A new bid to break the cycle of poverty

The phrase “cycle of poverty” reminds us that poverty is self-reinforcing. Children in poverty often attend less-effective schools, live in substandard housing, are targets of racial or ethnic discrimination, are victims of crime, and live in families with little social capital.

The poverty of places is also self-reinforcing. An impoverished housing stock continues to disintegrate as weak home values discourage repair and renovation. Abandoned homes attract vandalism or demolition. Vacant lots can become dumps and discourage new construction. Businesses face higher costs and lower margins. Residents who achieve economic stability leave for better neighborhoods.

New opportunity

The Opportunity Zone program attempts to break the cycle of poverty for places by reducing the cost of investing in disadvantaged neighborhoods. 

In 2015, a pair of economists—Jared Bernstein from the left-leaning Center on Budget and Policy Priorities and Kevin Hassett from the right-leaning American Enterprise Institute—teamed up on a plan to drive new investment to distressed communities. Dubbed an economist’s “science experiment” at a conference I attended recently, it found its way into the Tax Cuts and Jobs Act of 2017 at the urging of tech entrepreneur Sean Parker with the sponsorship of Republican Sen. Tim Scott of South Carolina. It didn’t hurt that Hassett was then chairing Donald Trump’s Council of Economic Advisers.

The Opportunity Zone program uses the federal tax code to dramatically change the incentive to invest in these communities. 

What’s the advantage to investors?

With the S&P 500 Index doubling in value from 2011 to 2018 and the real estate market booming in many markets, investors who cash out face the prospect of paying very significant taxes on their gains. That’s how the income tax applies to assets: The fact that an asset—say, shares of Amazon or Apple stock or a piece of real estate—has increased in value doesn’t affect your taxes until you sell it. Then you owe tax on the gain you realized from the sale.

By reinvesting the capital gain in designated distressed neighborhoods, opportunity zone investors defer paying tax until the 2026 tax year. The program offers two other sweeteners: The tax owed on the original gain is cut by 15 percent after seven years, and any gain earned on the new investment is tax-free if held for at least 10 years.

 

Do place-based programs work?

Economists have long debated the relative effectiveness of “place-based” economic development programs. There is an argument in favor of programs that target people who are disadvantaged over neighborhoods that house people in poverty. A previous Rochester Beacon post by Kent Gardner discussed this issue at greater length.

Suppose you sell a building or a few shares of Berkshire Hathaway and have a taxable gain of $1 million. You will likely owe federal income tax of 20 percent on the gain, or $200,000. By investing in an opportunity zone, the tax is deferred until the 2026 tax year. The cash “belongs” to the IRS, but you get to use it for seven years before you hand it over. Were you to invest $200,000 at 5 percent, for example, you’d earn $10,000 each year the tax payment is deferred. That’s what the deferral would be worth to you.  

You qualify for the tax deferral by investing in a zone through a qualified opportunity fund (QOF). The value of that investment grows tax-free for 10 years. So, were you to sell that investment for, say, $1.6 million at the end of the 10 years, you would owe no tax on the $600,000.

There’s more. The original $200,000 tax liability is cut by 10 percent after five years and by 15 percent if the asset is held for seven years. When you file your taxes for 2026, you owe $170,000 in federal income tax on the prior capital gain, not $200,000.

Let’s add this up. Assume that you have two alternative investment opportunities, both earning 5 percent compound annual rate of return. One venture is in an opportunity zone and one is not. Example One in the table below demonstrates that you would be more than $300,000 better off at the end of the 10 years by investing in the qualified opportunity fund. (For simplicity in these illustrations, I’ve only included the federal income tax.)

Looks pretty sweet, doesn’t it? The incentive to invest in an opportunity zone is powerful. The proponents hope this incentive will drive lots of new investment into needy neighborhoods. 

Don’t try this at home

If an investment in an opportunity zone appeals to you, reach out for help. The details governing the program are daunting.

• To qualify, the capital gain must be reinvested in a qualified opportunity fund within 180 days of the event triggering the gain.

• The QOF must hold at least 90 percent of its assets in qualified opportunity zone property, which could be either real property or a business interest in a qualified opportunity zone business.

• To be a qualified opportunity zone business, an entity must have substantially all of its tangible property located within the zone and earn at least 50 percent of its gross income from within the zone.

• To qualify for the tax exemption on the gain, the investor has to sell his or her interest in the fund.

