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Opportunity Zones: Opportunities Wasted
I recently attended the 2019 Opportunity Zone Expo in Los Angeles. This sold out event was billed as the largest gathering of experts in the country on the subject of investment in an “opportunity zone (OZ),” using a “qualified opportunity fund (QOZ).”
It was held in the ballrooms at the LA LIVE - JW Marriott Hotel in downtown. Keynote speakers included California Secretary of State Fiona Ma, U.S. Congressman Alex Mooney, Former Nevada Attorney General Adam Laxalt, and former U.S. Congressman Keith Rothfus. The Expo was opened with an enthusiastic videotaped welcome by Los Angeles Mayor Eric Garcetti.
Event panels and breakout sessions had names like Capitalizing on opportunities: financing, sourcing and investors; Following your money: Choosing the best investment and protecting your capital; When to head out: understanding your fund and exit strategies; and Right place, right zone: identifying promising zones and why.
The 1,000+ attendees overflowed the well-appointed facility. Each panel was standing room only, filled with a sea of mostly male participants talking about deal flow, rates of return, whether partnerships or C Corps were the best investment structure, and so on. And on the dais of each session sat developers, fund managers, investment bankers, financial advisors, tax accountants, and incisively articulate, high-priced Washington DC lawyers, comparing bragging rights about their assets under management (from the low hundreds of millions to the tens of billions) available for office, commercial, retail, hotel, resort, industrial, and high density luxury housing development.
You know, just regular folks.
I jest, but make no mistake about it these were some very smart people. And they are precisely the people you want to have sitting around the table with you, figuring out how to address affordable housing needs, environmental protection and social justice – and how to make money doing it. These are the people who are really good at figuring that out. The only problem is if we let the unbridled pursuit of profits be their only guide, we end up with results that throw everything else under the bus.
There was no doubt that the OZ Tax Code is a game changer that could supercharge investment in real estate. But at the end of the day it became equally clear that this would probably be just another case of the rich getting richer.
Don't get me wrong. I have nothing against anyone getting rich. In fact, I'm absolutely all for it, especially if they get rich doing right by others. But if they're getting rich as the result of a gift from the government (taxpayers), then there have to be commensurate public benefits. Otherwise, it always ends up leaving the rest of us holding the bag.
So what are opportunity zones and qualified opportunity funds, and why should you care?
Opportunity Zones and Qualified Opportunity Funds
Opportunity Zones and the use of Qualified Opportunity Funds are the result of a relatively small provision in the 2018 Federal Tax Reform Bill. Simply put, the law establishes “opportunity zones” (land parcels in every state and city that designate where the tax code wants to incentivize investment) to provide a way for private investors, who have an unrealized capital gain in one type of investment, to be able to move those gains into a new investment (in real estate / new business creation) within one of those designated opportunity zones. And if they do this reinvestment of deferred capital gains within very strict timelines and using a financial entity called a “Qualified Opportunity Fund,” they can defer all taxes on the capital gains on their original investment until 2026, and if that new opportunity zone investment is maintained for 10 years or more, the investor can pay zero taxes on all those gains… forever.
As I said in a previous article, this an extremely big deal and a huge investment incentive. It is based on the economic calculus that business creation and capital investments in these designated areas will ultimately have a multiplier effect, the results of which will produce far more wealth than the cost of the tax forgiveness. It is an effort to tap private capital for investment in low income and under-developed census tracts. At least that’s the theory. But the qualifying question remains, wealth for whom?
The specific parcels that ended up being designated on the national maps were decided by the Governor’s office of each state.
The overall intentions in the Tax Law were a step in the right direction. But there is one gigantic problem. The whole exercise is a monumental case in point of what happens when you have legislation written predominately for business interests by business interests: the tragedies of the commons that flow downstream are enormous and remain unpaid by those reaping the financial rewards.
What is most disheartening is that the opportunity to do this right was completely ignored. And that is why you should care.
Maximizing the efficient use of private capital for public benefit?
Lately, I’ve been writing about the importance of the “efficient” use of capital, and the men and (the occasional) women at this event were clearly really good that doing that, thus the hyper-enthusiasm and “S.R.O.” attendance. I would conservatively estimate that this event’s participants were within 1 or 2 degrees of separation from over $1/2 trillion of investment capital. So, one would assume that since the Tax Law purports to target lower income census tracts and under-developed areas (e.g., brownfield sites, old rail yards, etc.) it’s all good news, right?
Not so fast.
As I sat and listened to the panels of experts and advisors throughout the day, I began to have the uncomfortable feeling that I had entered a parallel universe. Everyone was extremely positive, you couldn’t find a more energized group of people. But public benefit considerations were completely missing from the discussions: with holes in the exuberant narratives big enough to drive a truck through.
