The Opportunity Zone - Do the Math
Stites & Harbison Client Alert, October 23, 2018
On April 9, 2018, upon receiving certification of the 144 Kentucky Opportunity Zones by the U.S. Department of the Treasury, Governor Matt Bevin announced that “Kentucky will maximize this golden chance to attract economic development projects to communities most in need across the Commonwealth, and the Kentucky Opportunity Zone Initiative will strengthen and rebuild both rural and urban areas, from the Mississippi River in West Kentucky, throughout West Louisville’s neighborhoods, to the heart of Appalachia, these zones will spur investment, growth and community development.” Stakeholders, investors, entrepreneurs and economic development agencies at the state and local levels are in the process of figuring out how best to take advantage of this unique economic development tool. Likewise, local communities are doing their part to cater to viable projects in order to attract institutional, corporate and individual investment dollars. Conceding that investments into Opportunity Zones are intended to positively impact distressed communities, attention is focused on the Opportunity Zones’ tax incentives and whether they are sufficient enough for investors to part with their unrealized capital gains in projects located in areas which they would not have otherwise invested. Lining up long-term private equity, also called “patient” equity, for investment in economically distressed communities runs contrary to the strategy of market rate investors.
The Opportunity Zone legal structure is fairly straightforward and not all that difficult to understand, although there are a few nuances here and there. Procedurally, investors invest their unrealized capital gains in Opportunity Zone Funds, which in turn invests their capital in qualified Opportunity Zone businesses which are located in certified Opportunity Zones. Currently, the U.S. Treasury and Internal Revenue Service are in the midst of drafting regulations on how the program will work for investors and the types of projects that will be eligible. At the same time, business communities are reviewing their business practices to entice entrepreneurs to set up operations in hopes that Opportunity Zone capital will follow. In the end, the success of the program will depend partly on whether the Opportunity Zone tax incentives produce an investment return for those that make and hold their investment over an extended period of time in an Opportunity Zone.
To entice private capital, the Opportunity Zones program offers three attractive income tax incentives for
investing in low-income distressed communities through a qualified Opportunity Zone Fund:
- First, the deferred gain associated with the invested unrealized capital gains must be recognized for tax purposes on the earlier of: (i) the date on which the taxpayer/investor’s Opportunity Zone investment is disposed of, or (ii) December 31, 2026.
- Second, the Opportunity Zones program offers a stepped-up basis for those capital gains reinvested in an Opportunity Fund. If the investment in the Opportunity Fund is held by the taxpayer for at least five years, the tax basis is increased by 10% and by an additional 5% if held for at least seven years, thereby excluding up to 15% of the original gain from taxation.
- Third, 100% of any gain realized from the sale or exchange of an Opportunity Zone Fund investment held for at least 10 years is excluded from tax. This exclusion applies only to gains accrued after the investment in an Opportunity Fund is made by the taxpayer/investor.
In order to understand the full impact of the income tax incentives on an Opportunity Zone investment, a comparison of an investor’s available after-tax investment in a traditional standard investment vehicle to that same investment made in an Opportunity Zone Fund is set forth below based on the following fact situation:
In 2018, Investor sold stock which resulted in a $1,000,000 of unrealized capital gain. Investor decides to reinvest the full $1,000,000 into an Opportunity Fund, which in turn invests the Fund’s capital in a qualified Opportunity Zone business located in one of the 144 Opportunity Zones in the Commonwealth. Investor holds that investment in the Opportunity Fund for over 10 years.
(a) By investing in the Opportunity Zone program, Investor is able to defer paying the federal income tax on the original $1,000,000 of unrealized capital gains until December 31, 2026. On the other hand, if Investor had decided to invest the $1,000,000 in a standard investment vehicle, like stocks, bonds or mutual funds, Investor would be required to pay federal capital gain tax and Kentucky income tax on the $1,000,000 in 2018. The end result is that Investor, with its Opportunity Zone investment, has the full $1,000,000 working for the next seven years, while its standard investment provides only a net after tax amount ($1,000,000 minus the federal and state income paid) to invest and hold over the next seven years.
(b) By holding the investment in the Opportunity Zone Fund for seven years, Investor’s income tax basis in Investor’s Opportunity Zone Fund investment is increased 15% from $0.00 to $150,000. When the income tax comes due in 2026, Investor pays federal and state income tax on $850,000 ($1,000,000 original unrealized capital gains minus $150,000 stepped up tax basis = $850,000), thereby eliminating federal and state taxes on $150,000 of its original unrealized gains. There is no such benefit for the traditional investment after tax investment.
(c) Finally, since Investor has held the investment in the Opportunity Zone Fund for at least 10 years, Investor will owe no income tax on the investment’s appreciation when it is sold or exchanged. Once again, there is no comparable benefit available upon the sale of the traditional investment. At that time, Investor would be required to pay federal and Kentucky income on the sale of such standard investment. (See comparison below)
It is being reported that there are $6.2 trillion of unrealized capital gains available for investment by individuals and corporations in the Opportunity Zones. However, it is not clear at this time what investors will be looking for or how they will choose to deploy this investment capital. What is clear is that this is not free money, therefore investors will expect their money back at some time in the future and the receipt of a reasonable annual return while its invested. What makes this a challenge is that for capital to run into these distressed communities, investors must be convinced that by investing in local businesses or projects, they will be provided a projected rate of return which, when combined with the tax incentive, adequately compensates for the investment risk. The success of Opportunity Zones will likely come down to the ability, determination and innovation of state and local stakeholders to create this type of investment model rather than the benevolence of the investors.
The comparison assumes (i) 6.0% annually growth over the 10 year period for each investment option and (ii) the after-tax sale of Investor’s original unrealized capital gain which occurs in 2028 takes into account the loss of earnings on the capital used to pay the deferred tax value of Investor’s original $1,000,000 in 2026, Investor’s investment in the Opportunity Zone Fund has increased over time some $533,673 over the standard investment and some $376,576 increased upon the sale of each investment in 2028.