Opportunity Zone Progress Slows in COVID-19 Crisis
- May 06, 2020
This was slated to be a critical year for Opportunity Zones, the feature of the 2017 Tax Cuts and Jobs Act that provides a tax break for property investment in low-income areas. The Treasury Department last year finally clarified some regulations that the original legislation left unclear at a time when demand for apartments and other commercial property was still riding high.
Fate, however, had other ideas. When COVID-19 hit the U.S. with full force in March, investors hit the pause button on capital allocations, and the outlook for commercial development demand abruptly turned cloudy. “Everybody’s assessing,” said Michael Novogradac, managing partner of a San Francisco-based accounting firm that bears his name.
The level of investment in opportunity zones has fallen short of the buzz it initially created in the industry. The program provides tax breaks to investors that reinvest capital gains in qualified funds, which in turn can buy assets such as real estate, businesses and infrastructure. Investors have set up more than 600 opportunity zone vehicles, but the amount of capital raised is fairly slim.
As of April, 406 vehicles have raised $10.1 billion for Opportunity Zone funds, Novogradac reports. The firm notes that its data may under-report the capital raised by more than half because many funds are private and do not report fundraising totals. Even so, Opportunity Zones have failed to approach initial estimates by some proponents who eyed the $6 trillion pot of capital gains that could potentially be invested.
Qualified Opportunity Funds focused at least partially on residential development have raised close to three quarters of that $10 billion total. Funds that allocate at least a partial share of their capital to commercial properties have raised nearly 61 percent of the total. (The percentages add up to more than 100 because many funds have multiple areas of focus.)
The first quarter was expected to be a banner time for capital raising because April 15 was a deadline to get the full benefits of the tax breaks. However, the shelter-in-place orders that went into effect in March created a sharp drop in the equity market and led to a freeze of many commercial real estate investments. For some, the decline in asset values diminished or wiped out capital gains that could have been invested in Opportunity Zones.
Some capital gains were created by stock sales in March and April, so it is possible that investors have gains that need to be invested. “The real question is how many investors received gains (on stocks sold) during the stock market tumult, and how many will invest in Opportunity Zone funds,” Novogradac said.
The IRS has extended to July 15 the deadline for investors to place capital in Opportunity Funds without penalty, and a clearer picture of the amount of dollars raised will emerge by then.
Whether to allocate capital to funds that invest in commercial real estate will depend on how investors view the demand for property. Opportunity Zone investments bear several types of risk. One is that investments are limited to 8,700 designated zones nationally that have below-average income levels relative to the metro in which they are located. Many are in areas that have struggled economically.
Another risk is for development. In order to qualify for the tax break, funds that buy existing properties must spend a significant amount of money to upgrade the asset. Rehabilitation increases the project’s cost; shortages of construction material and labor now pose an additional challenge. Ground-up development for Opportunity Zone funds is further complicated by the typical lengthy entitlement and construction time, which can conflict with the strict deadlines for investing capital.
Finally, the pandemic and widespread shelter-in-place orders are causing a re-evaluation of the demand for commercial real estate. Multifamily demand, for example, is correlated to job growth. Household formation will diminish if unemployment remains elevated, as potential residents lack the financial wherewithal to move to apartments.
In addition, small businesses are failing, corporations are considering cutting back on the use of office space, retail chains are filing for bankruptcy and hotel occupancy has plunged to less than 25 percent nationally. Given the landscape, investors may decide that there are more productive places to park their capital than commercial real estate.
Wanted: legislative fixes
Even though the Treasury Department has clarified much of the uncertainty surrounding the regulatory language of Opportunity Zones, proponents have been lobbying for additional regulatory and legislative fixes to enhance the program and make it more permanent. Those fixes are yet another element that has been set back by the pandemic. Congress is focused on emergency aid and is unlikely to pay much attention to less critical issues so close to a presidential election.
Maybe the most significant change being sought is in transparency and data collection. A bipartisan Senate group—which includes the Opportunity Zone program’s original sponsors, Tim Scott (R-SC) and Cory Booker (D-NJ)—has proposed legislation that would require the Treasury Department to collect data on the number of funds and their impact on the communities they invest in. Proponents believe that the program would benefit if the public could see the impact on jobs and investment.
Another change being sought is to make the tax incentive permanent. Under the law, shareholders who keep their investments for five years will pay no taxes on 10 percent of the investment’s gains. After seven years, 15 percent of gains will not be taxed. Shareholders who hold Opportunity Zone investments for 10 years can avoid paying taxes on all gains. However, the incentives of the 2017 law expire after 2027, which means that investors receive a diminishing benefit as time goes on. Proponents believe that Opportunity Zone provisions would be more attractive if they do not expire.
Scott and a group of Senate Republicans introduced a bill on Monday aimed at minimizing the impact of Covid-19 on opportunity zone investors. One provision would extend the period in which investors could put capital gains into opportunity zone funds. Another would extend by 12 months the period in which funds must complete required upgrades. The bill also directs regulators to not penalize investors for the impacts of the pandemic and to ensure opportunity zone projects are provided with emergency aid.
Opportunity Zones have had a short and checkered history complicated by the hasty manner in which the original bill was written; the questions surrounding what constitutes a qualified investment; and now, the deep recession in which the country is mired.
The final chapter has not been written, however. Proponents say that the Opportunity Zone incentive can be a valuable tool for some types of development, and can help forge public-private partnerships that revitalize communities through such projects as brownfield development, affordable housing and mixed-use projects in transportation corridors.