Financial advisors looking to attract and retain sustainable and impact investors may have a new arrow in their quiver in the form of the Opportunity Zone program—a special real estate and business development investment that incentivizes capital flow into low-income census tracts.
The initiative, which grew out of the Tax Cuts and Jobs Act of 2017, offers a number of potential benefits to investors who seek financial, as well as social and environmental, returns on their investments. Chief among them is a tax-smart way to diversify capital gains into real estate and business development while investing in projects that could provide benefits to residents and businesses in approximately 8,700 low-income census tracts across the U.S.
The Opportunity Zone program seeks to attract investment in economically distressed communities by modifying standard tax treatment of capital gains to potentially defer and reduce the investor’s capital gain tax liability. Further, future appreciation earned through a Qualified Opportunity Fund (QOF) may receive tax-free treatment. To qualify for these benefits, investors must reinvest realized capital gains into a QOF.
Still, questions about the structure and implementation of opportunity zones remain. In April, the IRS and the U.S. Department of the Treasury released a second round of proposed regulations designed to clarify questions and give local city officials guidance and developers and investors more confidence in connection with investing in and forming QOFs and investments in qualified opportunity zone businesses, but attorneys and tax specialists are still poring over the new regulations.
As these issues get sorted out, interested advisors should understand how the twin trends of impact investing and opportunity zones could converge, potentially leading to growth opportunities for their practices.
Investor interest in opportunity zones is growing significantly—and for good reason. They are potentially a win/win/win, benefitting low income neighborhoods by providing incentives for individuals and corporations to invest, and entrepreneurs to relocate to blighted neighborhoods, which could, in turn, rev up local jobs and economic activity.
According to the Economic Innovation Group (EIG), a bipartisan public policy organization founded by Sean Parker, John Lettieri and Steve Glickman, the potential investor base for opportunity zones is an eye-popping $6 trillion. EIG’s calculation includes U.S. household unrealized capital gains at $3.8 trillion and an estimated $2.3 trillion in unrealized capital gains on the books of U.S. corporations. “If only a fraction of that $6 trillion flows into Opportunity Zones,” notes EIG, opportunity zones “will quickly become the largest federal community development initiative in memory.”
While impressive, the appetite for sustainable and impact investing dwarfs opportunity zones. In its 2018 report, US SIF, The Forum for Sustainable and Responsible Investment, found that investors now consider environmental, social and governance (ESG) factors across $12 trillion of professionally managed assets, a 38% increase since 2016.
Sustainable and impact investing demand is likely to continue its upward trajectory, thanks to key demographic trends. In its 2018 survey, American Century Investments found that the "appeal" of impact investing reached 49% among 2018 survey participants, compared with 38% in 2016. At 56%, millennials find impact investing most appealing, followed by Gen Xers and baby boomers at 52% and 44%, respectively. In addition, 2019 research from Morningstar found a majority of the U.S. population—72%—is now interested in investing in sustainable and impact investing mutual funds.
Potential Investor Benefits
While the potential impact investing benefits are appealing to many investors, the potential bottom line benefits of opportunity zones are particularly compelling as a tax strategy for clients when looking to defer capital gains taxes. Our model suggests that an investment in a QOF has the potential to generate an after-tax, investment-level IRR that is approximately 300 basis points higher than the same investment made in a non-QOF vehicle. Here are some—but not all—of the key considerations advisors should evaluate when contemplating whether an opportunity zone works for client portfolios.
Ability to Diversify Into Other Asset Classes: The Opportunity Zone program enables advisors and their clients to diversify a portion of their existing real estate investment into another asset class. Only realized capital gains are eligible for the tax benefits associated with the Opportunity Zone program. Therefore, investors can take the gain associated with a sale of a property(s) and invest it into a QOF and take the original basis and reallocate into another asset class.
More Flexible Investment Process: To invest in a QOF, there is no required intermediary. Advisors and their clients can use cash on hand, and the timeline to make the investment provides a sufficient window for investors to make an informed investment. To qualify, investors must make the investment within 180 days of realizing a capital gain. If the capital gain was realized within a partnership, the investor will have 180 days from the last day of the tax year for that partnership. This timeline should give investors plenty of time to research investment options to match risk profile and return objectives.
In addition, there is no tracing of funds. So the investments into a QOF can come from any source the investor sees fit. Finally, capital gains, except for 1231 gains, do not need to be netted against losses, giving the investor the ability to carry forward losses to apply against future taxable income.
QOFs have the potential to change lives and communities, and reverse the decades-long dearth of economic investment in underserved areas. By using the power of capital, advisors can help clients lift communities up, stimulate entrepreneurship and find a market solution to a growing social problem. And they can potentially help their bottom line by adding an impactful offering to clients.
Terry Anderson is co-founder, with his brother Ryan, of Platform Ventures, a Kansas City, Kan., real estate investment firm founded in 2008.