An error in timing or documentation could eliminate the benefits of the opportunity zone investment.

What can go wrong?

Although the tax benefits of opportunity zone investments are considerable, the risks can be, too. As discussed above, census tracts that qualify for zone status are disadvantaged, some significantly so. The requirement that qualified businesses earn at least half of their income from within the zone could be a high bar for non-real estate investments, depending on how the final rules are written. 

Let’s revisit our “base case” and change the assumptions. In Example One, both projects earn a 5 percent compound rate of return. Example Two shows that the advantage of the opportunity zone investment disappears if the rate of return on the non-zone investment rises to 7.3 percent while the return on the zone investment remains the same.

Example Three tests the impact of the opportunity zone investment earning only 2 percent with the non-zone investment staying at 5 percent. The net lossat the end of the investment period is $153,498.

Looking for a few good projects

Remember, too, that the investments—both inside the zone and outside the zone—are entirely at risk. There is no federal government guarantee to save you if the business declares bankruptcy and your money disappears. Nearly by definition, the average opportunity zone investment will be riskier than the average investment outside the zone. 

The program truly will be an opportunity for selected ventures. Several sources agree, however, that many of the program’s detailed requirements will bias its application to real estate projects, particularly the need for a timely exit, the fact that half the business proceeds must come from within the zone (a provision that is still not clearly defined) and the relatively long “lock-in” period for investors. Good legal work and savvy owners could attract opportunity zone money to, say, a manufacturing venture, but the complexity of the deal is greater, making it more costly to set up and increasing the risk of losing opportunity zone benefits.

The need for good legal work also suggests that the cost of setting up and monitoring an array of qualified opportunity funds will be nontrivial, eroding the return on investment.

A number of other tax-advantaged investment vehicles and rules confer some of the same benefits, notes Dennis DeLeo, president of the Venture Jobs Foundation, which invests in small businesses that will bring jobs to higher-poverty neighborhoods. He does not presently anticipate that opportunity zones will be widely employed by VJF, but the organization will be evaluating their utility for selected programs. (See his post on VJF’s goals and plans.)

Many investors in Rochester may be willing to assume higher risk in service of a higher goal, however. Laura Smith and Josh Gewolb, with law firm Harter Secrest & Emery LLP, have been fielding questions on opportunity zones. Gewolb told me many who seek their counsel are eager to put their money to work improving Rochester, even with the added risk. He also noted that the rules governing opportunity zone selection permit the inclusion of many promising development sites, including all of downtown Rochester. 

The advantages of opportunity zones may not be sufficient to unleash a tsunami of new investment but could nudge many worthy projects from the “no” column to the “yes” column.

How are the zones selected? Where are they located?

Each state can designate up to 25 percent of its eligible census tracts to be opportunity zones. A tract qualifies if the poverty rate is at least 20 percent and the median household income does not exceed 80 percent of the greater of metropolitan or state median household income.

Census tracts are county sub-units established for purposes of statistical reporting. Ideally, they follow recognized physical landmarks like rivers and major roadways, as well as the boundaries of civil divisions like villages and towns. Unlike congressional districts whose boundaries are adjusted to maintain the same population (to conform to constitutional “one person, one vote” mandates), census tract boundaries are intended to be semi-permanent, allowing for comparisons from one census year to the next. The population of census tracts can vary from 1,200 to 8,000, with 4,000 as the target. Tracts are further divided into blocks and block groups.

The graphic below displays current census tract boundaries for the northern half of Rochester (green) and all of Irondequoit (purple) and one census tract (125) in Brighton (lavender).

New York has selected opportunity zones from among eligible census tracts. A national map of eligible and designated tracts can be viewed on a website maintained by the Community Development Financial Institutions Fund.

CDFI reports that Census tract 57 (in the Beechwood neighborhood) has been designated an opportunity zone. The poverty rate is 44 percent and median income is 31 percent of the area median income. Census tract 58, with a 40 percent poverty rate and median income 41 percent of the area median income, is eligible for opportunity zone designation but was not selected by the state. Tract 58 is also in Beechwood.

With a poverty rate of 14 percent and median income 81 percent of the area median income, census tract 60 in the adjacent Culver-Winton neighborhood is not eligible for opportunity zone designation.

New York opportunity zone maps by region are here. Thirty-one census tracts in the Finger Lakes region are included (note that tracts labeled as “suggested” have now been approved as “final”).

—Kent Gardner