Finally, at one of the afternoon sessions, a silver-haired speaker up on the dais, made the following comment to his colleagues, almost as a half-joking aside. He said, “You know I was telling my daughter about all this the other day and she looked at me and said, that all sounds great, dad, but what are you doing for the people in those communities?”
And he said this in a way that clearly showed that this was a totally new concept for him: that he should bother thinking about the connection between the multi-billion dollar investment fund he ran and the impacts of its investments on the communities he was “investing” in. In his way of thinking, investment was always a good thing.
The others on the dais sort of hemmed and hawed, awkwardly mulling that over for a moment, until one finally concluded, “Yes, I think that’s something we’re going to have to deal with, going forward,” as if to suggest that it was yet another obstacle to doing business, an annoyance, and just another cost that they needed to begrudgingly throw some money into the investment return calculations to account for.
With only one or two notable exceptions, the majority of the audience seemed to concur. It would be another challenge and cost of doing business, but by no means an integral part of anyone’s development plans. Many even acknowledged that the opportunity zone legislation pretty much guaranteed displacement and gentrification of existing communities. But, they concluded that’s just how it is.
It was then that it became clear to me what was wrong with this whole picture. The Opportunity Zone legislation was not just about doing “business as usual” with extra tax incentives. It was, as one CPA on a panel put it, “tax advantages on steroids” without any requirements for public benefits, whatsoever.
In my recent articles, I’ve been arguing that we should be tapping private capital instead of taxing private capital in order to address affordable housing challenges. The OZ regulations were clearly a chance to do that, except Congress flat out blew it.
Opportunities squandered
You can’t pick up a newspaper these days without reading about the affordable housing crisis or the impacts of climate change. So why were the opportunity zone regulations written without any public policy goal requirements? Why aren’t its tax benefits tied to creating affordable housing, or mitigating environmental impacts, or providing public transportation, or using green building methods, or protecting existing residents from displacement and unwanted gentrification? Or what about jobs creation, worker education and training, paying a living wage, or environmental preservation and restoration? There are also no provisions in the legislation to benefit local residents or local, community-serving businesses. And there is no consideration given to the unique challenges that smaller, local developers face.
Apparently, we are just collateral damage.
If we’re going to give the investment banking / development community what one tax expert on a panel called “the biggest tax benefits in recent U.S. history,” don’t we want the outcomes to be tied to the biggest socioeconomic challenges we face? Why just give it all away?
How else are we going to pay to mitigate the impacts of this new development – with drinking water taxes like our new Governor wants to do?
At present, none of these issues are addressed in the OZ regulations. And that’s a tragedy, because it would have been relatively easy to create a point scale system, whereby the more public benefits a development provided the greater the tax benefits the investor would receive. We had a golden opportunity to address a long list of public policy goals, which has been squandered for no purpose other than to enhance private profits.
When are we going to stop giving away the store in the misguided belief that “the market” will solve everything on its own?
It won’t.
Worse still, we have the attention of some of the best and brightest problem solvers in the financial industry, and we’ve wasted that once in a lifetime opportunity. If there’s any way to make a buck doing the right thing, I’m confident this group would find it. But they need the guidance of well-crafted tax law to do it.
The shortcomings of the OZ tax scheme
The list of what is wrong with the OZ legislation is long, but here are a few examples.
Maps are dumb
The opportunity zone incentives are based on maps of every parcel in the entire country. These “top down” maps were drawn by bureaucrats in Washington DC and Sacramento, sitting around looking at census statistics. The result is counter-productive, because no one in Sacramento is smart enough to look at a map from 10,000 feet and tell what is or is not a real estate investment opportunity or even more ridiculously where and what types of uses should or should not be built. It's like a form of reverse "red-lining."
Investment opportunities in communities are a fluid phenomenon that are in a constant state of change, depending on an ungainly list of things like competition, market demand, terms of purchase, local conditions, government regulatory changes, interest rates, available financing, the economy and the whims of millions of people who are not always rational actors. That is why on-the-ground brokers and developers know best what is or is not the place to build this or that type of use at any given time. That is why if given specific incentives to develop specific types of uses (such as affordable housing), they will be best at figuring out exactly how to do that profitably.
For example, in a number of Bay Area cities that I’ve studied, the opportunity zone maps only identify only single family zoned neighborhoods as opportunity zones. But areas with existing multifamily zoning nearby are not included. Dumber still, adjacent commercially zoned areas (where mixed-use would likely be preferable and potential jobs could be created right next to existing housing) are not included either.
Looking at the maps, one has to ask what genius made these decisions.
