This article was originally published by Minnesota Council on Foundations in Giving Forum Magazine’s Spring 2019 Edition
Written by Susan Hammel, CFA
Call me Pollyanna but I believe there is still a real chance these new investment flows may actually benefit the people living in the designated zones. For that to happen though, we need the philanthropic community to engage. The good news is that many foundations around the country and here in Minnesota are doing just that. If more of our foundations step up to partner with people in the zones, perhaps another “Minnesota Miracle” can indeed happen.
The Tax Cuts and Jobs Act of 2017 created Opportunity Zones (“O-Zones”) to spur economic development and job growth in distressed communities by attracting private capital investment from individual investors to those communities through a combination of capital gains tax deferrals, reductions, and exemptions. During spring 2018 governors in each state designated more than 8,700 zones, primarily in low-income census tracts, with final approval from the U.S. Treasury in April, 2018.
Are you ready for some tax talk? I promise to keep it brief.
Investors who have done well on their investments can benefit through investing capital gains from the sale of property, businesses, or securities into qualifying O-Zone funds.
There are timing constraints on how quickly investors must invest those capital gains (within 180 days), how quickly the O-Zone funds need to invest the money they raise (six to 31 months, depending on the type of investment), and on how long the benefit will be available (currently the full benefit is available to investments made before December 31, 2019, but this may be extended). O-Zone funds can invest in businesses, property or equipment finance.
That’s it for the tax talk, I promise. There are a ton more details so please consult your favorite tax advisor about any/all of the above. I’m a CFA, not a CPA for goodness sakes.
First off, timing matters. Since the investors need to act by the end of this year to get the maximum benefit, they prefer projects that are ready to go. Second, investors prefer real estate projects because the physical address of the investment makes meeting the geographic constraints of the O-Zone regulations simpler than when investing in a business, which is more likely to relocate. And third, investments in real estate are both easier to underwrite and much more common than investments in businesses in these neighborhoods.
In addition to the tax savings, there is another force pushing investors into opportunity zones: the high price of real estate. Real estate investors, who are used to 9-11% annualized returns, have begun to eye less-affluent areas for investment as the returns on projects in “core markets” (typical real estate developments in major city centers) have pushed prices high enough to reduce prospective returns to 5-6%. These investors will be the first to move capital into Opportunity Zones, purchasing the properties most fit for new apartments with high rents.
Financially motivated investors will move swiftly. After the most appetizing market-rate investments have been made, impact investors and community development organizations will have the chance to push forward projects that would benefit the community.
While the interests of impact investors and community development organizations are closely—albeit obliquely—aligned, both groups must surmount significant barriers if impact investments are to be made. There are two requirements:
First, there is the issue of investor confidence. The initial Opportunity Zone regulations outlined the basic shape of the tax deferral, reduction, and exemption, but left investors unsure as to how Opportunity Zone investing would work in action. The IRS has since released clarifying regulations, but investors are still uncertain about a range of things, particularly if they will be able to reinvest gains from O-Zone sales back into other O-Zone investments. While the absence of regulations has done little to stop some types of investors, impact investors are cautious by nature, and many are reticent to deploy capital into uncertain situations.
Second, community voices are essential. Community development organizations are faced with the challenge of determining which projects are best positioned to benefit their communities and then promoting those projects to investors. There is currently no federal-level policing of gentrification projects, and it has fallen on community organizations and local governments to develop and enforce do-no-harm policies in their neighborhoods. The difficulty in communicating community needs to investors is that community development organizations and individual impact investors have little to no experience working together. Community development organizations have worked with banks, foundations, and developers while investors have worked with advisors and most often, through investment managers, rather than directly in projects. The community development organizations have extensive affordable housing and community development project experience, but do not have experience working with individual investors or setting up funds.
This sounds hopeful, so why am I worried and what can the philanthropic community do to help?
O-Zones hit all of my impact investing concerns head on. The good news is that while foundations’ tax-exempt status precludes them from benefiting from the Opportunity Zone tax incentive, they hold tremendous power over the outcome of the legislation in their communities. Several Minnesota foundations realized this and have taken action to bridge the gap between community development organizations and impact investors.
Impact Washing refers to companies marketing a social or environmental impact that doesn’t exist. Unlike previous federal programs such as Low Income Housing Tax Credits, New Markets Tax Credits, and Enterprise Zones, there are not yet regulations defining impact in O-Zones. So anything goes, as long as they meet the zip code and other non-impact requirements.
Philanthropic Community action steps needed: As of this writing we are eagerly waiting for new guidance from the Treasury Department. Rumor has it they may adopt similar impact requirements as with New Markets Tax Credits. Until then, there are three measures we can take:
Impact investor opacity creates challenges for entrepreneurs since it is difficult to know who is doing impact investing, what kinds of investments they make, and how to apply for them.
We are seeing more public information about O-Zone projects but the investors are remaining private since many are private companies and individuals.
Require public communication and disclosure of deals in which foundations provide risk capital.
Silicon Valley has a culture of “just trying stuff. That attitude leads to many failures but it also leads to spectacular successes. For O-Zones, this risk aversion is even more dramatic because investors will only receive their maximum tax benefits IF the underlying projects succeed. Unlike the tax-credit programs that came before it, the O-Zone benefits offer no risk mitigation.
By now I hope you’ll join my cautiously optimistic view. After all, O-Zone is the first new federal incentive to invest in low income communities in almost two decades. Plus, unlike previous incentive programs, there is no cap on investment into O-Zones. Not all of the $8-11 trillion in unrealized capital gains is expected to be realized to take advantage of the O-Zone benefits, but we can anticipate between $100-400 billion will be invested over 2018-2019.
MCF philanthropic members care about what happens in these zones. Many foundations and nonprofit intermediaries have invested in these places for decades. We also care about the people living in these zones. Let’s get to work showing how MN O-Zones truly are places of opportunity for all.
Top of my mind these days is investing in line with Diversity, Equity, Inclusion values. Many institutions promised bold moves after George Floyd was murdered. Who is following through and doing this well? Racial justice requires new pathways for capital flows. I’m excited to be part of the McKnight Foundation’s Groundbreak Coalition, aiming to deploy $2b in flexible capital over 10 years to disrupt the status quo. In Minnesota we are a generous state, a charitable state, a hard-working state: we need to try new approaches to create that famous quality of life for all. We are leading a session on Place Based Impact Investing at the Mission Investors Exchange conference in Baltimore. Reach out if you’ll be there so I can include you in the informal MN meet-ups.