Don't forget about the businesses! An update on Opportunity Zones
It’s been a little while since we have shared any information on Opportunity Zones (OZs). Inclusive Action has been closely following the topic. Since our Primer on Opportunity Zones, a new set of regulations was released along with multiple requests for information and comments from the federal government. It is anticipated that the third and final round of regulation guidance will be released soon. As the regulations have rolled out, we have become increasingly concerned with the lack of requirements ensuring investments are truly good for the community, especially residents who have lived in these designated neighborhoods for years or longer.
Inclusive Action focuses its efforts on economic development because we feel that access to capital is the main barrier for the people we serve: as we have stated before, these systems were not built for us. The manner in which Opportunity Zones are implemented will have a profound effect on existing residents in these neighborhoods. Our take is that the private and public sectors both need to play a proactive - instead of reactive - role in ensuring that OZ investment supports inclusive and equitable development. But take a look for yourself! Below is an overview of a few key points in the new regulations, as well as some food for thought.
A REFRESHER ON OPPORTUNITY ZONES
As a reminder, Opportunity Zones are designated census tracts where capital gains - or profit made on the sale of an asset like a property or stock - can be invested in exchange for delayed and reduced tax payment on those capital gains. Qualified Opportunity Funds (QOF) are the vehicle through which investment is made to buy and/or develop properties, businesses, and land in Opportunity Zones. Opportunity Zones and their companion Qualified Opportunity Funds work together to create a tax deferral, meaning investors can delay paying taxes on capital gains income invested through this new mechanism. For investors to take advantage of the delay in tax payment, the investments have to be made for 5, 7 or 10+ years. To gain the greatest benefits of the program, investors need to put their money in a QOF before December 31st of this year and hold it there for 10 or more years. Here’s a simplified visual aid to explain a little more about how it works:
One important thing to remember about this tax incentive is that the money invested has to be used for equity capital (money paid back with the sale of the property, like a down payment) and not debt capital (a loan that has to start being paid back almost immediately, like a mortgage). It is important to keep in mind that there is a gap in equity funding of businesses owned by people of color. The OZ incentive has a few major effects on the communities where investment happens. For small business owners, this is an opportunity to do direct improvements to existing properties and businesses. For residents in the neighborhood, there will be immediately visible changes in areas where investments are taking place. For investors, there is a weighted importance on the economic vitality of the neighborhood because investors in the QOF will want to see greater returns once their shares are sold back. To see if there’s an OZ near you, check out the OZ map the City put together. If you live outside of the City of LA, the State has a similar resource documenting OZs across California.
As mentioned in our primer, the poverty rate in OZs across LA County is nearly twice what it is for the County overall, and the median income in LA County OZs is $37,346 versus $66,213 in LA County as a whole. As a result, there are significant implications that equity capital will have on these neighborhoods, requiring guardrails around these investments. It is immensely important to make sure this incentive doesn’t further facilitate gentrification and displacement in OZ areas.
THE LATEST CHANGES
The latest round of OZ regulation updates provided much clarification regarding what can and cannot be invested in to receive the tax benefit. There were two major pieces that we felt help understand the potential impact of this incentive on designated areas - 1) how to determine if a business qualifies as an investment and 2) clarifications around vacant and depreciated (declining in value) property requirements.
BUSINESSES IN OPPORTUNITY ZONES
As mentioned, businesses are one possible place of investment for QOFs. Businesses, known as Qualified Opportunity Zone Businesses (QOZB), have a few requirements around what makes them qualify for investment. The state requirement is that they must have at least 50% of their gross income (the amount of income made before accounting for any expenses such as bills) generated from within an OZ. There are a number of different ways to interpret this, but with the regulation clarifications in April, it detailed that this requirement can be met by achieving one of the following:
50%+ of services performed (based on hours) are executed in the OZ. For instance, if a startup business that designs software is in an OZ, and the main way their customers get their products is through downloading it, the business could still qualify as QOZB because the employees and independent contractors perform the majority of their work hours on developing the product at the business location within the OZ.