“Opportunity investments” not “Opportunity Zones”
The “market” knows how to efficiently allocate capital and maximize return better than bureaucrats and planners, regardless of what type of development is allowed. We should have legislation that lets them do that. However, if we want to solve our current socioeconomic challenges, the gift of tax deferral and forgiveness needs to be tied directly to development of things we need, such as affordable housing and using green building methods, or mitigations against community destroying gentrification and the wholesale displacement of the residents of low income communities.
The OZ legislation fails to do that.
The OZ legislation ensures gentrification, displacement and concentration of poverty
Because the Opportunity Zone maps intentionally outline parcels in low income census tracts, but include no affordable housing or other public benefit requirements, they absolutely guarantee that if housing is built in those areas, it will be luxury housing and result in displacement and gentrification. Or if any affordable housing is built – to be in compliance with local in-lieu requirements -- the OZ approach absolutely ensures that low income people will remain concentrated in existing low income neighborhoods, contradicting the stated public policy goal of providing affordable housing throughout the SF Bay Area.
For example, Marin County has almost no opportunity zone areas identified, because we are not a low income census tract. That’s really dumb and proof why maps are dumb to begin with. So as written, the Opportunity Zone legislation ensures the status quo. It guarantees that no investor will have any incentive to build affordable housing in Marin, which is precisely where we want and need it to be built.
If our goal is to have affordable housing built in every community throughout the region, then there have to be incentives to make that happen... everywhere.
The OZ legislation offers nothing to small entrepreneurs and local developers
One thing that became abundantly clear at the OZ event was that the Opportunity Zone rules are complex. As such, the “opportunities” are largely inaccessible for the average local developer. It’s not that the law excludes anyone from taking advantage of its benefits and it is likely that some of these benefits will prove valuable to smaller development projects once all the technical regulations are released. But the price of admission will be steep.
The panelists strongly advised that anyone considering entering this investment landscape needs to hire the best possible legal and tax advice money can buy, because there are so many uncertainties. The panelists also readily admitted that the regulations favor the biggest and best funded development and investment banking / fund advisor interests, who can afford appropriate legal representation.
So, how would a small to mid-sized developer or an agency in a small city stand a chance of getting in this game without the benefit of a high-priced Washington DC-based law firm essentially lobbying for them.
Scrape and built is favored?
It appears that the legislation is written to heavily favor “scrape and build” development projects, which it refers to as “substantial improvement.” And because the OZ legislation includes onerous time period provisions within which an investor must invest and actual construction must begin (a maximum of 30 months for everything including receiving entitlements), it seems the law is mostly targeted to fund “shovel ready” projects at a large scale.
Most small to mid-sized developers need considerable time to put their deal and financing together, while major funding aggregators are building up war chests from their major clients to be ready to fund projects on short notice.
Some panelists also suggested that in some instances an IRS private letter ruling might be required to green-light a project, which assumes that a small developer could afford that kind of high-priced legal counsel.
Investment benefits only go to those who have capital gains to defer
It’s pretty clear that beneficiaries of the OZ legislation will be predominately the very wealthy, because the only kind of capital that qualifies for the tax benefits is unrealized capital gains. Anyone wanting to just invest cash in an affordable housing project, for example, does not qualify for the tax benefits (I consider this a major flaw, particularly as it relates to smaller projects that are more difficult to finance).
The OZ legislation works well for large asset management and investment advisory firms, who are amassing pools of capital, but how many small developers or small city agencies know individuals who have a few million in unrealized capital gains lying around, to invest? Probably very few, which is a problem, because there’s little chance that any of the funds aggregating billions of investment dollars will even look at a project for a 25 unit apartment building or anything that is not of institutional size (150 units or more).
I assume this is all well and good for MTC and the corporate interests that brought us the CASA Housing Compact, but once again, this does next to nothing to increase the capital available for smaller, infill affordable housing development that we so desperately need.
Legislation gone wild?
The whole thing is just upside down. My guess is that 90% of all the tax benefits will go to the very top and 90% of the impacts will be unnecessarily borne by everyone else. The OZ legislation is business as usual and offers little to help us solve our affordable housing challenges from the ground up, in a community-serving and environmentally sustainable way.
Because this tax giveaway fails to create a nexus between market forces and public policy goals, it all but guarantees that the rich will get richer, extracting wealth out of our communities, while the rest of us will pay the costs of the impacts by way of increased taxes and fees and penalties that will be needed to fund those same unfulfilled public policy goals.
Some will argue with this... something about the importance of letting "animal spirits" run free, or whatever. But my bet is that our short-term and often too-clever schemes need start considering the bigger picture if there is any hope of preserving our liberal democratic institutions in the future.
Bob Silvestri is a Mill Valley resident and the founder and president of Community Venture Partners, a 501(c)(3) nonprofit community organization funded only by individuals in Marin and the San Francisco Bay Area.