten years, they may then sell it free of capital gains tax. (Investors receive smaller breaks if they sell after five or seven years, but must hold on to the investment for a decade to receive the full benefits.)

Across the country, businesses are sitting on more than $2 trillion in unrealized capital gains. (Individuals are also sitting on nearly $4 trillion, though they may be less willing to invest in these sorts of endeavors than businesses would be.) If the related assets were to be sold, they would be taxed at a maximum federal rate of 20 percent plus a 3.8 percent surtax. By offering a break on these taxes, the Opportunity Zones program seeks to direct the investment of the assets into areas that are struggling.

While the setup looks good on paper, the Brookings Institution wonders what effect an influx of new investments and businesses might have on existing residents and establishments:

In an optimistic scenario, the tax benefits might encourage purchasing and rehabilitating residential property or expanding local businesses. But the value of the tax subsidy is ultimately dependent on rising property values, rising rents, and higher business profitability. That means a state’s Opportunity Zones could also serve as a subsidy for displacing local residents in favor of higher-income professionals and the businesses that cater to them—a subsidy for gentrification.

The eligible Opportunity Zones are based on maps of census data dating back to 2011. The problem with this criteria is that many previously impoverished areas have greatly improved in the last seven years, but still qualify for the program. Investors would generally be more willing to invest in these already up-and-coming areas than in more stagnant areas.

Supporters of the program claim that these gentrifying areas are outliers and that the majority of the Zones are "severely distressed," with poverty rates over 30 percent and median family incomes at only 60 percent of the area average.

According to Bloomberg, proponents of the program say that it "could promote the kind of investments that are intended, such as new small businesses and affordable housing—but the legislation is so broadly written that savvy investors, corporations, and real estate developers could exploit it," such as converting affordable housing into market-rate condos.

The ten-year timeframe of the program was chosen as a way to discourage investors who are just looking for immediate tax relief, putting the focus on long-term, stable investments. But while that timeframe prevents quick buy-and-flip schemes, it doesn't necessarily mean that investors will have the community's best interests in mind as they choose their investment vehicles. 

In the coming months, the Department of the Treasury will be writing further guidelines for the program. Hopefully, the guidance will help the program focus investments in a way that will truly help needy communities.