50%+ of the total compensation amount (salary plus benefits) goes to employees or independent contractors performing work in an OZ. For example, if a business’ few, high-paid workers operate and work in an OZ each day, but the business also has a warehouse outside of the OZ where many more lower-paid workers perform the work of stocking and distributing products they could qualify as QOZB. In this case, the salaries of the higher paid workers, although fewer, must equate to 50% or more of the compensation the business pays out in total.
The property of the QOZB is in an OZ and the management and operations done for the business is necessary to generate 50%+ of the gross income of the business. For example, if a business’ headquarters is located within an OZ but their operations take place both within and outside of OZs, they can qualify as a QOZB if the management and operational functions performed at the headquarters in the OZ is necessary for more than 50% of the business’ income.
The implications of this are two-fold. First, it clarifies for potential investors what parts of the business must be within an OZ, and what can be located outside of it - meaning that it’s okay for a business to have some dealings outside of the OZ, as long as it meets one of the three criteria detailed above. It also means that the impact of the QOZBs will be felt far beyond the confines of the OZs themselves. Next, it could stimulate the hyper-local economy through direct, potentially long-term employment opportunities and direct services within the OZ. However, there are still no guardrails around these investments, it is not required that: businesses hire locally (either within or near the OZ the business is located in), existing businesses in OZs be given priority for work, or that businesses prioritize existing residents within an OZ - meaning they also may attract people from elsewhere for the jobs being established by the development of QOZBs.
VACANT & DEPRECIATING PROPERTIES AND LAND
Part of the framing of this program as a development option for underserved communities was that any property bought needed to be “substantially improved” - meaning the same amount of money (or more) that went into buying the property needs to be put into improving the property. It has also been clarified that vacant properties and land that is bought via a QOF must have been vacant for at least 5 years at the time of sale in order for the substantial improvement requirement to not apply. It had been originally suggested by the Economic Innovation Group (the advisors for this legislation to the Federal Government) that the rule be one year, but the five year mark was put in place by the IRS to deter landowners from making their land/property vacant for one year to increase marketability for purchasers. Further, properties depreciating in value must still meet the substantial improvement requirement - much to the chagrin of investors.
WHERE DOES THAT LEAVE US?
Do the new clarifications resolve previous criticism of and concerns with OZs? Definitely not. There are still no requirements that investments create affordable housing, spur local hiring, or invest in businesses owned by OZ residents. The only major guardrail is the “anti-abuse” measure that will revoke tax breaks if investments of the Qualified Opportunity Fund are found to not align with program interests. With this rule, however, the onus is on the IRS to do the investigation. It is unclear if there will be a reporting mechanism for people who feel a project does not align with the OZ program. Further, the Qualified Opportunity Funds are self-certified LLCs or Corporations, meaning there is little to no oversight on how they spend the investments.
The final round of regulations is anticipated to come out soon (before the end of this year). One of the most anticipated guidance pieces is around the reporting requirement for QOFs. The Treasury released a Request for Information (RFI) for comments on what and how data should be collected and how. There is hope that this next set of regulations will also encourage venture capitalists to invest in QOFs because they likely have an interest in diversifying their assets (especially for businesses), and in creating a stable economic environment within OZs.
Both residential and small business gentrification has been occurring in the communities Inclusive Action serves. This tax benefit has the power to exacerbate the displacement of low-income residents across the region. Because of this, we believe that Los Angeles has an important opportunity to ground Opportunity Zone investments within a framework of equity that helps to support local small businesses, affordable housing and an inclusive economy. To do this, we believe the public sector, even here at the local level, needs to engage firmly with the private sector to drive development in a way that meets the needs of its most vulnerable residents. In the absence of “guardrails” from the Federal government, local leaders can create an inclusionary policies that support the types of investments that long-time residents of Opportunity Zones need. A proactive stance from local leaders on Opportunity Zones can result in a model for how other communities contend with this new federal investment tool.